How to earn a living

Jeff Immelt, boss of GE, the World’s largest manufacturing company, has been talking at the London Business School.

He is convinced that in the US  “a 30-year transition from a manufacturing export-led economy to an importing service-based one typified by the growth of Wall Street is over and has left America damaged“.

He believes that the workings of the world economy have been “reset” and are moving onto a new pendulum swing which will see the future dominated by new levels of government intervention, new markets and new technologies based on good old research and development.

I think he’s right and that’s a problem for UK plc.   We are good at inventing new things (at least we think we are!) but commercialising those inventions is something that Britain has been poor at (with honourable exceptions) for 100 years and more.

So how will we earn our living in the future now that banking and finance isn’t looking like such a good bet?

Change we can believe in – if only!

A funny thing has happened almost by stealth sometime in the last two weeks or so.  Progressives, who might be excused for thinking that Obama’s election would indeed lead to “change we can believe in”, have had to admit that he’s getting it wrong, badly wrong as far as the financial crisis is concerned.

Now an excellent interview with William Black on Bill Moyers Journal provides much of the context and moreover shed an uncomfortable light on developments on this side of the pond.  (The video is about 30 minute long but well worth it.  A transcript is provided if you prefer).

William K Black is now professor of Economics and Law at the University of Missouri, Kansas City and was formerly a regulator during the savings and loan crisis of the late 80s. 

Black’s thesis is simple; the financial crisis is driven by fraud on an epic scale.   He explains to Moyers how it works:

WILLIAM K. BLACK: Well, the way that you do it is to make really bad loans, because they pay better. Then you grow extremely rapidly, in other words, you’re a Ponzi-like scheme. And the third thing you do is we call it leverage. That just means borrowing a lot of money, and the combination creates a situation where you have guaranteed record profits in the early years. That makes you rich, through the bonuses that modern executive compensation has produced. It also makes it inevitable that there’s going to be a disaster down the road.

BILL MOYERS: So you’re suggesting, saying that CEOs of some of these banks and mortgage firms in order to increase their own personal income, deliberately set out to make bad loans?

WILLIAM K. BLACK: Yes.

He goes on to explain that the big banks knoew perfectly well that the liar loans and the like were fraudulent, but that complex financial instruments were deliberately created so that swindlers could exploit them.  The fraud became widespread.

BILL MOYERS: And was this happening exclusively in this sub-prime mortgage business?

WILLIAM K. BLACK: No, and that’s a big part of the story as well. Even prime loans began to have non-verification. Even Ronald Reagan, you know, said, “Trust, but verify.” They just gutted the verification process. We know that will produce enormous fraud, under economic theory, criminology theory, and two thousand years of life experience.

And now there’s a cover up.

BILL MOYERS: Yeah. Are you saying that Timothy Geithner, the Secretary of the Treasury, and others in the administration, with the banks, are engaged in a cover up to keep us from knowing what went wrong?

WILLIAM K. BLACK: Absolutely.

But the whole thing tracks back to a small number of individuals.

BILL MOYERS: This wound that you say has been inflicted on American life. The loss of worker’s income. And security and pensions and future happened, because of the misconduct of a relatively few, very well-heeled people, in very well-decorated corporate suites, right?

WILLIAM K. BLACK: Right.

BILL MOYERS: It was relatively a handful of people.

WILLIAM K. BLACK: And their ideologies, which swept away regulation. So, in the example, regulation means that cheaters don’t prosper. So, instead of being bad for capitalism, it’s what saves capitalism. “Honest purveyors prosper” is what we want. And you need regulation and law enforcement to be able to do this. The tragedy of this crisis is it didn’t need to happen at all.

Which brings us back to the beginning.  How is a highly intelligent man like Obama getting it so badly wrong?   Ditto Gordon Brown?

Shredding Sir Fred – and friends

Rewarding senior executives for failure has become all too  common in recent years.  The £16 million pension awarded to Sir Fred Goodwin, former boss of RBS, may make him ‘media hate person of the day’ but his is only the latest in a long line of payments for destroying perfectly good companies.

Gordon Brown may view it as ”unacceptable” and be taking legal advice about how to claw it back but surely we need to draw the general lesson here and not just beat up on one case – however offensive that case might be. 

And that general lesson should surely encompass the thought that all rewards – including salaries, bonuses and pensions – should be commensurate with results.   In other words the perfectly justified public anger over this case (and banking bonuses generally) could and should be harnessed to put through some long-overdue changes to corporate governance.  

In too many large firms the rights of shareholders (and that means most of us through pension funds etc.) have been expropriated by a breed of self-serving managers who serve no higher goal than short term greed.  It is too easy for a dominant Chairman to pack his board with yes-men who can be relied on to lock arms and push back against even the most determined efforts to question pay awards or strategy.  No wonder we are in a mess.

Corporate governance needs to move on from being the domain of buccaneers and kleptocrats to one of managers who actually serve the longer term interests of shareholders (and in practice therefore also of employees and the wider society). 

So what can be done?

I suggest that legislation to restore shareholder control is the democratic and effective way to go.  Legislate that directors of public companies may only draw a salary package up to a maximum of a specified multiple of average wages in their firm – say a generous 20x.  That should be more than enough for anyone to live on!   Any remuneration above this level (whether as bonus or pension etc.) would be subject to two votes by shareholders -   the first to agree and set up a bonus scheme and a second vote five years later to confirm (or deny) any sums awarded under such a scheme.

In practice the shareholders would be pension funds etc so they would use such powers responsibly and sparingly but the threat of being able to do so would be a powerful deterrant to bad behaviour in the first place.

If it turned out that the Directors had been utterly foolish and/or negligent then the shareholders would have the right to decline to pay the accrued bonuses.   However ,shareholders would be constrained to behave fairly and not unreasonably or they would find it impossible to attract and retain quality management.

Funds accrued could earn interest while in trust so there is no ultimate loss to the directors involved – only a delay so that any short-termism is exposed.

And just imagine; if such legislation were introduced in the next few months and backdated to late last year,  it might even catch Sir Fred.

That would seem perfectly fair.

Interesting Times

Shanghai in 2009 is New York in 1929 – in a manner of speaking.

Shanghai owes the shiny new tower blocks on its waterfront to China’s booming economy of recent years just as New York owes its Manhattan skyline mainly to the booming 20s. 

And, by curious coincidence, Herbert Hoover, the US President in 1929 was a  geologist as is Chinese Premier Wen Jiabao.   A fluent Mandarin speaker, Hoover was instrumental in founding one of the companies that later merged to form Rio Tinto – in which a state-owned Chinese company Chinalco has just bought a large stake.

Fascinating but irrelevant trivia. 

Of more immediate concern, however, is what might happen in the near future: China in 2010 certainly does not want to be where the USA was in 1932.   But, as Patrick Chovanec, of Tsinghua University points out  the slowdown in the West started at the top as the result of extreme foolishness (and, I would add, not a little corruption). 

In the West it is essentially a financial panic and the first layoffs have been bankers.   However, in China it started at the bottom and is a collapse of demand that is chopping the economy off at the knees with migrant workers the early casualties.   The political and business elites are still partying – for now at least.

The implicit contract between rulers and ruled (we give you jobs/you leave politics to us) is being stress tested.   These are indeed interesting times.

We shall see.  My guess is that the parallels between 1930s USA and modern China have a way to run yet.

Shop till you drop? Here’s a better plan!

We have got into a whole heap of trouble by doing too much shopping funded by borrowing.  So what is Brown & Co’s plan to get us out of this hole?  A marginal cut in the rate of VAT to encourage more shopping funded by more borrowing!  You couldn’t make it up.

At least until now we as individuals have had the freedom to choose whether or not to live above our means.  Monday’s Pre-Budget Report nationalises this decision and removes our freedom to choose.  It also proves beyond reasonable doubt that the government has little idea what’s going on in the real economy or how to respond to the crisis.  Moreover, since the government has also been living beyond its means for years, it doesn’t actually have the financial capacity to do as it now proposes (indices that measure risk on government debt are soaring) and can make it ‘work’ only by fiddling the figures with a wholly unbelievable forecast of a quick economic rebound.

Debt is perfectly fine when its adequately supported by underlying cash flows but governments have allowed banks to compound debt to levels far in excess of anything sustainable with a monstrous bubble in house prices.  Hence this is a ‘balance sheet recession’ caused by the collapse of a house-of-cards edifice of debt far in excess of sustainable levels.   It’s an avalanche that, once started, can’t be stopped until it reaches the bottom.

Now there is a further risk – that many perfectly viable and healthy businesses will be hit by what the military coyly call ‘collateral damage’ – killed in the crossfire.  But this further reduces the underlying earnings in the economy which is the only thing that will eventually stop the avalanche.  If this happens and large numbers loose their jobs, default on mortgage and credit card payments etc., the whole process turns into a death spiral and recession becomes depression.

It follows that one of the things the government badly needs to do is to improve the strength of the underlying economy.  To an extent they are doing that in leaning on the banks to keep lending but that is more about damage limitation than being proactive and it’s a tough call because lending capacity is just exactly what the banks are short of (hence ‘credit crunch’) although the government is doing its best to ignore this important detail.

I don’t think people are stupid enough to be bribed back into the shops by a 2.5% VAT giveaway at a time like this.  (Particularly so since much of the 2.5% will probably be absorbed by retailers).  In promoting more shopping the government is treating symptoms, not causes.  So what should the government do? 

Firstly, Vince Cable is absolutely right to call for a reduction in the tax burden on low earners.  In hard times people near the bottom of the pile always suffer most so social justice demands no less, especially since the whole credit crunch crisis was born and raised in the top echelons of society.

But we need to do more; we need to think about what can be done to help business weather the storm.  For if businesses stay healthy then salaries get paid, debt is affordable (even if uncomfortably high) and confidence will soon come flooding back – and flow into the shops. 

One way this could be done is to change the basis of taxation for small businesses so that they are taxed only on drawings (or dividends if incorporated as a company) rather than on profit.  Then, provided their owners choose to live modestly and keep profits in the business, they would be free to save or invest their money as they saw fit without the government grabbing it.  This would quickly make a big difference since one of the biggest problems for small businesses (even in normal times) is accumulating sufficient capital.  For those with ambitions this would make it much easier to accumulate a modest amount of capital and then expand, diversify or whatever.

(As an aside; this is the same strategy that successive governments have used vis a vis the illegal drugs trade and which has helped make it one of Britain’s most ’successful’ industries.   Although never any government’s intention, the practical effect has been that with drug seizures – their equivalent of tax – normally at very low levels, the backers have had ample capital from retained profits to develop and diversify their criminal business).

With stronger cash flows small business would be less beholden to bank lending policies.  Many would be able to increase their bank deposits (or reduce their overdrafts) which would in turn help stabilise the banks. A proportion would soon accumulate the capital to consider an expansion and take on staff.  BERR estimates that there are over 4.6 million small business (with less than 50 staff) in the UK.  If just one in 5 of these took on just one extra person over the next two years, that is a million new jobs and many times that with renewed confidence in their job security.  It  also creates a high probability of a recovering economy.

Moreover, small businesses collectively have an enormous fund of experience; anecdotal evidence suggests a high proportion are rather well run so new investment would automatically flow to areas where it would do most good.  It is unlikely that much would go into retailing or building (although there must be some good niches even there).  In other words, helping small business would improve the accuracy and flexibility of the economic response to the crisis.

From the government’s point of view there would be a hit to cash flow into the Treasury, but only a temporary one as sooner or later owners would increase their drawings (and in any case not all owners would be willing or able to reduce drawings).  In the meantime the government revenues would benefit from increased PAYE, NI and VAT on increased economic activity.   

It could also be good politics.  If each small business influences the voting intentions of just four people (partners, family, employees etc.), that is more votes than the Lib Dems got at the last election!