THE EYE OF HORUS
The drop in the American economy that wiped out more than $2 trillion dollars in global financial wealth in less than an instant of historical time occurred as a result of poorly designed and executed monetary and fiscal policies where in this case independently managed monetary policy alone could have made a profound difference. This single factor, more than any other, serves to place the blame squarely on the Federal Reserve Bank that did not carry out its mandate and role to act as an independent global observer, advocate and voice of the American people, but more importantly, as a modifier of ill conceived government fiscal policies, economic misalignments and aggregates of apparent monetary risks and anomalies often encapsulated in the workings of interest and currency rates for which financial instruments and products are of no more than ancillary considerations. For if the Fed fails in this meager endeavor to seek out, find and correct corrosive financial risk factors that could lead or contribute to markets failures or the eradiation of base capital that support the pillars of the modern scientific economic order, the basis of which is often referred to as ‘free market capitalism', when such can be prudently identified and converted in a timely fashion, and oftentimes with precision, then on what basis should Congress allow the Fed to act as an unregulated regulator of the American economy that is but one of many systems in global financial affairs that drive production and distribution of wealth and economic prosperity derived from man-made goods and services harnessed through the use and/or exploitation of natural resources? This is the central question that the new Congress will have to address in both the House and the Senate next year. However, our interest in this brief note is far more immediate, germane and at home.
BAIL US OUT TOO!
The recent passage of the $700 billion Economic Rescue package, referred to here as the “Me First Bail Out Package” violates all unwritten laws and intuitive understanding of the workings of modern capitalism that rest upon the human psychological factor of honoring one's debt and payment obligations upon which many countries and institutions depend. The egg is cracked. Can Humpty Dumpty, the Great Cosmic Egg, be put back together again?
WHEN GUIDANCE FAILS
The $700 billion rescue package is being used, among other things, to nationalized mainstream financial institutions that were the bulwark of the American capitalist system. In his recent testimony to Congress, former Fed Chairman Alan Greenspan admitted that he did not fully understand what caused, what he referred to as a “credit tsunami,” and added that he was partially wrong in believing that banks and financial institutions would behave and act in a manner to protect shareholders' wealth and interests, but for reasons unknown to him, this did not happen calling into question the very foundation and pillar that the system rests on – i.e., the invisible hand of enlightened self interest! Where is Harvey (1950) when you need him?
IN SEARCH OF A DESCRIPTIVE & FUNCTIONAL UNDERSTANDING
If one of the most esteem and praised economic gurus of the modern financial age did not and still does not seem to fully understand the problems that led to the credit crisis and tsunami as he called it, then what should we think or believe as users, consumers, deposit holders and investors about the safety and security of global capital and financial markets to which we are all indelibly tied? While we may not be able to answer those questions definitively or even partially in this note, there are some factors that we may consider to stimulate discussion that have not been commonly discussed in the mass media that may deepen or contribute to our knowledge and understanding of what may have caused the 2008 stock crash and credit tsunami.
9-22: THE HOUSE IS BURNING!
When U.S. Treasury Secretary Henry M. Paulson, a former Wall Street investment banker, announced to Congress during the week of September 22, 2008 (9-22) that we were on the brink of a global economic meltdown by stating figuratively that the ‘sky is falling', few if any, understood the problem or actions needed to formulate a workable solution. As a result, Congress established an oversight committee and approved the first tranche of $250 billion of a $700 billion undocumented and unsubstantiated bail out package. But what caused the global financial catastrophe, what were the driving forces and how did we get into this mess in the first place?
THE SEVEN DEADLY SINS SPELLED ‘EROSION'
Much of the problems that we are experiencing today in global financial markets can be traced back and attributed to a few economic factors that we call the Seven (7) Deadly Sins of Modern Capitalism, (i.e., scientific economic modernism) that led to the global economic collapse and credit tsunami of 2008 that fits the acronym EROSION, a true symbol and recipe for global financial disaster described as follows:-
1) Eradication of capital and savings base;
2) Relatively high energy prices;
3) Over reliance on credit to fuel national economic activity;
4) Slow down in real economic output;
5) Irresponsible low interest rates;
6) Over dependence on a low cost strategy to drive economic output and corporate profitability;
7) Never before seen narrow or tight profit margins and interest rate spreads for corporate and banking activity, respectively.
1. ERADICATION OF CAPITAL & SAVING BASE
During the early protestant Christian era of American capitalism (1865-1940s) savings was considered an essential and key component to driving economy growth. This was supported by a strong belief in building value in American companies through the maintenance of a sound capital base. The Glass-Steagall Act of 1933 reinforced this position after the stock market crash of 1929 (that started on Black Thursday, October 24, 1929) requiring the separation of banking and investment activities to allow for more transparency and accountability in America's financial banking system. Today, we have moved far away from these insightful protection mechanisms blazing a new trail of our own that has been heavily influenced and driven by modern computerized technology and advance mathematics that gives us a super human strength to leap national boundaries in a single bounce and an undeniable and unquestionable sense of scientific invincibly; the era of scientific economic modernism had begun!
It was system that relied more on computers and machines and less on human insight and oversight than was practiced in the past. The idea that capital could be substituted by debt was widely promoted by many economists, and some countries, including Chile, tested these theories in their national economies with devastating consequences.
In 1929, the national saving rate in the United States (U.S.) increased to 25% while the rate of population growth and price of capital goods in relative terms dropped by 2% and some 66%, respectively compared to current times whereby between 1995 and 2000 U.S. GDP grew from 2% per annum to about 4.8% while the savings rate dropped from 4% to 2%. During the Bush era, we witnessed growth in GDP between 2002 and 2006 Q4 from a 0.35% per annum to 3.00 % per annum. The savings rate dropped during that period from positive 2.8% to a negative -1.2% without any meaningful fiscal (government) or monetary (Fed) redress. This means that growth during this period was being financed with debt, much of it foreign, and not by stock growth or economic wealth creation. This speaks volumes for the type of economic growth that we were experiencing between 2002-2006 that contributed directly to the stock market crash and credit tsunami of 2008 – that of credit financing.
It's a Bull Market Out There, But Where's the Chicken?
By the turn of the 21st Century that started on January 1, 2000, capitalism had become a fad on Wall Street; there was no real capital for the capitalist. Like good chicken soup, the recipe was intact but the ingredients and proportions for making curative medicine were being substituted with ever weakening ingredients and formulas for producing ever yet better medicine that slowly ceased to work. There was no capital for the capitalist and no chicken in the soup. For example, while spiking to over 120% during World War II, public debt as a percent of GDP went from about 16% in 1929 to 65% in 2004.
Market capitalization, which reflects the public's view of the value of companies' equities or stocks, had risen in nominal terms but had started to fall in real terms around the turn of the 21st Century. It was clear that an adjustment was imminent. For example, market capitalization of all publicly traded companies in the world was over US$51 trillion in January 2007 and rose to over US$58 trillion in May 2008 before dropping below US$50 trillion in August 2008 and slightly above US$40 trillion in September 2008. This represents more than US$18 trillion loss in total market capitalization over a four month period.
In summer 2007, US total market capitalization was about US$19 trillion. US market cap at the beginning of October 2008 was about $13 trillion, a drop of $5.8 trillion over a 13 month period.
Chickens Come Home to Roost
According to the World Bank, in 2000 US market capitalization to GDP was about 153% before the dot com correction which brought it down to about 90%. In December 2006, the ratio fell to about 120% against GDP of some US$13 trillion. By mid October 2008, even after the September 29, 2008 correction, market capitalization to GDP was 180%-200%. This ratio is only 100%-150% for developing countries and about 120% for the world on a whole. The capital base was highly inflated in both real and nominal terms and a look at real returns shed light that was major correction was in the making for all to see.
Elliott Wave International
According to Robert Prechter of Elliott Wave International, if you were to consider that the Dow priced in real money or gold, there has been a substantial decline in real values since the turn of the Century's (1999) peak in real values. Prior to that there was a progressive increase in the value of the Dow mapped against gold from about 1980 to the start of 2000. Since then for the past 8 years there has been a substantial decrease in the value of the Dow relative to gold due primarily to the fall of the dollar driven mostly by “credit inflation.”
If you use oil as the price of real money, you will find that the Dow is priced at the price where it was at about 8 years ago but with a substantial fall in purchasing power. The recent increase in oil prices provided a temporary increase of the Dow above that level to which we have recently returned.
When Up is Down!
The real purchasing power of Dow stocks has declined substantially over the past 8 years since 2000. For example, according to Prechter, Dow shares had lost about 33% of its purchasing power in 2007 when plotted against the price of commodities in 2000. Massive credit inflation, that is leverage upon leverage, a house of cards , has been the primary support for the dollar since 2000. The Dow dividend yield for 1987 (Black Monday occurred October 19, 1987) was 2.6%, lower than that of 1929 and stood at 2.0% and falling on October 19, 2007. Stock price to book value jumped from $1.73 in 1987 to $4.04 in 2007.
Hidden Inflation Leading to Loss of Purchasing Power
What this means is that we have been enduring a tremendous amount of inflation since the year 2000 that is not reflected in general economic price indices such as the GDP. For example, the cost for every annual dollar of Dow dividends in 1987 was $39 which rose over the past eleven (11) years to more than $50 in 2008. Moreover, the dividend yield in 2008 continues to be below that of 1929 and 1987 when the stock market experienced a strong decline.
Speeding Up Time!
The psychology of investors has changed significantly since 1929 where investors today rely more heavily on capital gains to make up the lost in yield. For example, people no longer talk about how much dividends they will receive from a share of stock but are more interested in finding out if the share price will go up soon. To feed this appetite and psychology for higher prices, financial advisors have been bullish on stock prices for more than nine years before the October 2008 crash.
2. RELATIVELY HIGH ENERGY PRICES
Energy is often considered as the backbone or hidden nerve center of the global industrial society, very much in the way that gold was the main source of wealth and support of ancient and 1st and 2nd millennium A.D. societies. Gold and other precious metals have earned their place in human affairs as a storehouse of value and acceptable currency of exchange that will be sought after for many years to some, but their use and place in modern economics have changed dramatically over the past few decades presenting new risks and opportunities for investors.
New Bullions of Modern Industrial Society
More so than gold, it is important to note that two factors over others form the basis, structure, backbone and support of the global industrial society .i.e., 1) energy and 2) money, in that order. While energy is a physical matter whose prices and properties are affected by supply and demand characteristics, money is invisible and ephemeral and is more dependent on human psychological factors which measure its value in terms of “stocks” that can retain or increase value over time with little or no erosion - similar to the role gold played in earler times. For this reason public confidence in the monetary and banking system is indispensable which must be earned and physically checked and demonstrated over time and not preached.
Capital & Labor Gives Way to Money!
At the turn of the 20th Century, capital and labor were considered the main factors of industrial production and development but has since been subsumed and made subordinate to the role of money and energy in global economic affairs. While capital, both financial and industrial as in capital goods, still commands a respectable position and role in modern industrial society, labor has not done so well and remains the step child or black sheep of the family due primarily to increased focus and attention on the creation of wealth through ever increasing scientific enquiry and technological advancements where money plays the main role or initiating factor.
Energy Weights In
While energy takes many forms in modern industrial development and societies, such as electricity, natural gas, coal, nuclear power, solar and hydro to name a few, none will disagree that crude oil is by far the main source and link between money, development, wealth creation, economic prosperity, and in some cases, the alleviation of poverty in modern industrial society that many claims has the potential of freeing whole groups of people and nations from unwanted geo-political dependence and control for which the United States and its relations with oil producing Middle Eastern nations is no exception.
Hence, energy and particularly crude oil prices can serve as a strong barometer or test of national economic stability in the creation and formulation of the wealth of nations, and in this regard, is a meaningful index for measuring the prospects of future economic growth and development within the modern “progressive” (to what we don't know) scientific human development framework or paradigm. In this regard, the formula is simple: low energy price translates into low manufacturing cost which increases output while high energy price has the reverse effect of lowing national or global output that drives national economic growth and development.
Impact of Energy Price On U.S. Economy
In a reverse manner, strong world economic growth has often been cited has the main cause behind increasing oil prices. According to a 2007 report put out by the US Department of Energy, “global oil consumption rose by 1.1 million barrels per day (bbl/d) in 2006, and is projected to rise by 1.1 million bbl/d in 2007 and 1.5 million bbl/d in 2008.” High oil prices have been a contributing factor to slow economic growth in the United States, but not in China that has shown few signs of slowing down. The decline in the value of the dollar against other currencies supports continued oil consumption growth in foreign countries, but has also had the reverse effect of increasing energy prices in US domestic markets.
Outlook for Winter 2008
Energy Information Administration (EIA) of the U.S. Department of Energy (DOE) expects the average fuel cost to be higher in winter 2008 than prior winters. EIA expects winter 2008-09 to be 2% colder than winter 2007-08, but 2% warmer than the 30 year average. With no more than a 1% increase in average consumption, the Agency expects an 18% increase in consumer expenditure based on a projected 17% price increase.
Crude Oil Price
EIA expects crude oil prices to remain high, projected in October 2008 at over $100 per barrel. However, actual crude oil prices on the New York Mercantile Exchange are much lower hovering around $66 per barrel on October 28, 2008. On Friday, October 24, 2008, the Organization of the Petroleum Exporting Countries agreed to cut production quotas by 1.5 million barrels a day, but OPEC members' adherence to such agreement is likely to be smaller.
Where is it Going?
The picture we are painting is a confusing one, but so it is. Government expects high energy prices that can only be realized through a reversal in current market trends, a much colder winter than expected or some combination of both barring a unexpected natural disaster or other unforeseen uncertainty.
An appreciating dollar is likely to have the effect of further lowering the price of crude to historic low level by winter 2008-09. Many oil analysts believe that there are no factors to support higher oil prices unless the world experiences a freezing winter – freeze baby, freeze!
If global warming trends continue, the world including the United States could see one of the warmest winters on record. Global recession fears have heightened concerns about declining energy demand that could further lower prices. A Democratic victory in November '08 could usher in lower crude oil prices stimulated by plans to transform America's energy future by gradually switching the country from heavy reliance on fossil fuel energy to greener alternative sources, but this is to be seen.
Setting the Bar
Are energy prices as high as they seem in real terms? For the first time since 1919, real gasoline prices have matched or exceeded nominal prices. As shown in the following chart produced by the U.S. Department of Energy, real prices are at an historic all time high, which weakens economic stability and erodes the foundation for wealth and capital formation.
Plans to increase production by drilling, “drill, baby drill,” does not provide a practical solution to address the problem and would do nothing to reduce the immediate impact that high oil prices have had on the American economy and on the strength of the dollar in particular. While the U.S. economy has been able to keep the nominal price of gasoline at the pump substantially below the real price since 1919, in recent years we have experienced a progressive reversal of these trends, starting in 2000 where the nominal price at the pump for the first time has overtaken and at times exceeded prices in real terms. When this happens the impact on the productive capacity of the economy and related monetary aggregates and indicators can be enormous affecting both the purchasing power of the dollar and relative consumer prices. Many economists believe that we are in or headed towards a recession, meaning lower output in monetary values, while other point to the recent decline in stock market values as a correction of the current state of affairs.
As shown in the chart below, real imported crude oil prices has been running parallel with nominal prices since January 2000 increasing pressures on U.S. economic output.
3. OVER RELIANCE ON CREDIT TO FUEL NATIONAL ECONOMIC ACTIVITY
The growth and creation of a myriad of derivative financial instruments and products coupled with the creation of a very tight credit system to measure, control and maintain corporate and consumer spending limits led to the proliferation of credit cards and credit through home-equity loans to almost every living being in the American consumer society regardless of income, assets or creditworthiness, since one could always declare bankruptcy when found over the limit to start all over again.
Buy, Baby Buy!
The credit system was not new to American business or economy. It was the way in which business was done and the way in which banks controlled and financed corporate growth and expansion since the formation of the nation in 1776. What is different in Contemporary times is that this system, which was initially designed for governments and corporate entities, was being transferred on an wholesale basis to individuals and households on a massive scale in the 1970-2000 thanks to the development of the computer, advancements in automatic cash dispensing machines and the development of credit cards that brought high interest borrowing rates of 18% - 30% to the American consumers' door steps, which previously under old banking regulations were considered usurious by the Department of Banking of most state governments in the United States. “Buy baby, buy and pay tomorrow” was the new mantra of the modern progressive capitalism that was made available to everyone who had a valid home address, telephone number or social security card.
Chains that Bind
Time tested and honored traditions and values of capital formation through hard work and savings upon which the great wealth of past American generations were built were thrown out the door thanks to strong banking lobbies that persuaded the American Congress and the Offices of various presidents to allow banks and financial institutions to link an individual social character, rights and privileges, including the right to work within the profession of one's choice, and in some cases, classification as being a social outcast or “pseudo-social-terrorist” for those who do not conform to expected criteria of “financial credit” as formulated, controlled and monitored by the American banking and credit industries.
Change in Consumer Credit Values
The House and Senate Banking Committees as well as the Departments of Banking of most states all across the United States turned a blind eye to these malefic financial practices and instead passed or supported legislation that enforced rules that used credit as a social criteria to characterize an individual by denying employment to any American citizen that did not meet stringent credit criteria as defined and determined by the American banking system. This was a new form of social castration and financial terrorism that gravely affected consumers and creditors alike.
What is often not explained is that the impact of the American credit system is vast and pervasive, even global, and not merely relegated to the corporate, state or national affairs. For example, a citizen denied a job in the U.S. due to bad credit or a low credit score could easily find similar denial in any country in the world that uses the credit system to evaluate a candidate's moral and social character or fitness to do the job. This is an issue that no one in Congress wants to address. The power and influence of the banking industry is such that everyone has been quietly and passively accepted credit discrimination as a “normal” way of doing business.
People do not care about being Black anymore, but they fear as hell about being poor!
When Credit Affects Jobs!
During these credit crisis and stock market crash American citizens are waking up the cold and horrible reality that the credit system that they have honored, endorsed, defended and supported for the past four decades since the late 1960s no longer serve their needs, for with so many job losses occurring through down-sizing and out-sourcing, any bad credit or late payment reported by TRW or Equifax on a credit report grossly reduces an individual's chances of finding gainful employment in the U.S.A. in their field of training or choice.
An Open Book for All to See!
This does not address the question of protecting public privacy. Though the many unregulated pre-paid services offered on the internet, almost anyone or corporate entity can find just about any financial information they wish about a person's credit, assets or financial liabilities. In some cases, recruiters, corporations and government organizations use background check and financial credit subscription services to pre-screen job applicants without the applicant's consent or foreknowledge in order to increase efficiency and reduce hiring cost.
Economic Output Financed Through Credit
On the corporate side, every conceivable avenue to make loans (commercial paper) and finance production and consumer demand was taken in order to increase economic output. Many car dealerships no longer owned the cars they sell on the lot; they were all purchased on credit. Farmers farmed for the banks and the government in almost every agricultural producing state. Cheap labor was needed to make the system work, since that was the only reliable constant in the equation that could be managed if gotten out of line, so the borders on Mexico and migration from Eastern Europe, Africa, the Philippines and Asia were strongly encouraged by loosening and non-enforcement of U.S. immigration laws - backed and supported by the captains of industry.
The Immigration Problem
Furthermore, there was an added economic benefit to inflating population growth through immigration, which increased the Gross National Product since all these new people who entered the country, legally or otherwise, had to be fed, clothed and live in a house in the American society. The impact on urban areas was staggering, but no one seemed to care provided the City was making money through this new form of “labor financing”!
A Shattered Sense of Self!
The sense of identity that formed the American social structure and psychology was under attack by the values, traditions and customs that an increasing steady flow of new immigrants brought to America, coming from almost every conceivable nation in the world seeking the wealth and opportunities of the American dream. A new “Conservatism” was on the rise since the 1980s, one that sought to denigrate the separation of church and state and other time honored traditional American values that were enshrined in the Constitution by the founding fathers, the purpose of which was an ideological response to separate the wheat from the tears.
All for One, and None for All!
It was every man for himself and every corporation and banking institution was on their own as well to do as they pleased in making money any which way how.
Era of Illusion
We had entered the era of self aggrandizement and economic illusion where truth was being sacrificed every day on the cross to serve a “me first” mentality where greed and meaningless non-productive iconic and comedic entertainment led the way. Nothing was sacred any more. Laughter and jokes defined the new American spirit and mentality for problem solving until the Titanic hit rock when Katrina struck home in 2005 and the stock market crashed in September-October 2008 that sank to precipitous levels never seen before in America's 230 years of history. The fall of the American system was at hand, but who cares that the ship is sinking, when it is okay for the captain to leave the control tower and party with the ship's guests and crew. Civil and mature sensibilities were removed from the realms of corporate leadership and basic principles of public governance.
4. SLOW DOWN IN REAL ECONOMIC OUTPUT
The gross domestic product (GDP) or gross domestic income (GDI) is one of the measures of national income and output for a given country's economy. GDP is defined as the total current market value of all final goods and services produced within the country in a given period, which is usually a calendar year. It is also considered the sum of a value added at every stage of production of all final goods and services produced within a country in a given period of time measured in monetary value.
According to the U.S. Department of Commerce, real gross domestic product increased at an annual rate of 2.8% in the second quarter of 2008. In the first quarter, real GDP increased by only 0.9%.
Current-dollar GDP, the market value of the nation's output of goods and services, increased 4.1% in the second quarter 2008 to $14,295 billion. In the first quarter, current-dollar GDP increased 3.5% or $120 billion.
Average real quarterly GDP growth has remained below 4% since the start of 2003. This performance has been strong enough to offset other factors weighing on the economy.
One of the main drags on growth has been consumer spending. According to Bloomberg , “Consumers reined in spending as energy prices climbed, while business investment in new equipment fell for the first time in more than three years. Futures traders put the probability of a move when policy makers meet next month at 28 percent, down from about 90 percent last week.” Home construction, consumer spending on durable goods, and corporate purchases of equipment all declined in 2008 which has not happened since 1991.
US consumer confidence dropped to its lowest level on record on October 28, 2008 as the financial crisis deepened. According to the Conference Board, consumer confidence fell from a reading of 61.4 in September 2008 to 38.0 in October 2008 – the third-largest monthly drop since the index was established more than forty years ago.
The Treasury Department reported that the U.S. federal budget deficit soared to record $455 billion in the fiscal year of 2008. The deficit for the budget year that ended Sept. 30 was nearly triple the $162 billion recorded in 2007. It was also about 3.2% of U.S. GDP. The housing crisis is largely responsible for the increase as well as strained capital markets and slower growth.
The U.S. needs to boost output. Further deterioration in the housing market will retard output putting greater pressures on energy and monetary aggregates.
5. IRRESPONSIBLE LOW INTEREST RATES
Interest rates in the U.S. are the lowest that they have ever been in U.S. Conventional wisdom says that this is good for the economy because it stimulates growth, increase stock market values, albeit temporarily, and encourages lending. However, closer evaluation and analysis of the effects of low interest rates reveals that it is having and has had the opposite effects.
Negative Interest Rates
The Fed funds rate currently at 1.5% (expected to fall to 1% on October 29, 2009) is far below the consumer price index of about 4.9%. With Treasury bills yielding 1.01%, it is almost impossible to stay ahead of inflation. Real dividend yield mentioned earlier is below 2.9% on Dow stocks. Whether investors go to the stock or bond market, yields will remain negative deteriorating the value and stocks of money. The economy has been propped by credit inflation, which puts everything at risk since there is no base stock that is carrying or accumulating real value anymore.
Real interest rates would increase earnings on corporate and individual investment portfolio as fair compensation for inflationary risk. This aspect of traditional economic value has been removed from the table as a talking point. The risk that negative interest rates presents are many, some of which we recently experienced in the stock market crash.
The Fed should review its policy of keeping interest rates below the inflation rate that excludes energy and consumer spending for food and other household items.
For more information on this subject, please visit:
1) Open letter to Ben Bernanke
2) When All Else Fails!
3) Response to Alan Greenspan
6. OVER DEPENDENCE ON A LOW COST STRATEGY
Many companies adopt a low cost strategy to increase profitability. With labor cost equalizing all over the world towards a common international standard in real dollar terms, businesses that adopt a low cost strategy as the primary vehicle for increasing or improving profitability might be more susceptible to loss stemming from changing economic conditions involving fluctuating currencies, interest rates and energy cost than those that weight the cost and benefits of such strategies. Globalization has increased these risks tremendously opening businesses to the ebbs and flows of currency revaluation, global recession and competition. In some cases product differentiation and innovation are not sufficient to keep businesses profitable when under stressful competitive or economic pressures or disadvantages. As a result, all businesses need to do more!
To remain competitive and ahead of the curve, companies need to focus on growing revenues in real terms. Under current economic conditions, every $1 of marginal revenue earned is worth less than the $1 earned before due to inflation and negative interest rates. This means that companies need to ensure that there is a strong demand for their product and services that out paces their need to incur cost through unnecessary capital expenditures that might increase production cost and thereby reduce profitability.
In this environment, cash cow businesses might be in the best position to ride out current economic storms allowing the company or group of companies to take on riskier projects when monetary fundamentals and other economic factors are more stable or shares the risk by providing a more reasonable and assured return on invested capital. Companies that do not generate "secured cash flows" from their operations need to consider diversification strategies that would allow them to do so in order to balance out the strength and stability of their cash flow profile. This is perhaps the gravest danger facing companies in the modern economy, that of relying on a low cost strategy that might not offer sufficient avenues for creating a more dependable and secure basis for generating cash. Companies that take risks in businesses that are subject to various monetary or economic risk factors, such as interest and currency rate fluctuations, return on liquid investments, inflation, deflation or high cost of energy increase the risk of default under current economic conditions unless these risks are mitigated through hedges that can somehow be controlled or managed by the company.
7. NEVER BEFORE SEEN NARROW OR TIGHT PROFIT MARGINS AND INTEREST RATE SPREADS FOR CORPORATE & BANKING ACTIVITY.
In an economic environment plagued by negative interest rates on equity and bond liquid investments, the asset side of the balance sheet comes under ever increasing pressures to generate revenues that can properly support the cost base of operations over time while meeting dividends and interest obligations.
One of the risk presented by globalization that were of meager concerns in the past is the cost of energy and its effects on transportation that increases the cost of goods and services produced overseas that are essential to domestic operations and production.
The modern banker and corporate manager of the 21st Century are faced with enormous obstacles and barriers against success that his predecessor did not have to contend with. Gone are the days when a banker could make a loan on a Thursday and take Friday off to play golf because the spread on the loan was sufficient enough to secure the bank's future for years to come. Banks are now faced with extremely tight net interest spreads (the difference between net interest income and net borrowing cost) between earnings on loans and the cost of money that they must pay on borrowing liabilities. For some banks, this spread is negative, but due to fees and other ancillary financial revenues and products, many banks can post a modest profit.
We are living in a time whereby the system of capitalism is being eroded by the very agents or sources that feed or take revenues away from corporate activity. The simple business model exists no more, except for some “mom and pop” operations.
To return to the good old days is not an option. We must learn to navigate these turbulent financial waters or risk corporate annihilation.
One of the keys to success in this environment is to build value that can be stored, sold or transferred at a later date for alternative use. In this regard, the decision to purchase a factory or start a retail operations must consider demand for the land and real estate value as that might be the single factor that will allow the manager to sell the business at a profit in the future. Having access to locally produced inputs at competitive prices may influence a manger to consider purchasing cheaper items from aboard should changes in the future results in uncompetitively higher cost? The modern manager must think about the value of money and the safety of local banks before contracting to do business there. But perhaps more than anything else, companies that operate on thin profit margins or banks with narrow interest rate spread may wake up one morning to find their world turned upside down should future economic events change. Such companies operate at the mercy of the broader domestic and sometimes global economy running the risk of default every day!
What does this mean? It means that the modern business manager and banker must give greater consideration to unexpected outcomes in the future than they did in the past. A business model based on historical performance sensitized to changing future prices are no longer a safe approach to doing business modeling. One is forced to think outside the box, and invent and evaluate business changing conditions and environments that the modern bank or business manager may face in the future.
Since much of this planning has to do with downside risks, doing similar analyses for making supra normal profits would not serve any useful purpose. Companies and banks that operate on thin profit margins or net interest spreads are more susceptible to business failures than those that maintain a healthy margin or interest rate spread on primary business and loan activity.
We are living in a time where right is wrong and wrong is right in that traditional values do not matter anymore. In this upside down world that we find ourselves in with respect to money, economy, corporate profit making and banking, playing defense is just as important, and in many cases more important than playing offensive in global financial affairs. The business manager and banker of the past did not have to worry about storing and protecting the value of money over time, all he had to do was to make it. Today's banker and business manager is required to be more astute. The biggest risk facing banks and corporations, the primary generators of economic growth and output in our economy is erosion leading to deterioration of hard earned accumulated value. Laws enacted by governments the world over inch away at this value every day of the week whether it be through increased taxation or penalties on real estate that are the homes of the elderly, car tax, transportation tax, tolls, head tax, income tax - the list goes on and on. There is a need to reverse these trends in order to make life more livable and sustainable for the average human being, but from all indications in the world it appears that such realization will not be reached until after there is some great economic crash or calamity that forces people the world over to rethink the value of money. It appears that we are now at the brink of that disaster leaning over the precipice of economic damnation, some ready to jump, but until we rearrange our values and put people first not much will matter with regards to all the wealth, accolades and material possessions that we might accumulate over our life time.
Fort Lee , New Jersey
October 28, 2008; 10:42 PM EST