We've been working very hard on producing In the Books, our annual review of business books, for many months now. Like the year itself, it wasn't an easy project, but it is always a labor of love and one we're extremely proud of. We've mentioned many times over the year that the downturn in the economy has hit us as it did everyone else out there, and along with focusing on the many books that address—and offer solutions to—the challenges we all face, it is something we go into a bit more personally in this year's annual.
Financial Markets: Their Promise and Failure (and Promise) BY DYLAN SCHLEICHER The year 2008 will go down in economic history. The current credit crisis is the most fundamental challenge we have experienced in our economy since The Great Depression. The books published this year reflect turns of profound optimism, harsh reality, and a dire skepticism of what the future holds. Jeffrey D. Sachs' Common Wealth and Muhammed Yunus's Creating a World Without Poverty, both published in the early months of 2008, envision a world where poverty is not only alleviated, but eradicated through the forces of market capitalism. Gary Hirshberg's Stirring It Up envisions a world where market forces serve as stewards of an environmental revolution, and in The Necessary Revolution, Peter Senge illustrates how these forces, in alliance with various government and non-profit entities, are bringing an end to the divisions of the industrial age and quietly addressing the challenges of a growing climate crisis. But the crisis of the year has so far been in the very markets these authors see solving those humanitarian concerns. To have any hope of these visions panning out, the world economy will have to right itself. And so we turn our eyes to Wall Street. In his superlative history of "the Street," Wall Street, Steve Fraser describes the development of our current economic system, set up in the latter part of the 19th century and resulting in what is commonly referred to as "The Gilded Age:"
...Wall Street housed the engine room which transformed the structure of industry, providing the capital resources and organizational inventiveness that gave birth to the modern, publicly traded corporation and thereby to the modern economy. United States Steel, General Electric, and International Harvester were but a few of the household names of American business midwifed and often controlled by the Street's great investment banks. It was on the Street that the nation's great undertakings—its coast-to-coast railroads and stupendous agricultural output; its gigantic steel, oil, and raw materials industries; its pioneering technologies in electricity and chemicals—were alchemized. ... Here New York's investment bankers and brokers turned the tangible wherewithal of the country into its paper facsimile, a virtual economy whose very liquidity made possible the mobilizing of ever greater capital funds to further enlarge the scope, efficiency, and power of the whole U.S. economy. (Wall Street, 30-31)And, these innovations have continued to power the whole economy for over a century. Remember, though, that the Gilded Age ended in the Depression, and there have been many bumps in the road. Many commentators, including Nobel Laureate in Economics Paul Krugman, have dubbed the most recent excesses on Wall Street the "New Gilded Age." Is the current crisis just another bump in the road? Certainly the "very liquidity," or lack thereof, "that made possible the mobilizing of ever greater capital funds" seems to have dried up, at least temporarily. Thankfully, a number of big names have weighed in to help us understand the topic. David M. Snick (The World is Curved), George Soros (The New Paradigm for Financial Markets), and Charles Morris (The Trillion Dollar Meltdown) all tackle the issues competently, looking at the historical factors and bafflingly complex financial instruments that led us into this turmoil. All three of these authors extend their histories of the current economic climate back to the end of World War II, and trace the rise of market globalization to the early 1980s and the policies of the Reagan Administration, which took The Chicago School of Economics belief in free markets as gospel and began the deregulation of financial markets. Snick sees it as the beginning of "a golden age of wealth creation and poverty reduction never before seen in the history of mankind," (The World is Curved, 15) but qualifies that statement by saying, "That is the good news." Well, that is some pretty wonderful news, and though it may sound like hyperbole, the statistics bear it out. While globalization has had its great benefits, beginning the process of systematic deregulation that allowed it is also the point at which what Soros calls the "super-bubble," and Morris simply calls a "credit bubble," began to inflate. Snick gives you the bad news himself:
The bad news is that today's spectacular global economy is both unstable and unsettling. As jobs and investment move around the world, people lose incomes and pensions. And as these enormous shifts occur, the economic benefits of the system are often unfairly distributed. (The World is Curved, 16)We have now seen that instability play out. Soros was prescient in The New Paradigm, projecting that "Eventually, the U.S. government will have to use taxpayer money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent..." On the 3rd of October, the United States Congress passed a bill that injected 700 billion dollars of taxpayer money into the credit markets, buying up the "toxic waste" mortgages on Wall Street's balance sheets in the hope that once free of them, financial institutions would begin lending money again and provide the much needed liquidity to the economy and rescue Main Street from the crisis. (As I write this, mid-October, 2008, we have yet to see if this has worked.) Liquidity today is largely a game of confidence. Snick argues that liquidity is simply another name for confidence. In his book, he discusses with Alan Greenspan how "the job of central banking, because of the need to bolster confidence, has become an elaborate form of 'theatre,' with the financial markets acting as audience." (The World is Curved, 23) Neither Soros nor Morris spent any time in conversation with Mr. Greenspan, but he does make an appearance in their books. Morris describes "The Greenspan Put," which, according to the author, is a market where "No matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles." (The Trillion Dollar Meltdown, 65) As he writes further in The Trillion Dollar Meltdown:
In the aftermath of the tragic events of September 11, 2001, the Fed continued to lower rates—all the way down to 1 percent by 2003, the lowest rate in a half-century . The Fed did not start raising rates again until mid-2004, and for thirty-one consecutive months, the base inflation-adjusted short-term interest rate was negative. For bankers, in other words, money was free. (The Trillion Dollar Meltdown, 59)How things have changed. But why have a few (okay, a lot) of default mortgages caused such fear that banks are increasingly unlikely to lend to each other and other businesses—providing the liquidity that has fueled our economy for so long—while only a few months ago they were still scrambling to do so? David Snick compares the global credit market to a benevolent great-uncle:
During the Great Credit Crisis of 2007-2008, the benevolent great-uncle panicked, not because of the subprime mortgage default, or a U.S. housing bubble that was spreading beyond its shores. The panic unfolded precisely because suddenly nobody could say which financial institutions held the subprime toxic waste, and at what price. The situation was exacerbated by the sudden complexity of the financial system as a result of securitization, which resulted in a lack of transparency. (The World is Curved, 14)Charles Morris describes that complexity in further detail:
Residential mortgages became grist for quantitative portfolio management after they had been re-engineered into instruments that looked much like tradable bonds. The investment efficiencies generated large benefits for both investment banks and consumers but were quickly carried to dangerous extremes. Since then, however, there has been an all-out push to reconfigure almost all assets—office building mortgages, emerging market bonds, risky bank loans, and much else—so that they behave more like idealized securities rather than the lumpy, gnarly instruments they really are. The re-engineering greatly improved market efficiencies and reduced funding costs but also created the illusion that the underlying risks were well understood and under control. (The Trillion Dollar Meltdown, 57-58)After more than a century of economic growth that has built America from a relatively small nation at war with itself into the world's premier superpower, the system that put us there is on the brink of chaos. Economic innovation turned into financial creativity, which like many arts, has become a little too creative for anyone to truly understand (which is OK if you're looking at a canvas, but disastrous if you're looking at a spreadsheet). We'll soon see, possibly by the time this is published, whether the steps taken to avert disaster have been successful. What's certain is that the entire game seems to have changed, or more accurately, to be changing. The game is still being played with American dollars, but it has been globalized, and not everyone is playing with the same set of rules or institutions. Peter Senge sums up how he sees the whole of the current economy in The Necessary Revolution:
In effect, there now exists a vast casino sitting atop the real economy, and the casino players, increasingly, are dictating the course of those involved in real business. "How is it" [Charles] Handy mused, "that those who provide the money carry more clout than those who actually create the wealth?" (The Necessary Revolution, 351)That casino is no longer paying out, and the new president and next Congress will have to hammer out an entirely new financial structure and regulation system. It will be interesting to see what it looks like. While the publicly traded corporation has been the driver of economic growth for over a century, some see even that as corrupted and in need of change. In a chapter entitled "The Future of the Corporation," Peter Senge and his team question:
How is it that investors, who once needed protection, now dominate to the extent that thirty-year-old analysts can cause fifty-year-old CEOs to quake at their displeasure? How is it that societies that trumpet democratic values seem to be blind to the fact that their most powerful institutions operate much as totalitarian states? How did we lose sight of the historical perspective that the privatization of wealth was a privilege granted by corporate charter rather than a right gained merely by personal ambition? (The Necessary Revolution, 349)They come to the conclusion that:
Corporations are artifacts of history. Their design stems from mental models, not the laws of physics. When the time is right, they can and will change, probably far more rapidly than almost anyone expects. (The Necessary Revolution, 354)We don't know what they will end up looking like, but there are already changes being made in the structures of global finance. Sovereign Wealth funds are funding much of America's current debt, while the financiers of the past—Wall Street's great investment banks—are great no longer, having either been swallowed by rivals (Merrill Lynch, Bear Stearns and Lehman Brothers) or, under the instruction of the US Government, become bank holding companies (Goldman Sachs and Morgan Stanley). Yet, looking beyond the current crisis, innovation and hope are still being driven by markets and capitalism. By providing a very small amount of liquidity—micro-loans to those unable to attain credit in the traditional market around the world—Muhammed Yunus and micro lenders like him have created a new entrepreneurial class that proves that the fundamentals of market capitalism work. In Creating a World Without Poverty, Yunus writes that "Globalization, as a general business principle, can bring more benefits to the poor than any alternative," but tempers that enthusiasm with statements like, "Unfettered markets in their current form are not meant to solve social problems and instead may actually exacerbate poverty, disease, pollution, corruption, crime, and inequality." (Creating a World Without Poverty, 5) This is what he believes social business can address. He sums up his feelings, writing, "I am in favor of strengthening the freedom of the market. At the same time, I am very unhappy about the conceptual restrictions imposed on the players in the market." (Creating a World Without Poverty, 242) In order to fulfill the promise of addressing the problems humanity faces as Yunus, Sachs, Senge and others suggest they can, markets must actually work. But it is no longer true that we can simply let the market work. We must create markets that work for us. We must replace the invisible hand with a guiding one. Here's to hoping that the United States Government and the American Taxpayer, acting as the world's largest hedge fund, are up to the job. The books published this year won't be the final word on this crisis, but I do hope they are read widely, especially by those sculpting the solution to the crisis and rebuilding our markets.