Tuesday, March 31, 2009

How Marketing Feeds the Boom-and-Bust Cycle

It wasn’t so hard to sell people a newspaper every day a generation ago when the price was between 10 and 25 cents. Now that the price is more like a dollar, it’s a tougher sell. Large numbers of people still buy the newspaper, but not as often — perhaps just once a month instead of every day.

And therein lies the failing of one of the most trite ideas in marketing, an idea so pervasive in current management thinking that it often goes without saying. It is, after all, a very simple idea. If business revenue depends on the number of customers, the frequency with which customers buy, and the price they pay, then the way to make a fortune in business ought to be to sell a big-ticket item to a large number of repeat customers.

It makes sense, right? Do everything you can to increase the number of customers, the price they pay, and the number of times they buy, and watch your revenue go up and up. But while this approach may work in the short run, it does not work in the long run. And when you look at what has happened to newspapers, you can see why.

The more your customers pay, the greater the incentive they have to find alternatives. Then, if your competitors don’t take your customers away, some customers will find a way to bypass your industry entirely.

With this dynamic, the most successful marketing strategies will tend to lead to a boom, as more customers buy more often at higher and higher prices, followed by a bust, as customers notice how much they’ve been spending and seek out alternatives.

Worse, the bust tends not to happen until customers get squeezed financially and are forced to cut back. We saw newspaper revenue hang on remarkably well, in spite of the industry’s obvious problems, until about two years ago. Then it declined rapidly, and the decline in newspapers is adding momentum to the recession.

The same thing is happening, of course, in automobiles. That industry did remarkably well over the past half century at increasing its customer base, frequency of purchases, and prices. Most impressive was the way it kept a large number of its customers on a three-year replacement cycle even as the improved reliability of the product made that unnecessary. When that pattern started to fall apart around 2005, the industry was in trouble. If customers move from a three-year cycle to a five-year cycle, that is a 40 percent decline in sales, which of course, is about what has happened so far. Auto dealers say a five-year cycle will be the new norm, with people replacing their five-year-old cars, but it could just as well be a 12-year cycle. It depends on what the customers decide. It is not up to the dealers, who cannot influence this pattern until the potential customers find time to visit the showroom.

Whenever you see an industry that is doing remarkably well at expanding its customer base, frequency, and price, it is fair to ask when the collapse will come. We have been asking this question about the cellular phone business for three years, and indeed, two former industry leaders, Motorola and Nokia, are being forced to cut back. But looking more broadly at the economy, what about:

  • Health care. Prices keep going up, and the industry is lobbying hard for universal coverage to expand its market reach, but are people actually getting healthier?
  • Banking. The latest refinance boom is just another reminder that this industry relies too heavily on loans to repeat customers, many of whom would really prefer not to be in debt at all.
  • Entertainment. Look at cable TV, movies, or concerts, and you can’t help but ask, “How can they keep raising their prices like that?”
  • Government and education. A sector can use its monopoly powers to postpone modernization only so long. The cracks are already starting to show.

It might seem strange to list the banks as potentially heading for a fall when many of them are in serious trouble already, but it would be foolish to dismiss the many consumers who swear they will never borrow money again as merely blowing off steam. And when the top financial experts talk about the collapse of the financial system, they are not talking about something that has already happened, but something that could happen in the next couple of years if things go badly.

Last weekend we heard this from renegade financier George Soros, who in an interview with The Times saw the G20 summit as the last chance to avoid a financial system meltdown.

The odds would favour that it fails because there are such differences of opinion. It’s difficult enough to get it right in your own country let alone with 20 governments coming together, but if it’s a failure I think then the global financial and trading system falls apart.

Soros’s prediction of a depression is probably a fair description of what will happen across the financial sector, and also in automobiles, home construction, and other areas of the economy that have perhaps been a little too successful in squeezing money out of their customers in recent years. As the recession leads people to examine and adjust their spending priorities, it will create permanent realignments in economic activity.

Monday, March 30, 2009

Putting the “Plan” Back in Planning

Maybe it’s a sign of what Washington has become. People promise plans, then deliver documents that don’t have any kind of plan in them, and think they can get away with it.

Last week, it was the House Republicans, putting out a 19-page pamphlet that barely mentioned the budget and calling it a “budget plan.” When they were quite properly taken to task for that deception, you would think General Motors and Chrysler would know what was coming to them. Both companies had promised turnaround plans as a condition of their emergency loans, but when it came time to deliver, had nothing to offer. General Motors apparently did not start on theirs until the weekend before the deadline, and offered, an hour late, a vague document with no “turnaround” and precious little “plan” in it. Chrysler’s “plan” was even more superficial. At the time, I assumed that General Motors and Chrysler would be rushing to get their real plans to Washington over the next couple of weeks, but from what I am hearing, they never did anything of the kind. They turned in “F” papers and sat back and waited, hoping the professor would return them marked with the “B+” they needed.

Backed into a corner, Obama did the only thing he could do: offered an extension (60 days for General Motors, 30 for Chrysler) in the hope that the two companies would try harder knowing that this was really their last chance. But it should not have been necessary. The executives of these companies had two months to come up with business plans and effectively another month to remedy any defects in the plans. The skeleton of a business plan, the back-of-the-envelope version, takes only about a day to do, but they did not even do that. And I am sure it is not that they did not know how, but that they did not believe it was really necessary.

I am not quite sure how Washington turned into a place where you can promise a plan, deliver a token document with no plan in it, and expect to be taken seriously, but I hope that these stories are an indication that that is now changing.

Sunday, March 29, 2009

Ford Gets Its Bailout From Car Buyers

It is one of the great economic ironies. Ford has spent the last two years shrinking as fast as it could. The result? It is rapidly gaining market share. Meanwhile, customers are deserting the competitors that tried the hardest to expand in 2007 and 2008.

A Los Angeles Times story today suggests that the shifting market is because of the ongoing public relations disaster related to the federal bailout at General Motors and Chrysler:

A survey released this month by polling firm Rasmussen Reports found that 88% of Americans would prefer not to buy a car from an automaker receiving government aid. That’s worse than the 63% who said they would eschew buying from a bankrupt car company.

The bailout boycott is surely a part of what’s going on, but I believe it’s only a small part. There is also a positive reason for the shift to Ford. People believe that by buying a vehicle from Ford, they are contributing to the company’s survival. Ford encouraged this kind of thinking when it turned down bailout money and said that the sales revenue from the vehicles it sold would be enough for it to survive. In essence, Ford said that its bailout would come from car buyers. This positioning lets Ford customers buy into a survival story.

It’s the American way to root for underdogs, winners, and people who work hard. Right now, the way the public sees it, Ford is all of these. When people are choosing a new car, why wouldn’t they choose one that comes with a story like that?

Saturday, March 28, 2009

The Republican Road to Minor-Party Status

The House Republican leadership is being mocked from all quarters for their new “budget proposal,” and rightly so. “The Republican Road to Recovery” is not a budget plan at all, but a 19-page political pamphlet that consists of little more than a rant against the various proposals for economic recovery and health care reform. The 29 short paragraphs that come under the heading “Republicans’ Solution” don’t offer any solutions at all for the budget. The few legitimate proposals they do offer — expanded oil drilling off the coast of Alaska and the Carolinas, windmills in the middle of the ocean, more coal plants, winding down Fannie Mae and Freddie Mac, and national licenses for health insurers — don’t really belong in the budget process, and offer the sort of minor tinkering that people undertake when they are trying to avoid the real issues. The many bubble charts included are the kind of empty filler you put in your high school term paper in the vain hope that your teacher won’t notice that you didn’t really write anything. The pamphlet as a whole does nothing but reinforce the popular perception that the Republicans don’t care about solutions because they don’t expect to be in a position of any real responsibility. In short, it’s the kind of document you expect from a political party trying to make the jump from 0.1 percent support to 1 percent support so they can be sure they’ll be included in the third-party debates. And that is the kind of position the Republicans in Washington could find themselves in if they don’t eventually decide to go back to work.

Fun facts about “The Republican Road to Recovery”:

  • Total length: 19 pages. Net length, excluding front and back cover, 2-page cover letter, and three nearly empty chapter pages: 12 pages.
  • Number of graphs that estimate the financial effects of an early version of the Democratic budget proposal: 3. Number of graphs that explain the Republican proposal: 0.
  • Number of signatures: 10. Number of House members attempting to explain it to the press at the press conference on Thursday: 1.
  • Quotes from Barack Obama: 2. Quotes from Republicans: 0. Quotes from other U.S. citizens: 1. Quotes from U.K. citizens: 2.
  • The only budgetary number included in the “Republicans’ Solution”: $3,128, an estimate of the annual cost per household of a proposed energy tax.

Friday, March 27, 2009

This Week in Bank Failures

Wall Street is getting mad. An AIG senior manager resigned very publicly on the editorial page of the New York Times this week, pointing fingers at both AIG executives and Washington politicians. Bank CEOs have started to issue veiled threats directed at Washington in their public statements. A parade of large banks have said they no longer want the bailout money they got last fall, and plan to return it. Yet the threats are empty and the anger is more an expression of frustration than a preparation to go to battle. Wall Street has scarcely any ammunition left. Some of the Treasury money that banks say they are giving back cannot be returned until the banks earn their way out of the hole they are in, and that might not happen. Banks want to return the money because they are not using it to make loans, yet making so few loans, it is hard for them to make the profit they need to make so they can pay the money back.

The strategy of the largest banks seems to be to wait out the recession and then go back to business as usual. It is not exactly a business plan. The recession is not likely to end until the economy has shrunk another 5 percent or so, and the banking sector could be absorbing most of that decline, coming out, by some estimates, 30 percent smaller than it was at the peak of the bubble three years ago. If that is true, the rest of the economy may start to turn around 6 months from now, but the banks and closely related businesses may continue to decline for another 5 years.

The banks that are hurting the most now are those that competed most aggressively for real estate and consumer loans in 2005 and 2006. Perhaps the biggest temptation for banks in 2009 is to view the current turmoil as an opportunity to grab market share. Banks that think they can expand their footprint now and get their operations under control later may find themselves repeating the mistakes of MCI and AOL, the champions of customer acquisition when you look at the last 20 years, but companies that saw their hard-fought market positions evaporate when they couldn’t deliver.

You don’t have to look very far to find examples of bank operations that are out of control. In a bizarre story that came out this morning, Wachovia, a failed bank now owned by Wells Fargo, apparently was trying to use a preemptive foreclosure to force a borrower to accept changes in the terms of a loan. That is the way the court saw it, at any rate. The court not only issued an injunction preventing Wachovia from proceeding with the foreclosure, but will be holding a hearing to determine whether Wachovia is entitled to any of the cancellation fee it claims it is owed on the loan.

There is a legal basis for the idea of a preemptive foreclosure. If a lender can prove that a borrower will not be able to repay a loan, it might be able to initiate foreclosure proceedings even though all loan payments so far have been made on time. It is nevertheless a terrible idea, and it must have taken several layers of management failures at Wachovia to let a story like this reach the point where people can say to each other, “They made all the payments on time, and the bank still tried to foreclose!”

This kind of story is bad for business. The perception that it is no longer safe to borrow from banks already has consumers paying off their loans. The Federal Reserve calculates the household debt service ratio (DSR) as the percent of income taken up by required debt payments. DSR peaked at 14.29 percent in 2006 and 2007, then fell to 13.90 percent by the end of 2008. It may be falling faster this year, as the savings rate has jumped up from near zero in recent years to 4 percent this year. That’s a savings rate large enough to cut total household debt by about 10 percent a year. DSR could easily fall back to the 11 percent level of the 1980s, or below, and if banks try to replace the lost income by raising consumer interest rates further, it could fall even more.

When banks get a smaller share of income, it means the banks have to be smaller. This is the kind of shift that has people projecting a banking industry shrinking by 30 percent.

You might think bank failures could provide a way for the banks to shrink, but so far, most failed banks have been taken over by other banks, providing no immediate change in the size or capacity of the industry as a whole. Tonight’s failure, though, is an exception.

Omni National Bank, a billion-dollar bank based in Atlanta with 6 offices in 4 states, was closed tonight, and when its offices reopen on Monday, it is only to let people take their money out in an orderly fashion. In Houston and Dallas, Texas, Omni National Bank used the name OFSI National Bank. SunTrust Bank, a large regional bank also based in Atlanta, is taking custody of Omni National Bank’s offices and deposits.

Unlike other recent bank closings, SunTrust is not assuming the failed bank’s deposits, but instead is acting as an agent of the FDIC to operate the failed bank for one month to give depositors time to withdraw their deposits. Customers can access their accounts, make deposits, and receive direct deposits starting probably on Monday and continuing until April 27, but they should make arrangements next week to open accounts at other banks.

Omni National Bank specialized in loans for urban redevelopment, and that can become a tough business in a time when no town is a boomtown. At the end of last year, a third of the bank’s $600 million in loans were considered nonperforming. Its holding company was placed under financial oversight by the Fed last week because of concerns about its capital levels. The Office of the Comptroller of the Currency (OCC) ordered the bank closed today after finding that its capital and earnings were rapidly disappearing.

The FDIC is projecting a cost of $290 million from the Omni National Bank failure. Omni National Bank is the largest of three banks to fail in Georgia this month and is the most expensive bank failure for the FDIC so far this year.

Thursday, March 26, 2009

Ain’t Much But It’s Home: The New Hoovervilles

The cover photo on today’s New York Times was a tent city. It accompanied a story on the new Hoovervilles. When you look at the photo, and other photos that can be seen on the web site, you might imagine that you’re looking at the people who arrived early for a big music festival. The story is not as happy when you learn that the tents are occupied by people who have no other homes, many of them recently evicted from their houses. They have nowhere better to go. There is little good one can say about the situation beyond, “Well, at least they have high-quality tents.”

Camping out is better than trying to make a home out of a crate, a scene seen too often in 1930 and 1931 — but not much better. It is hard to avoid the term “Hooverville” from that era. The tent cities of this spring might be more colorful and modern-looking, but the essential problem is the same: people living the best they can when, for economic reasons, they don’t have access to a building.

There is something about this situation that doesn’t quite make sense, though. The United States is experiencing record rates of foreclosures and evictions at the same time that there is a record amount of vacant housing. According to one estimate, U.S. suburbs have so many extra houses that they cannot be filled for at least 12 years. Meanwhile, builders keep building more, albeit at a slower pace. Some urban centers also have high levels of vacant housing, but others are getting squeezed as more workers, weary of the cost of commuting, move from the suburbs into the city.

With so many vacant houses, and so many people without housing, you would think there would be a way to put the two together. That won’t happen quickly, though, and that failing is an excellent example of the kind of economic dysfunction that causes depressions. Depressions occur when people’s experience leads them in the wrong direction, so that their actions no longer connect to any economic benefit.

A TV pundit this month described foreclosure as a beneficial process in which you get the people who cannot afford a house out so that other people who can afford the house can move in. But that’s a description based on an experience from three or more years ago; it does not fit what is going on now. When people are evicted from their houses this month, in many cases, it will be so that the houses can sit vacant for five years or longer until a buyer, or at least a tenant, can be found.

Foreclosure may be mostly paperwork, but it is still hard work, and when businesses go through that kind of work and don’t get the financial benefit they were hoping for, it is hard to keep the economy rolling. It’s like having a cell phone conversation and hearing only every third word — it’s a lot harder to keep the conversation going when things aren’t connecting.

So what needs to be connected for the economy to work? It starts with people expressing themselves. That’s the starting point for the economy because it’s something people do no matter what is going on. When people have a way to express themselves that involves action, and that action creates a social benefit and a financial reward, that’s a cycle that can’t be stopped. The economy depends on the connections between expression, action, benefit, and reward. To build a better economy, we need to make more of those connections.

Wednesday, March 25, 2009

Not the Same Situation: Just Ask Students

The situation comedy form has affected U.S. culture in a way that has not been widely recognized. The fact is, half of us are still walking around in a situation comedy trance, believing that nothing ever really changes from week to week. Situation comedy thinking colors the popular views of:

  • The Republican Party. It’s swimming against huge demographic and cultural trends and flirting with minor-party status, yet pundits insist the “political pendulum” could bring the Republicans back into power as soon as next year.
  • Style. Style watchers continue to try to catch the newest style trend, ignoring the fact that only a couple of fashion trends have caught on with the public in the last decade, and the latest trend has people not buying new clothes.
  • Television. The situation comedy genre all but disappeared from the TV schedule more than ten years ago, but many people still haven’t noticed the change or don’t think of it as a permanent change.

Situation comedy thinking affects the popular view of the economy too. It helps to explain the popularity of The Great Depression Ahead, a book that invites people to look at an 81-year economic cycle and imagine that the events of 81 years are happening all over again. Just like a situation comedy, nothing ever really changes. Yet people who miss the changes, the fundamental differences between 1929 and 2010, may not see the chance to avoid the looming depression.

There is, however, a group of people who can easily see how much things have changed. They do not automatically think of the present as a continuation of the past, because they see fundamental change happening on a daily basis. How do they see what the rest of us are missing? They are not subject to the situation comedy trance. This group consists mostly of students. If you take a survey of U.S. adults and ask the questions a certain way, you can get more than half to agree that a repeat of the Great Depression is likely. But ask a typical group of college students if they think the economic situation coming up in 2010 will be fundamentally the same as 1929, and they’ll look at you like you’re nuts. Or they’ll assume it is some kind of trick question.

It is not because they are students, or young, or idealistic, or any of the clich├ęs I have heard repeated over the years, that they see the situation differently. It is because they have not had widespread exposure to situation comedy television programs. The situation comedy gave way to reality shows and procedural dramas around 1997, so those who were 11 years old or younger at the time, born after about 1986, did not have much of a chance to absorb situation comedy thinking directly from the TV tube. They still could have heard it secondhand, but that’s not the same thing.

Without that cultural backdrop to color your thinking, it is impossible to see the world as essentially unchanged from week to week even as momentous changes occur all around you. That’s why, when we collect ideas on how to solve the current economic problems, it is essential to get the thoughts of people born after 1986. And if you are one of the people born after 1986, you need to realize that there is a sort of “mass insanity” that prevents most people born before 1986 from seeing the changes that occur from week to week as having any fundamental significance. When you see possibilities and wonder why people born before 1986 aren’t taking action on them, it could just be that they are not seeing what you are seeing.

Monday, March 23, 2009

Who Can Rescue the Economy?

The U.S. economy has never had 10 million high-skill, high-performance workers only fractionally employed, and that is what is about to happen. It is not that they will be forced out of the job market or out of business, but they will be forced to make compromises, and many will choose to spend less time on the job.

This group also holds the best chance of rescuing the economy from a depression.

Of course, if you are a talented person who just can’t get any breaks, is barely scraping by, and would risk getting laughed out of a bank if you asked for a loan to start a new business, it surely sounds strange to hear that you’re the one who can rescue the economy. As strange as it sounds, though, it just might work.

It has to work. To begin with, there is no one else. Others are working overtime trying to rescue the businesses they work for. Whether they succeed or fail in the end, the effort of trying to prop up a faltering institution is sure to leave them exhausted and ill-prepared to take on any new challenges. And Washington? Same story there. If politicians can figure out a way to keep the government out of bankruptcy, that is enough of an accomplishment. At the same time, there are also people who are really not getting by — too worried about their own situation to look at the bigger picture. Let’s face it, if you had to spend the day figuring out how to build a shelter out of cardboard boxes, you might not end up doing too much more than that. When you look for answers along this continuum, underemployed and barely scraping by is the most powerful place to be.

And if that’s not reason enough, there is your own economic security to think about. When you aren’t in a position to profit from a downturn, and you can’t build financial strength by saving your excess income because you’re not making that much income. But you can get a head start on whatever you might do in the future. Anything at all you can do at this point to prepare yourself will tend to boost your future production and income. And your actions in getting ready for your future work in better economic times are part of what will create those better times. So, in a sense, being partially employed now lets you get a head start on the coming boom.

It scarcely matters specifically what you do to prepare, as long as you are solving problems or investing in yourself. Many people, those with the money to pay for it, are going back to school to get master’s degrees. When you get right down to it, studying anything that interests you and is of value to society makes you better prepared to produce something of value. On the other hand, just making yourself more healthy also has that effect. If you smoke or are a little overweight, you will never find a better time to get fit and develop healthy habits. Remaking your lifestyle is a tough thing to do when you’re working overtime, but becomes much easier when you have extra time to dedicate to it.

What else can you do if you find yourself with more time on your hands than you are used to? If you have a backlog of things to do, perhaps some things to fix around the house, get them done now. This is something I write about in my book Fear of Nothing and from time to time in the Fear of Nothing blog. I also write about the need to eliminate clutter, and if you are less than fully employed, you might sell some of your excess possessions that in busier times might not be worth the time to sell.

If you are not so worried about how you will make money, there is no end of useful things you can do. Depending on your skills and interests, you might contribute to an open-source software project or create your own secret software product that you will spring on the world a few years from now, after you finish it. You might clean up all the litter in the neighborhood or teach people how to read. If there is something you like to do, you might learn how to teach it so other people can do it too.

Some people with unexpected free time are forming bands, making movies, writing novels and blogs, and training for marathons. Anything like this creates a basic vitality that adds to the strength of the economy.

An especially valuable thing you could do is come up with a solution to one of the economy’s problems. By this, I don’t necessarily mean solving the banking crisis, but just finding any way to make something better or more efficient. If you can design a more efficient grocery bag or a faster way to wash a car, those are the kinds of innovations that help bring a depression to an end. And when you just learn or try out other people’s innovations — maybe something as simple as working out how to scan your files instead of keeping a file cabinet — this helps to speed the process along.

Whatever you decide to do, proceed as if today is the day. You never know how long a recession will last, and if you are counting on a slow economy to give you the time to accomplish something, you need to seize the moment as soon as it arrives. Imagine you’re one of the people who decide it’s time to get a master’s degree. It takes many people four years to get a master’s degree while they’re working part-time. Four years from now, will the economic expansion be just getting started — or will it be well underway, and will you have missed the chance to get in on the ground floor in an up-and-coming company in your field? You can’t say at this point what will happen, so you are better off being ready as soon as you can be — and then doing more to be even more ready. Whatever tasks you choose for yourself, there is a chance that time will run out. If you decide to fix up your house, then get a job offer that requires you to move and sell your house, you will surely wish you had started sooner on fixing the house. So don’t delay. Though it sometimes seems otherwise, time in an economic downturn is ultimately as valuable as time in an economic boom, so make the best use of it that you think of.

The best thing about this is that all the actions of the people who decide to get a head start on the coming economic boom will be what creates the economic boom. A boom happens because there a high level of economic activity. The things you do now to get a head start on the boom will make the boom happen that much sooner.

Don’t Think of It As a Depression, Think of It As Designing a Lifestyle

The 4-Hour Workweek suggests ways to streamline your life and your work so that you work just 4 hours a week instead of the conventional 40 hours a week. Tim Ferriss did not write his book with an eye toward changing the economy, but it is changing the economy. When individual workers decide to work less and produce less, it reduces the total amount of economic activity. If just 10 percent of workers followed Ferriss’s example, it could reduce the economic aggregates enough that economists would call it a depression. But it wouldn’t really be a depression. It would just be a lifestyle change.

Economists mostly use GDP, gross domestic product, as a proxy for economic activity, and the conventional thought has always been, as long as GDP has been recorded, that more is better, but that is not always true. Case in point: a year ago, motor fuel prices were shooting upward, boosting GDP numbers. It led some economists to say the economy was booming, when in reality, the high prices at the gasoline pump were not an economic benefit, but were part of the reason the economy was falling into a recession. Later in the year, when fuel prices fell, GDP showed a disastrous decline. In fact, though, the falling fuel prices were good news.

In the same way, if you hate your job and decide to work fewer hours, that might improve your life, but to those who look just at GDP, it looks like a problem.

The timing of what goes into GDP also distorts its view of the economy. If I spend two years writing a book, I don’t appear in GDP at all during those two years. I’m no different from someone who isn’t working at all. If I then publish the book and go off on an extended vacation while I collect the royalties, I show up in GDP as someone who is producing a great deal even though, in fact, I have stopped working.

If this happens on a large scale, the GDP numbers can show ups and downs that don’t exist in the economic activity that GDP attempts to measure.

I am sure millions of people have heard of The 4-Hour Workweek, although they haven’t had time to read it, and they’ve said to themselves, “Someday I should do that, figure out how to arrange my work and my personal expenses so that work doesn’t take over my life.” They may get their chance if the economic downturn takes away their job or most of their business. Others may not really want to work less, but will find a way to adjust to it. And so, if present trends continue, we may by the end of the year find ourselves with millions of high-skill, high-performance, partially employed workers, people who aren’t letting their reduced incomes slow them down. And as I will explain next, that is the main reason I believe the current recession will not develop into a depression, or if it does, the depression will not last for a long time.

Sunday, March 22, 2009

Maximizing Leverage?

I wrote yesterday about the difficulties of the concept of maximization as it appears in economic theory. There is an additional point of confusion about maximization that I need to mention. Depending on the theorist, the assumption of maximization may include the assumption that every institution, including every household and business, is fully leveraged, that is, that they are going all out in pursuit of the particular thing they are trying to maximize. The assumption could be that people have borrowed as much as money as would be useful for them in achieving this goal, within the limits of what they are able to borrow.

In reality, no one is going all out for very long, for the simple reason that no one is absolutely sure what they are going for all day long. As I mentioned yesterday, most of us are not particularly clear about what we are trying to accomplish, and when we feel doubt and uncertainty, our actions are more limited.

Nevertheless, the assumption that households are fully leveraged was not so far from the truth in the Great Depression. It was a desperate time, and for more than a few households, it took everything they had just to get food, clothing, and education for everyone in the house. “Took everything they had” is a phrase that indicates being fully leveraged, or going all out. The current times are similarly desperate for those households that have lost their home and all of their jobs, but that is a much smaller number of people.

What this means is that some of the economic models that helped to describe the Great Depression will not do so well in describing the current recession. In a way, going all out means lacking flexibility, having little choice about what you do. We have far more choices and possibilities now than in the 1930s, and that will still be true even if economic activity declines further.

Clothing is one example of this. Clothing is far more durable now, and in a pinch, you might get through a decade wearing the clothing you already have. True, this depends on your size not changing, and you would have to get more socks and shoes eventually, but still, the quantity and durability of clothing available now is a big improvement over what you would find in 1930.

For this and a dozen other reasons, households that lose most of their income because of the economy this year do not face the same desperation that they might have in the 1930s, and this means they have more choices, more flexibility in responding to the state of the economy. People with more flexibility means the economy as a whole has more flexibility, and with more flexibility, it is easier to find solutions to problems. This is the main reason why I believe a repeat of the Great Depression is impossible. Even if there were to be an economic downturn on the scale of the Great Depression, with economic activity falling another 24 percent, it would not be the same experience at all. People might find it bewildering, but in the Great Depression, there were businessmen in three-piece suits whose supper depended on how many pencils they could sell on the street. If a depression happened now, we could do much better than that.

Saturday, March 21, 2009

Knowing What You’re Maximizing

One of the toughest problems in economic theory has to do with the question, What do people want? One of the early answers said that no matter how much you had, you would always want something more. By the early 20th century, economists generally accepted the idea that we don’t have to know what you want, but we can assume that you want something and are organizing your life to get as much of it as possible. Later, theorists said that people really can’t maximize their lives in the short run, because that would be too complicated. Instead, people make changes in areas of their lives that are most obviously deficient in order to approximate, in the long run, the best they can do with what they want in life.

None of this, of course, answers the question about what people ultimately want. But if a precise answer to that question is not important for economic theory, it can make a difference in your individual life if you have a clear idea of what you are trying to get. Most life coaches will advise you to clarify this through a kind of goal-setting process, like you were an engineer designing your life, but it can be even more illuminating to approach this question from the opposite direction, effectively reverse-engineering your life.

To do a quick first approximation of this:

  1. Remember where you were and what you did over the last seven days.
  2. Write down five things you did each day, or tried to do, that took a considerable time, focus, or effort on your part. This gives you a list of 35 actions.
  3. For each of these things, what was the goal or motivation for your action? What were you ultimately trying to accomplish, or what was driving you?
  4. You’ll find that you have similar answers for many of the actions. Form them into groups and count the number of occurrences of the three largest groups. Looking at each of these three groups, what direction is your action taking you?

This gives you an idea of what you’re maximizing in life, based not on the goals and dreams you say you have, but on your actual recent actions. Very few people find a clean correspondence between where their actions point to and what they say their goals and dreams are.

There are two motivating factors that people often are not aware of, but that can easily eat up half of your time, focus, and effort. These are:

  1. Trying to improve on your parents’ lifestyle — living the same general kind of life, only slightly better in every way. For example, if your parents had a dog, you have a better dog.
  2. Trying to live up to what looks like peer pressure, which actually does not come from peers, but from commercial messages. For example, you feel as if you have to look “right” or go on a vacation you can brag about.

In both cases, you give up more than you realize by letting someone else — your parents or commercial advertisers — set the agenda for the way you live your life. How much do you give up when you give up control of the agenda for your life? It could be enough to make the difference between a 40-hour workweek and a 4-hour workweek. And to me, that’s what Tim Ferriss’s book The 4-Hour Workweek is really about. If you think about what you really want, you might decide that you don’t really want a dog, a house, or a full-time job. You could save seven hours a day! What will you do with all that free time?

Of course, there is always plenty to do. That’s a point on which traditional economic thinking is completely in line with common sense. You have to decide what you want to do. And if that is alien territory for you, Tim Ferriss’s blog and YouTube channel provide many colorful examples of the possibilities to get you started.

Friday, March 20, 2009

This Week in Bank Failures

Bonuses have been in the news this week, but while the discussion has focused on questions of fairness, deception, and possible securities fraud, there is a larger question. Did bonuses cause the credit bubble that led to the current crash?

Performance-related bonuses are tricky. If an employer chooses the wrong metric to calculate a bonus, the results can be disastrous. One bank failure so far this year has been specifically blamed on performance bonuses. When Silver Falls Bank in Oregon failed February 20, it happened because of a series of bad loans — loans that were issued recklessly because the loan officer was being paid a performance bonus based on the volume of loans. Similar stories have played out hundreds of companies. In the long run, workers respond to performance incentives even if their actions could destroy the company.

Banks are not supposed to pay this kind of performance bonus. Silver Falls Bank stopped doing so as soon as the FDIC found out, but it was already too late. There is no such restriction on Merrill Lynch or AIG, however, yet those companies were so closely tied to the banking system that their failures had the potential to bring down multiple banks.

It was just the size of the AIG bonuses, an a time of financial collapse at the company, the alarmed many people, but President Barack Obama was asking about the purpose of the bonuses. They seemed to be rewarding the very transactions that had ruined the company and brought the whole economy to the brink of disaster.

AIG’s involvement in the secondary market for bank loans was huge. The financial scale was larger than you previously could imagine, unless you were thinking of the galactic capital planet in science fiction such as Star Wars or Isaac Asimov’s Foundation series. How did AIG manage to issue hundreds of trillions of dollars in derivatives annually, largely backed up by real estate, when the total value of U.S. real estate at its peak was estimated to be less than $100 trillion? AIG’s bonus structure might be the answer. If AIG managers were paid bonuses based on the volume of financial instruments they issued, then it stands to reason that they would find ways to issue many times more financial instruments than would potentially be useful to anyone. And it is possible that this excess contributed to, or perhaps largely caused, the instability in the financial system.

As a preliminary step toward understanding this and related questions, I continue to believe it is important to have all outstanding derivatives contracts brought into the public eye, placed on the Internet for all to see.

As more details come out about the AIG and Merrill Lynch bonuses, one of the questions is who knew what and when. We are also examining earlier information to try to reconcile the divergent accounts of the sequence of events. Now I am not sure it was ever true that AIG’s bankruptcy had the potential to drag down the banking system as a whole. Its volume of business, on the surface, would seem to say that it did, but if many of its financial instruments were essentially duplicates, its effect would be less, and perhaps a manageable degree of government intervention could prevent any bank failures as AIG goes down. If AIG has become little more than a shell passing government money along to banks, then it would be financially more efficient to shut down AIG in the coming weeks and pass the money directly to the banks. That might be politically more difficult, but it is proper that these trillion-dollar policy decisions be made in public anyway.

And Congress appears to be taking action in that direction. Rep. Barney Frank yesterday had his staff start to draft legislation to give the government authority to seize a company like AIG when its insolvency threatens the banking system. The rules would also apply to bank holding companies such as Citigroup.

FDIC chief Sheila Bair called for “an end to ‘too big to fail’” in testimony before a Senate committee. Her recommendations included more stringent capital requirements and supervision of any bank that becomes large enough to be a threat to the economy, and rules for key institutions and assets in the banking system that are currently exempt from regulation, such as credit default swaps and AIG.

Some of these regulatory reform questions will have to wait until later this year. I hope when Congress takes up the matter, they will not make the banking system more complicated than it is already. The simple answer is to require institutions such as AIG that have a key role in the banking industry to have a banking license and to follow all the regulations that are supposed to cover the banking industry. Effective regulation of the banking system will not be possible until the various securities that are based on bank loans fall within the same regulatory framework as the bank loans themselves.

The risk inherent in bank loans does not go away no matter how you structure or package them. At one time it was thought institutional size provided some protection against these risks, but last year’s multiple large failures suggests the opposite, that a large lender may, beyond a certain threshold, become simply too large to survive an economic shock.

One of those failures, IndyMac, is history now. The FDIC sold it to a Wall Street investment group yesterday, completing a deal worked out on New Year’s Eve. Failed banks almost never keep their names, because of the worry that the association with failure will keep depositors away. The new name for IndyMac, starting today, is OneWest Bank. The OneWest investment group paid $16 billion for IndyMac assets with a book value of $20.7 billion, and is receiving partial loss protection from the FDIC.

While under FDIC ownership in the fourth quarter, IndyMac recorded a loss of $2.6 billion, as the value of California real estate declined. The FDIC estimates its total costs for the IndyMac failure at $10.7 billion. This total could go up or down as more loan losses are recorded and assets recovered.

OneWest says it will make no immediate changes other than the name, but it plans to gradually expand its retail presence and eventually open more branches.

The FDIC might have that bank off its hands, but there were three more bank failures tonight, leaving the FDIC with about $320 million in assets that it can try to sell later.

Most of those assets come from FirstCity Bank of Stockbridge, Georgia, which had $297 million in assets and $278 million in deposits. No bank was willing to take over the deposits and purchase the assets of FirstCity Bank, so the FDIC will be paying depositors about $277 million to cover the insured deposits at the bank. Most of the checks will be mailed on Monday. The failure is estimated to cost the FDIC about $100 million.

The FirstCity Bank failure keeps up the pace of about one bank failure per month in the Atlanta metro area. The story of declining real estate values and defaulting loans is the same, but the history of FirstCity is different, going back to 1905 when it was founded as Gibson Bank. FirstCity had what looked like a viable balance sheet on December 31, but it reported a loss of $8 million last year and the value of its assets continued to decline this year. FirstCity Bank had three offices within a three-mile radius in the southern suburbs of Atlanta.

In Colorado Springs, Colorado National Bank was closed. Its $83 million in deposits are being turned over to Herring Bank, which is also buying 95 percent of the assets at a 3.5 percent discount, with the FDIC providing partial loss protection on about half of the assets.

Colorado National Bank had four offices, located in Colorado Springs and the nearby towns of Peyton and Monument. Herring Bank will operate these offices starting tomorrow.

Herring Bank has 10 offices, most of them in Amarillo, Texas, about a 4-hour drive south of Colorado Springs. The Colorado National Bank acquisition gives it its first presence in Colorado.

Colorado National Bank was affiliated with Teambank of Paola, Kansas, which was also closed tonight. Teambank had 9 offices in eastern Kansas, near Kansas City, along with three in Missouri and two in Nebraska. Teambank had nearly half a billion dollars in deposits. The deposits have been turned over to Great Southern Bank, which is also buying 98 percent of the assets at a 15 percent discount, with the FDIC providing partial loss protection on most of the assets.

Great Southern Bank is a regional bank with more than 30 offices, mostly in southern Missouri. Prior to this acquisition, it had only a slight presence in the Kansas City area.

The FDIC expects losses of $98 for the closure of Teambank and $9 million for the closure of Colorado National Bank.

Credit unions are expected to largely avoid the problems facing the banking system, but that is not the case for the so-called corporate credit unions, regional financial institutions which serve credit unions and operate almost like commercial banks. Some of the corporate credit unions are said to have invested significantly in the derivatives markets and are facing liquidity problems as a result. The National Credit Union Administration (NCUA), which regulates credit unions, seized two of the corporate credit unions, U.S. Central Federal Credit Union and Western Corporate Federal Credit Union, commonly known as WesCorp. Both of these corporate credit unions will continue to operate, and according to the NCUA, the retail credit unions that are their customers should not notice any changes. The two corporate credit unions have a combined $57 billion in assets.

Thursday, March 19, 2009

Two Ideas of the Meaning of Echoes

At first glance, the key ideas of The Black Swan and The Great Depression Ahead might seem to be direct opposites. The Black Swan suggests that the most important events coming can’t be predicted, and based on that, why bother predicting anything? The Great Depression Ahead, by contrast, says that the most important forces at play in the economy are the easiest to measure and predict because they are cycles that take place over an extended period of time.

Look at it another way, though, and both books are about echoes. They both suggest that you can find meaning in echoes.

The Black Swan says that ordinary events are of no consequence because there is nothing new in them — there are echoes of originating events, or Black Swans. If you look at ordinary actions, they can point you to the original actions that you really want to find out about.

Yet The Great Depression Ahead looks at ordinary activity and ends up pointing in a different direction — looking not to the past, but to resonances. A resonance, in acoustics, is a quality of a physical shape that organizes echoes so that a specific frequency of energy is emphasized. Resonances give musical instruments their musical tones. Elsewhere, in a mechanical design, resonances may be a design flaw that makes a machine rattle in a certain way no matter what work it is doing. If ordinary economic activity consists of echoes, then those echoes form resonances that determine the shape of much of what happens in the economy.

Those resonances are the cycles that form the core of The Great Depression Ahead. The value of measuring resonances is that they remain essentially the same regardless of the source of energy. In a familiar example, you hear the same characteristic sound of an auditorium whether its walls are echoing a Shakespeare play or a string quartet. You can close your eyes and still tell what room you’re in. In the same way, all the unpredictable changes that have taken place in the economy won’t change the resonant cycles in the economy unless the whole structure that supports the resonances has been rebuilt in a different shape. Regardless of the innovations, they tend to form the same echoes.

And so, using the view of The Black Swan, you can ignore the echoes when you are trying to predict the future because the important changes come from the unpredictable Black Swans, while in The Great Depression Ahead, the Black Swans mostly don’t matter because they form the same familiar echoes and resonances, which shape the future direction of economic activity in a way that, because it moves slowly, is somewhat predictable.

In the end, both are correct. It is possible to predict the recurrence of many of the same forces that caused the Great Depression, yet that does not mean we are doomed to experience a repeat of the Great Depression. The story of the economy over the last 81 years is not merely ups and downs, but has more to do with sudden changes, or Black Swans: the eradication of polio, the cellular phone, electronic banking, urban mass transit, and so on. We might be facing the next version of the same 80-year wave that we saw in the Great Depression, but the economy is 10 times the size and has resources — material, informational, and spiritual — that we didn’t have then. Some of the economic measures are bound to echo the Great Depression in the coming decade, but it would be a mistake to imagine that the story of the next decade will be a repeat of the story of the Great Depression.

Wednesday, March 18, 2009

Spiraling Down Into the Great Depression Ahead

The Great Depression Ahead isn’t simplistic enough to say that everything goes in cycles. It does, however, suggest that the long-term economic cycles give you the best chance of long-term economic predictions.

The author, Harry S. Dent, Jr., has been tracking economic cycles for half a lifetime, and has more to say about them than you would expect from a book with a sensationalist business-cycle title. Such a book might refer just to the well-known demographic cycle, which has been widely expected to drag down the U.S. economy, the stock market, and Social Security over the next decade. The demographic cycle is big, with no clear solution at hand, but that is not the reason Dent is calling for a depression starting in 2010.

It turns out that there are several cycles due to decline between 2009 and 2012, including most of the same cycles that ushered in the Great Depression 81 years before. A return of the Great Depression? That is essentially what Dent expects.

Here is a quick look at three of the cycles Dent is looking at:

  • The 40-year Demographic Cycle, which finds different numbers of people in different age groups. This is important because people of different ages have different tendencies. Most notably, those between 20 and 70 years of age are far more likely to work than those who are younger or older.
  • The 4-year Presidential Cycle, which finds different political priorities for the economy after a presidential election than are there before the election.
  • The 29-year Commodity Cycle, a recurring boom-and-bust pattern in basic materials.

Can you really predict economic trends years in advance? Yes and no. Yes, because long-wave patterns of economic activity are easy enough to spot in the historical record, whether you are looking at the 1800s or 2008. No, for a reason I alluded to last week: the hand is quicker than the eye. That is, people who take action (presumably using their hands) can change their personal economies around in a matter of months, faster than anyone who is following long-wave economic cycles can observe. If everyone took intentional action, the long-term patterns wouldn’t determine what happens to the economy.

Yet it is safe to say that people are, in general, not responding effectively to the larger economic trends. Most businesses plan next year based on what has happened in the last two years, with scarcely any awareness of the forces that could disturb the two-year trend line they are trying to follow (or trying not to follow). You don’t need to look any farther than yesterday’s housing construction report to see this in action. Housing construction continues at half the level of a year ago, despite the bursting housing bubble and projections that say that, even if no more buildings were built, the United States is likely to have an excess of 20 to 30 million housing units by 2020. Both the collapsing bubble and the long-term trend say that anyone who builds a house now, or pays to have one built, faces an almost certain significant loss in value even before the construction is complete. Yet the construction continues. Starbucks, General Motors, and Circuit City are current examples of companies that got themselves into trouble by looking only at short-term linear trends. The two-year trend line told them to continue to expand at a time when their market was already more than saturated. Most households, sad to say, base their spending decisions on how much money is left in the bank at the end of the month. Their decisions fully incorporate only about seven weeks of experience. There aren’t many people actively trying to position themselves ahead of the trends. And that’s why the long-wave economic cycles can repeat so regularly.

I still believe a depression can be avoided, but so far, the people making the big decisions, the government policymakers and large businesses, aren’t doing anything to help. They continue to act as if the larger trends in the current economic picture aren’t there at all. If we follow their lead, while they continue not to show leadership, all we can do is follow the long-term patterns as they spiral down into another Great Depression.

Tuesday, March 17, 2009

The Black Swan and the Heap of Straw

In this post I want to explain why you can’t find a Black Swan in a heap of straw. But first I’d better explain what I’m talking about.

The idea of a Black Swan comes from the book The Black Swan by Nassim Nicholas Taleb. In The Black Swan, a Black Swan is something new that cannot be predicted from your experience. If you have only seen white swans in your life, a black swan is basically unimaginable until you go to the place where black swans live and see one, after which it is self-evident. A Black Swan (capitalized) is anything that makes this leap from unimaginable to self-evident. This happens all the time, more often than we care to admit, so why are we so often caught off guard?

I can’t answer that without explaining a little of our intuitive idea of probability. And the easiest way to do that is with a heap of straw.

Imagine a blower throwing straw toward a point on the ground. This creates a kind of pile that, in technical discussions, we call a heap. Most of the straw lands near the center, where the heap is highest, but the heap also spreads out and there is some straw that settles a good distance away from the center. If you bundle up all the straw and turn the blower on again, it will produce another heap of almost identical shape. Blow in the same amount of straw, and you can easily imagine that it is the same heap all over again. Do this a few more times, and you can predict where the straw is going to fall even before you turn the blower on.

The shape of the heap of straw is what in probability is known as a normal distribution. A normal distribution is found in nature wherever a process combines a large number of small movements that can go in any direction — just the way a single piece of straw is small and can point in any direction when it lands.

The normal distribution is also one of the simplest probability distributions, so it is the favorite of economists, statisticians, and scientists generally as they try to explain the tendencies of any group of phenomena that they have identified. In education, the normal distribution is usually called the bell curve, based on the idea that the shape it creates resembles that of a bell, and it is used by educators to justify the low achievement of large numbers of students. Someone, after all, has to be well below average — the bell curve says so. In economics, though, the normal distribution is widely used in attempts to explain practically anything economists can measure.

We look at unemployment rates, for example, and we say that they are sometimes low, sometimes high, but usually pretty close to average — the same way that the straw mostly falls close to the center of the pile.

This kind of thinking can quickly lead us astray, however, if we start to imagine that it is the nature of unemployment to line up according to the tendencies we have observed in the past. It may do so with remarkable regularity for a period of many years, only to change completely one day, so that suddenly, we are no longer able to explain it. That kind of event is the Black Swan that Taleb warns us about. The inherent difficulty in predicting the future based on your experience is that one day things will change, and you won’t be able to understand the nature of the change until after it has taken place.

If you cannot predict the future from your experience of a phenomenon, then it also follows that you cannot predict the future from data, because data is just an organized numerical way of keeping track of past experience. Any predictions based on data will be approximately right for some length of time and then will be wrong.

We are led astray because of the intellectual appeal of being able to say what is going on. It is not easy to admit that what we have learned with considerable effort over a period of time is no longer of value.

Imagine that you are very efficiently making bales of straw, one after another, and a black swan wanders in. Will your experience with the straw tell you where in the pile of straw you are likely to see the black swan? No, because the nature of the black swan is different from the nature of straw. It doesn’t follow the same rules or respond to the same forces that you expect from straw. There is no reason to imagine that the black swan will be in the pile of straw at all. And that is the nature of a Black Swan: its properties are learnable, but are not able to be learned in advance.

This, as has been repeated endlessly elsewhere, is what killed the derivatives markets. These markets were trading based on quantitative models that had been tested only over a period of five years, in extremely limited economic circumstances. Quadrillions of dollars, more money than actually exists, were put on the line based on these models. Any surprising change in the economic surroundings would be enough to bring this party to a crashing halt. The popular explanation is that the quantitative models could not adapt to falling real estate prices, an economic circumstance for which they had never been tested. Yet the derivatives market began to fall apart a year before real estate prices began to decline nationally in the United States, so the real estate prices may not have been the original cause of the failure. Regardless of the specifics, something changed in the outside world, and the quantitative models that Wall Street had come to utterly rely on blew up in short order.

What Taleb is saying, translated to the metaphor I have been employing here, is that we spend too much time studying the heap of straw when the black swan is bound to wander by and change everything before too long. Yet we cannot study the black swan until it arrives.

If we must study the normal distribution of things, we should at least be prepared to drop our “normal” expectations and take a closer look when something comes along that doesn’t fit the pattern. Yet those are the exact observations that scientists are most likely to disregard. They are treated as “outliers” and routinely excluded from statistical studies on the suspicion that they may be trying to deceive us.

I know about this because I have worked in dozens of these studies. There is no time to find out about the outliers, but the statisticians are convinced they will ruin the study, so they are simply edited out of the data, as if they never happened.

Taleb suggests the opposite: ignore observations that fit what we are expecting, and look instead at those that are surprising. Find out what makes them different. Here we may discover the next Black Swan.

What does this mean for our current economic situation? You can see how the experts who expected the current recession to follow the pattern of all recent recessions have been disappointed. Those who expect it to be a repeat of the Great Depression will also get the wrong idea. Just the fact that journalists are using the phrase, “the worst recession since the Great Depression,” tells you that this is something different, more than just a repeat.

The insistence on seeing the recession as a repeat of past recessions has led to costly policy decisions. Former Treasury Secretary Henry Paulson justified the whole Wall Street bailout to Congress based on the scenario that housing prices could begin to rise again by December. It was a laughably optimistic prediction, excused only by the possibility that Paulson had had formal training in economics and was trying to fit this recession into the textbook model of a normal recession. The prediction that the bottom is just around the corner continues to be repeated, in spite of having been wrong for two years now.

The mistake is trying to fit the recession into our comfortable, familiar pile of straw — the normal distribution we got by measuring and analyzing past recessions. Economists are, on the whole, the worst offenders because they know better than everyone else how a recession “should” behave. If we could persuade economists that the current event is not a “recession,” but instead an “unidentified financial disturbance,” they could throw their preconceptions out the window, and their forecasts would improve.

The Black Swan is getting so much attention partly because it is a bold, brilliantly conceived book with important new ideas, and partly because investors are trying to understand how an investment model can just break down one day with no warning and never work again. But it is not just investors who should be paying attention. Every mental model we use to do anything will eventually fail; everything we take for granted will someday change.

Monday, March 16, 2009

How to Close AIG’s Bankruptcy Loophole

People are understandably upset about the recent half-billion in bonuses at broke insurance giant AIG. It’s not just people with names like Bernanke, Geithner, Obama, and Frank, but also millions of people who ordinarily pay no attention to the foibles of the banking industry.

AIG has apologized for the bonuses, explaining in a letter to Treasury Secretary Tim Geithner that it was contractually obligated to pay the bonuses. As outrageous as AIG’s position is, perhaps we should thank them for sending that letter, because reading between the lines, it points to the solution to the problem.

The half-billion in bonuses AIG executives just received are nothing new, but are part of a much bigger problem. AIG is not the first company to pay out bonuses in order to have less money available to the bankruptcy court when it finally gets there. Bonuses paid out in the final days before the bankruptcy filing can potentially be retrieved by the bankruptcy court, but executives of a company like AIG, where bankruptcy is highly probable but not imminent, can pillage the company all they want in the meantime.

There is a legislative solution to this. A new law should prohibit a publicly held corporation that is losing money in a big way from paying bonuses or large executive salaries. Instead of paying those bonuses when they are due, the company should be required to defer any such payment in order to keep the money available for the bankruptcy court. Of course, not every company that starts losing money in a big way ends up in bankruptcy. If the company can turn itself around and become decisively profitable again, then it can pay the deferred bonuses and salaries — but not until then.

As a first approximation, I think this rule ought to apply to a company whose net losses since its last full year of profitability exceed the amount of profit it made in that year. The rule should require that all bonuses and executive compensation over $500,000 per year be deferred until the company has proved its profitability by earning back all its losses. It should also prohibit executive stock options for the same period of time, since that could become an enormous loophole. I believe if Congress acts quickly, it can have a law in place before the next time AIG feels compelled to pay bonuses, potentially saving taxpayers another half a billion dollars.

And the half-billion that AIG just paid out? A bankruptcy judge might be able to retrieve that bonus money — if AIG goes into bankruptcy in the next few days. And I believe that can be done. With all the money that the Treasury has put into AIG, I believe the Treasury Secretary has the legal standing to go into court and file papers to put AIG into involuntary bankruptcy. Perhaps we can petition Geithner to do that. It’s true that shutting down AIG will have horrendous repercussions. But remember how upset people were to learn how AIG had spent half a billion dollars in taxpayer money. How much more upset will they be when they realize that AIG is burning through approximately that amount of taxpayer money every day, with no end in sight? The fact is, there is no possibility of a happy ending to the AIG story. It is already horrendous, and getting worse by the day. And so, perhaps now is the time to pull the plug and stop the bleeding.

Sunday, March 15, 2009

3 Best-Sellers

Three current bestselling books in the Business/Investing category have important things to say about economics. They say even more when you put their ideas together.

The three books I am looking at, and their key economic ideas, are:

The Great Depression Ahead. Everything in the economy goes in cycles, and looking at these cycles gives you the best chance of long-term economic forecasting. Unfortunately, the forecast is for a depression that starts in 2010 and lasts at least a decade.

The Black Swan. You eventually get in trouble if you use experience or data to predict future events. The momentous events are the ones you can’t predict at all.

The 4-Hour Workweek. The purpose of life is not to maximize your profits, but to maximize your life. Start thinking of ways to shrink your business, cut your living costs, and maximize your free time, and you discover a world of mostly unexplored lifestyle possibilities.

When I put these three ideas together with what is going on this year, I discovered who it will take to lead the economy out of its current recession (or the coming depression, if the forecast in The Great Depression Ahead is correct). The most important people will not be business or political leaders, but will be people who find themselves only partially employed because of the economy. These are the people who are preparing to turn the world upside down in the coming years, though most will not realize that is what they are doing. I came to this conclusion instantly as soon as I put these three books together. It is a process that I am convinced has already begun. I have started to write out the logical connections that brought me to this conclusion. I thought I might post that today, but it is far too much to get through in one day. Over the next few days I will explain some essential background ideas and draw out the logical connections for you.

Saturday, March 14, 2009

Untie Your Inner Octopus

The human physical form is more flexible than most other animals, and it is flexible for a particular purpose. The human abilities to wriggle, twist, scratch, and slap let us use our flexibility to defend our own skin.

Humans don’t need scales or fur to cover our bodies mainly because we have hands. If you have the normal flexibility of a human, you can reach every spot on the surface of your body with your hands. You can use this ability to wash yourself off in the shower, and in the same way, you can defend your skin from insects in a way that few other animals can.

Just the ability to access essentially the full area of your skin is a trait only a few animals can match. The cat, octopus, opossum, and a few others have a similar ability to change shape, but none quite match what a human can do.

We tend to take hands for granted, but if you take a fresh look at your hands, what makes them so useful is not just their strength, but their ability to take on so many shapes at will, combined with the arms’ ability to position the hands almost anywhere. The shapes and movements a hand can create are more than words can describe. It takes a whole book to catalog all the hand positions I use — just to play guitar!

Hands may be the fastest part of the body, but almost the whole human body has this kind of flexibility built into it. The neck bends from side to side not just to give you a different point of view, but also so you can duck quickly out of the way of a moving object. You can twist and squirm to get untangled or to avoid a collision with something near the middle of your body. You can squat, stand, crouch, stand, or stretch to change the length of your body. And I could go on and on describing how easily the human body changes shape, in comparison to most animals.

In spite of the innate human ability to change shape, more than half of adults are walking around showing about as much flexibility as a crocodile: shoulders rigid, legs moving only a little and only directly forward, no core body movement at all except when bending to sit in a chair. Much of the clothing of “polite society” severely restricts arm and leg movements. It is, of course, still possible to look dignified while moving slowly and stiffly, using a limited range of movement, but it is not possible to look healthy, suave, sexy, influential, or magical without showing some of the distinctive flexibility of the human form. Nor can you get much done in a material sense without flexibility of movement. Anyone who teaches adults any form of dance has to go to considerable trouble just to get her students to loosen up.

In my opinion, it is a fear of the magical implications of flexibility that lead people to leave their flexibility behind when they become adults. They are afraid that if they allow themselves the flexibility that humans naturally possess, they will embarrass themselves by doing something magical and disruptive. Yet, by the time we are 26 years old, most of us wouldn’t mind having lives that were a little more magical and disruptive — more changeable than they are.

Change your shape, change your life. A human with arms and legs that move only a little and an abdomen that has lost the ability to bend and twist is like a octopus that has tied itself in knots. This is something that only seems to happen to adults. Look at children and you will see a much more natural representation of the shapes of the human body.

If you have become a rigid adult with a regimented life, that can all change. Untie your inner octopus and rediscover how flexible your body, and your life, can be. There is no secret to regaining flexibility. Just act as if you can smoothly and gracefully take on any shape at all. Do this for ten seconds, one minute, five minutes. Bit by bit, the attitude of flexibility will begin to reflect itself in your physical form.

Rediscovering your flexibility means embracing your humanity. Flexibility is one of the special qualities of the human form, and when you experience this flexibility on a daily basis, it is a way of saying, “I am proud to be human — I am proud to be me.” At the same time, flexibility will make you feel more confident. This makes sense when you remember that as a human, you depend on flexibility to defend yourself. With more flexibility, you feel less vulnerable, and it is easier to simply go where you are going and do what you are doing.

Friday, March 13, 2009

This Week in Bank Failures

Banks and cardholders alike are canceling credit card accounts. The Wall Street Journal estimates $5 trillion in total credit card lines of credit in the United States, after that total was reduced by $500 billion in the fourth quarter. Most of the reduction must come from banks closing inactive accounts, but there is more going on than that.

The major banks are seemingly conspiring to raise the default interest rate on credit cards to 30 percent, and the prospect of possibly paying 30 percent interest, along with other, more onerous changes in terms, is leading cardholders to cancel accounts in large numbers. As one cardholder described the process to me, “It’s like the bank is saying, ‘We don’t want you around here.’”

Banks are cutting back on credit cards to reduce their exposure to the now-risky U.S. consumer and small business. The effect, though, is to reduce liquidity across the whole economy. People can’t spend as much because they don’t have as much money available, or because of the tremendous financial risk that a late payment on a credit card now implies. The ironic result of this is to increase the rate of defaults on home mortgages and business loans. With less liquidity, even a small disaster, such as a car breaking down, can result in a late loan payment.

With less liquidity, people have to cut back on their spending, and that is probably the main reason why the U.S. savings rate suddenly shot up to 5 percent after hovering near zero for a generation. “Savings” could mean putting money in the bank, but in this situation refers mainly to people paying down loans while not taking out new loans.

It is not that people have suddenly become savers, but that banks have suddenly stopped lending. The Wall Street bailout, which was supposed to spur new lending, has had the opposite effect. Banks are lending less and relying more on government handouts.

At the same time that banks have lost trust in consumers and businesses, people have lost trust in the banks. With so many stories of borrowers seemingly being cheated by banks, people are reluctant to put enough trust in a bank to take out a loan. The shock value of some of the new credit card terms is adding to the atmosphere of mistrust. People who had never before thought to question a bank are now doing so after feeling insulted or put off by unexplained changes in their accounts. And so, if banks were to change their minds and decide to start lending again, it is not as if consumers would be lining up at their doors. The large level of debt that most households and businesses have taken on will have to be paid down to a much lower level before people start feeling comfortable again.

Banks, of course, are happy to have borrowers pay back loans, but when that becomes a national obsession, it is not good news for banks. Lending is the core of the banking business, and if there is no nearly so much lending to be done, then there is not so much banking to be done. Some banks are set up to make a small profit from their other operations, but others are deeply dependent on lending to make a profit.

And banks need to start making a substantial profit again to dig themselves out of the various financial holes they have dug themselves into. Any bank that received Wall Street bailout money needs that profit just to pay the dividends on the Treasury money they are holding. The money to pay those dividends will have to come out of the bank’s profit from lending. And the dividend payments are not as optional as they might seem; a bank that fails to pay its Treasury dividends is a few short steps away from being nationalized or shuttered. Therefore, a bank cannot afford to start thinking of borrowers as the enemy. Yet that is what most of the large banks in the United States are now doing.

Thursday, March 12, 2009

Why Did the Great Depression Last So Long?

Why did the Great Depression last as long as it did? This has been a subject of media discussion this month, with some well-funded efforts to try to pin the blame on one policy or another of the Roosevelt administration.

There is just one flaw with that line of thinking. The premise of the question, that the Great Depression was an economic decline that lasted a terribly long time, is not really true. The profile of the Great Depression can be seen in stark, bold lines if you look at the employment numbers. Starting with the Great Crash in 1929, employment fell sharply, rather like it is doing now, but for four consecutive years. This contraction was caused by the stock market crash, the associated problems in banking, and the resulting general loss of confidence and was extended by unfortunate policy decisions that focused on trying to hold the economy together rather than moving forward. The policy approach was generally like the strategy coming from the White House these past seven months. Imagine that kind of approach continuing for four years, and it is easy to see how much economic harm it could do.

Then, with a change in government policy starting in 1933, employment began to grow again, and it grew robustly, year after year. The reason the growth seemed slow at the time, and might seem slow when you look back at it, was that it took about eight years just to expand the economy to the level it had reached before its four-year slide. But really, the economy was probably expanding as fast as could reasonably be expected.

You would hope that, after a precipitous decline, an economy could quickly return to the degree of activity it enjoyed before the decline, but there does not seem to be any basis for that hope. Aside from the snap-back recovery that follows a more mild recession, which I wrote about two days ago, there seems to be a hard limit on how fast a free-market economy can expand. The U.S. economy has never expanded as fast as it is currently contracting. Employers are not reserving empty desks in order to rehire the employees who have just been laid off, so there is no reason to hope for the economy to bounce back next year. But if the best we can hope for next year and in the years following is a normal expansion, it will take at least two years just to recover from the economic decline of the last seven months — and perhaps two years more to recover from the additional decline that may occur in the remainder of this year. With the population expanding, it will take two or three additional years to add enough jobs for unemployment to fall to the levels of two years ago.

And that, I am afraid, is the best case history has to offer for our current situation. Perhaps there are ways to make the economy grow faster, but the usual Washington gimmicks, such as investment tax credits and special tax rates and incentives for business corporations and the billionaire-investor class, have been tried in the past to little good effect, so there is no reason to hope they will help now. It will take a new kind of thinking and a new kind of action to make the economy grow faster. I am not sure what that might look like, but considering what is at stake right now, it is worth taking some time to try to imagine what might be done to make the coming economic expansion happen a little faster and start a little sooner.

Wednesday, March 11, 2009

A Convincing Case?

What makes a convincing case for a strategy, method, or proposed solution? How do you convince people that something will work — and when you hear a proposal, when should you be convinced that it is worth a try?

These are important questions in economics right now because of the ongoing discussion of and growing doubts about the U.S. Treasury’s role in “rescuing” the financial system, but they are just as relevant in any area of life where something needs to be done, but experience does not quite tell you what actions are needed.

These are a few things that make a proposal or strategy more credible:


Clearly identified benefits. With so many things to do already, people want to undertake something new only for a reason. The more clear the purpose of action is, the easier it is to get people’s attention.

Track record. An approach that has solved problems in the past, for people in similar circumstances, is far more credible than one that has never been tested, or that when tried, produced problematic results.

When you see someone take a series of actions with good results, and you can take the identical actions and hope for similar results, that is particularly appealing. Then, when something really works, it can get around without anyone really thinking very much about it. Years ago, on one of the early reality shows, I saw a man give up drinking Kool-Aid. He became visibly less jittery and someone said his skin improved. I was surprised by this effect, and gave up Kool-Aid myself.

I got generally similar results and was also happy about the money I was saving. My story, in turn, may have helped persuade a friend to give up soda last year. He saved money, as he had expected, but also lost several pounds of excess body weight without any effort at all. That success, combined with other stories, prompted me a week ago to give up drinking milk, which with its recent price increases had become one of the most expensive foods in my kitchen. Can I save money and lose weight by drinking water instead of milk? There is a track record I can look at that says I probably can.

Known limitations. No method works for every problem or every situation, so a method is more convincing if people can point out the limitations. If I say, “Clean up the clutter on your desk, and you’ll get more work done — it works, I promise,” that isn’t particularly convincing because I didn’t say anything about the limitations of this strategy. If I add, “Make sure you can find everything you need, and that you have plenty of space to work in,“ it makes it more convincing, because I’ve expressed one of the limitations of the strategy. I don’t want you to spend the rest of the day cleaning your desk, but perhaps just long enough to achieve these two benefits.

Advocates for change often forget to spell out the limitations of the changes they are promoting. “Recycle everything” is a nice idealistic slogan, but if you can provide a list of the five common household materials that are most effectively recycled at this point, people take more action. That list, I’m told, is paper (which has to be clean, with no food, plastic, or metal on it), aluminum, polyethylene terephthalate (PET), high density polyethylene (HDPE), and glass (bottles and jars only). Likewise, if we want to advocate rail travel as the most energy-efficient way for a person to travel, it is important to remember that, even in the most optimistic passenger rail proposals, most towns will not have a train station. Rail travel is an option in some places but not others.

Known risks. If you know what could go wrong and how it could go wrong, it makes an idea more comfortable than if all the risks are unknown.


Look for these elements in the U.S. Treasury plan to “rescue” the financial system, and it’s easy to see why the majority of citizens and a growing chorus of experts are not convinced it is a good idea. There is no track record for the bank bailout in the United States, and when other countries tried it, they were almost always were forced to nationalize the banks they had bailed out, sometimes with distressing results. The limitations have not been acknowledged. The main beneficiaries would not be the entire economy, but mainly Wall Street and very large corporations. In addition, the approach would not work for very long, and no one has drawn up an exit strategy. The risks are not only unknown, but secret, a subject officials have sometimes refused to answer in Congressional hearings.

But most of all, the benefits of the plan are not clearly defined. Why “rescue” the financial system at all? Even if the plan were to work perfectly, it is hard to say whether the result is better than doing nothing at all, because no one can point out the specific effects the plan is supposed to produce. It was supposed to increase lending, but lending has decreased instead, and anyway, lending is not an end in itself, so how do we know that a change in lending is resulting in something useful in the economy? The specifics just aren’t there.

I was going to make a list of things not to do when you propose something, or things that reduce the credibility of an idea, but I will leave that to another writer. Losing My Religion author William Lobdell last week wrote a list of the ineffective techniques have used to try to rope him, and people like him who have reluctantly lost their belief in Christianity, back into the Christian fold. Threats, quotes from advocates, free lunch, debates, and similar approaches won’t work, he says. Lobdell is writing specifically about evangelical Christianity, but the problems he cites apply in a similar way to discussions of economic recovery, climate policy, diet programs, or anything else you might consider. A convincing case ultimately has to be based on some kind of story of success, of problems solved. When the arguments do not seem to be convincing anyone, the problem could be that the story is not strong enough, but it could also be that the success that the story is based on is not large enough to support the claims that are being made.

Tuesday, March 10, 2009

Empty Desks and the Snap-Back Recovery

To a business, a recession is a time to tighten your belt. Budgets that normally expand from year to year get cut during a recession. Sometimes a company has a hiring freeze, so that positions go vacant for longer than perhaps they really should.

I remember how many empty desks I saw in 2002. In some companies, as many as 20 percent of job positions were vacant as the company slowed down hiring. The organizational chart might have showed 325 positions, but with 65 of them marked “Vacant.” There was a desk in place waiting to be occupied by the person hired for the vacant position. But with budgets being squeezed, the companies were extremely selective about who they hired, and it took two or three years to fill some of the vacancies.

The empty-desk quality of a recession is a factor that allows for a snap-back recovery. As soon as revenue starts to flow again, the company can expand just by filling its vacancies faster. In some cases, it is as simple as making the phone call to offer the job to a qualified candidate who has already been interviewed for the position.

There are some empty desks in the current recession, but the empty desks have not expanded the way they did in recent recessions. Just the opposite, in fact. From all the statistics I can find, there are fewer job vacancies now than in normal times. Employers are slowing down hiring, but jobs aren’t going vacant. How can this be?

The answer is simple and sobering. Employers are eliminating job positions faster than they are hiring new workers. And they are not just taking away a job here and there, but slashing whole departments and locations. Factories and stores are closing at the fastest pace ever recorded. A business can usually wait out a recession, and many businesses are taking that approach this year, but many cannot and are restructuring for survival. That’s why there are so few empty desks.

With few empty desks, it may not be possible for the economy to bounce back from this recession. It takes longer to create a new job than it does to fill a vacant job position. Even with an empty desk, it typically takes weeks to hire someone to fill that spot. But in many cases, creating a job means writing a business plan, selecting a location, arranging for financing, renting an office, getting furniture and networking put in, and then starting to interview job candidates. Even if the business need is urgent and the money is in the bank, this is a process that can easily take a year or two — three or four, if a new building has to be built. The longer time scale for adding jobs means a slower recovery.

Other economists have already predicted that this could be an “L-shaped” recession, with the current rapid decline in economic activity followed by a very gradual recovery. Those predictions were based on such factors as the banking crisis, government deficits, and household debt. The dynamics of the job market point to the same conclusion. The economy can stage a quick recovery from a recession when there are millions of empty desks to fill. After positions are eliminated, facilities closed, and companies liquidated, the process of economic expansion is not quite so simple.

Monday, March 9, 2009

Diabetes Is Caused By a Virus

Diabetes is caused by a virus.

This news, reported Thursday by BBC News, is sure to turn the scientific understanding of the most vexing metabolic disease on its head. But it was not discovered at one of the great research institutions, or at a research pharmaceutical company, but largely through the work of one Scottish doctor driven by scientific curiosity.

The virus in question is an enterovirus that infects a specific kind of cell in the pancreas. Scientists hope to find out which enterovirus is to blame so that they can find a way to treat or prevent the disease. The study specifically looked at type 1 diabetes, but scientists are speculating that type 2 diabetes could result from a similar mechanism involving a similar virus.

Diabetes is a particularly costly and disruptive disease, so this discovery adds extra weight to the need to understand viruses and their effects on cells.

Sunday, March 8, 2009

Partial Home Heating

I tried another experiment in home heating in February, this time fully heating just one room in my house while providing partial heat to the rest of the house. It was less of a compromise than I expected, and it cut my heating bill by a lot.

I imagined I might start to feel cooped up in my office, but that rarely happened — no more often, I think, than any other time. Actually, as I was in the middle of a tape archive project, I was going to be in the office most of the day anyway. I had to plan my showers an hour in advance so I could heat up the bathroom, but in practice, I can usually predict my showers more than a day in advance, so that wasn’t a problem.

I paid about $4 a day for heat, the least I have ever paid in a winter month, and while saving $8 a day might not sound like a big deal, it’s enough money to notice the difference at the end of the month.

I’ve been experimenting with home heating approaches because of the possibility that heating oil could someday cost $6 a gallon. That looked like a possibility for this winter just 7 months ago, which tells you how quickly it could happen. That’s a price at which home heating would become unaffordable for a great many people. Fully heating my house at that price would cost me more than $30 a day in winter — getting away to somewhere tropical might actually cost less than staying home.

But people can spend less by switching to electric heat and leaving some rooms only partially heated. It’s an especially useful strategy for a house that, much of the time, has only one or two people in it — but these days, a lot of houses are used that way.