I've been watching PBS's FrontLine piece on the global financial meltdown. Scary stuff... not so much because it has me worried about my future, but because it has impacts that are causing ripples through the entire global economy. These ripples include:
- Job security for employees of multinational publicly listed companies is in immediate jeopardy.
- Many of these employees are carrying credit based on the assessment that they were appropriately compensated for their abilities and safe in their positions.
- If my suspicions are correct, then the trickle (soon to become a stream, then a raging torrent) of highly skilled employees transitioning from employment with publicly listed companies into the job market is going to drive down the cost of labour significantly.
- With less spending power (and far greater credit constraint) in the economy, the price of goods and services is going to have to fall. People will simply be unable to afford to consume products and services at their current prices, thus wiping value and liquidity out of privately businesses as well.
- With lifestyles at risk, investment properties will be liquidated at fire-sale prices, banks will lose income on interest payments, the mortgage sector will drop further and so on.
- The only people who will benefit from this continuously falling spiral of cause and effect will be those with huge personal savings in liquid assets (gold, government bonds, etc) who can take control of tangible assets at very favourable prices.
- By the time the global economy stabilizes I expect to see close to a quarter of all publicly listed equity go up in smoke, the number of publicly listed companies to fall significantly (either through bankruptcy, or through fire-sale acquisitions), OECD poverty levels to rise sharply and the levels of government debt to double, or even quadruple over time.
In other words, the insanely rich will take an even greater share of the worlds' tangible assets (buildings, corporate equity, those who have clawed their way from lower to middle class, and from middle to the fringes of the upper classes will be kicked back down a rung or two. The gains of the last century of progress in providing access to leisure activities to entire societies will be lost, as more and more people will be forced to work additional minimum wage jobs just to make ends meet.
I can see two ways in which this can be prevented. Both of these require that governments step up and protect the retail economy from the disastrous excesses of "self-regulation" in the financial sector, and from other policies that have led to A) the enfranchisement of public companies in public sector spending, and B) the overvaluation of assets based on the credit leverage banks have offered over the last decade. Keep in mind that as far as the electorate are concerned, they are governed not by representatives of political parties, but by a monolithic organization called "The Government". This is not about pointing fingers and party politics. Western Governments have failed their governees by not placing adequate controls on the financial sector, and have a duty of care.
But first...
What's all this about public companies being in trouble?
Well... let's start with who the biggest shareholders of public companies are. Either directly, or via the investment trusts they manage, we're talking BANKS here people. So the pressure is on right now for public companies to pump out dividends like there's no tomorrow. Or yesterday. Or previous economic downturns where investors would patiently say "Ah well... economy's crap - we'll just have to be satisfied with lower dividends".
Why is this an issue? Because the banks need an influx of cash.
Reason one why banks need cash in a hurry:
Banks are in a position where they either need to build retail-level confidence in their investment instruments (401k plans, superannuation funds, etc) or get out of the business of managing these funds entirely. While it sounds simple to get out of the investment fund management business, it's not. This would mean dismantling two thirds (or more!) of the private bond market, and result in a huge loss in the amount of assets under management, which banks use to obtain credit (typically with a 1000% multiplier) and then issue either in the form of commercial or retail lending products. Also keep in mind that banks make fat commission and fee income out of managing long term investment funds.
Reason two why banks need cash in a hurry:
As discussed in the FrontLine feature, part of the problem the finance industry is having is that they are in a position where they may have to pay out hundreds of billions - even trillions - of (insert your OECD nation's currency) here to the investors who bought unsecured and under-collateralized insurance against the packets of sub-prime mortgages they had bought. The deal is, that if the mortgagees fail to maintain the mortgage, the insurer pays out the value of the mortgage security to the entity they sold it to. However, the insurance providers (typically investment banks such as Bear Stearns or Lehmanns) didn't have anywhere near the cash reserves required to pay out the value of these mortgages in a short term fashion. Some of these firms are being bailed out by government, others swallowed up by federally guaranteed banks - but even the federally insured banks are private enterprises. While governments are rapidly becoming shareholders in these banks, they are not necessarily majority shareholders. So the banks themselves have their equity leveraged across the rest of the investment industry and are under the same pressure to return dividends to shareholders as everyone else. But banks are also either accumulating or having to fund huge short term cash liabilities as a result of paying out on securities insurance claims. They are struggling to stay in business and need to fund these liabilities as quickly as they can.
Reason three why banks need cash in a hurry:
Greed. Pure and simple. The boys club at the top of the public corporations know the jig is up. The writing is on the wall. The securities industry and society as a whole will no longer tolerate huge job losses at the same time as the people mandating them are claiming massive bonuses by managing to keep shareholder (read: Banks) dividends at levels as close to pre-crisis levels as possible. They want to milk as much cash out of their insane performance bonuses as they can before the whole system collapses. This "old-boys" network has been largely self-perpetuating for the last 2-3 decades, replenished occasionally by sharp thinkers who can demonstrate a similar ability to focus on the numbers and forget about the human equation in business... but they know that if one of their members is knocked off his ivory tower then the rest of them are vulnerable too, and they ALL feel very vulnerable right now. For the record, I'm talking about people who have managed to in the area of US$100M apiece over the last 5 years (or less). I have no problem with company directors being paid well given the responsibility of their role, but their performance bonuses should not be greater than their salary - and certainly shouldn't be 20+ times greater than their salary. Likewise, given that the salary of the US president is only a six figure number, I don't believe that there's any justification for 8-figure salaries for board members and chief executives. I believe that all executive bonuses should be paid in fully vested shares - not in share options or cash. If they want to cash out their bonus shares, they can do so in line with the capital value of the company, which if they're doing their job right, should be continually undergoing organic growth.
So what's this about public companies shedding jobs?
As discussed above, banks are crazy for cashflow, so Fortune 500 company execs are getting a proverbial wedie by the investment industry and being told "We need Dividends... and NOW bitches!" This might be funnier if the majority of public companies weren't owned mostly by the investment industry. If the investment analysts (effectively a cartel operation in all but name) decide the public companies aren't playing ball, then they can simply sell down the company's stocks and refuse to touch them until the company directors comply. No matter what the strength of a public company's fundamentals, the only way they can remain fully capitalized in a situation where the institutional investment community has effectively blackballed their stock (which they do through credit ratings) is to take the opportunity to buy back their stock. Given that very few public companies have the cash savings required to do this, this means they are all at the beck and call of the banking industry.
One of the biggest costs for all public companies is labor. This has led to the huge off-shoring movement of the late 90's and early noughties, where increasingly better educated staff from developing nations are taking over the jobs of western employees simply on a price comparison basis. I respect the work of a lot of my colleagues in India (and now China, Argentina, Brazil, etc) do - it's often thankless, tedious and repetitive work - and I'm glad I don't personally have to do it. But as the public companies bite further into their delivery hierarchies in search of cost reduction, they are starting to replace people with 10-20 years experience with offshored resources with no experience at all.
While offshoring is a big component of job-losses in the western economies, it's not the only one. Another area being investigated by many public companies is reducing the liability of carrying long term employees, who under their contract of employment are entitled to be paid out for each year of service if made redundant. In the case of some of my colleagues, this is fast approaching a full year's worth of salary. If these people are being replaced at all, it is by graduates (or offshored resources) who carry no liability other than their lack of experience.
While a year's salary as a payout sounds nice, nobody really wants to hire fifty year olds into the same sorts of roles they were doing previously and on the same pay (unless they're part of the CXO boy's club). There's a myth about them being stuck in their ways, hard to teach, hard to mould - and in some cases this can be true. But many of these people are having to reskill into entirely new professions (e.g. accountants becoming handymen, IT pros becoming white-goods salesmen) with no guarantee of the same kind of income.
In addition to this, the majority of public companies are slashing job benefits; deferring pay-rises for promotions; asking employees to take pay cuts (a neat way to get long-serving staff to leave voluntarily, thus voiding the need for huge payouts - and incidentally, doing so with no guarantee of a return to their previous income when the economy recovers); cancelling training budgets; revoking company discout programs; and moving more aggressively to performance based pay based on metrics and KPIs that mean relatively little to the employees themselves. In other words, they're slashing and burning in every direction that they can to lower the cost of doing business.
However, sooner or later, the cuts are going to go critical. In some cases I suspect they already have. If a company cuts or disenfranchises its staff too much, it will be unable to deliver to its clients, end up losing revenue as those clients cut them loose, and then need to cut more staff in a cycle that ends with a bunch of confused board members with fat pocketbooks looking at the wreckage of what was once a fortune 500 company. There's going to be more than a few of these. There will also be huge numbers of people who work for these (often) multinational companies (myself included) left on the sidewalk wondering what just happened.
What are the solutions?
Solution 1: Government reform of retail credit.
The governments of OECD nations can buy bad "retail" debt from banks and choose to either forgive, postpone payments on an interest-free basis or call in those debts and resell the assets concerned back to their original owners at a more affordable base price.
As an example, consider a family with two bread-winners working for public companies about to find one or both of those breadwinners out of work. Let's say that based on 2 incomes, the banks have lent those people $500,000 for a $600,000 house, allowed redraw for cars, etc. With only social security income to draw on, this family has no chance of maintaining payments on a $500,000 mortgage, even at a 5% interest rate. Assuming the principal paid out so far is around $150,000, this family's total equity value would be in the area of $250,000 based on the value of their home. Foreclosure by the bank is a foregone conclusion, and with that level of equity, this family will probably be ineligible for government income support for several months. Additionally, it turns out that the property is now only worth $450,000 on the open market, so the family will be taking a $150,000 hit on their equity if they choose to sell the property in order to survive financially.
So... how do we fix the microeconomic problem this family faces?
Step one - rather than foreclosing, the bank offers the debt to the government, which assesses the value of the mortgage, the rest of the family's assets and equity and firstly revalues the mortgage based on a formula that takes into account the real value of the property once the inflationary effects of the banks' excessive credit leverage have been taken out of the equation. So, let's say after this, the family home is now valued at $400K. I know this is higher than the current market price, but it may not be for long.
Step two. The government revalues the loan on a pro-rata basis. So... remaining principal was $350K, government has devalued the property's book value by $200K - so the new "pro-rata" value of the mortgage value should be $235K or so. The government then charges half of the difference between the revised mortgage value and the bank's current "principal balance" to the bank. You thought I was going to let the banks get off scott free? This approach means that both accountable parties take financial accountability for their failings.
Step three: Part 1. If the family breadwinners have been able get new employment at a similar or lower salary, and can then stump up the money to take on a new mortgage at this value, the government goes back to the bank, says "we'll guarantee a mortgage to these guys for $235K", bank issues new mortgage and everyone's happy.
Step three: Part 2. If the family breadwinners are struggling to get work, because their skills are out of date (public companies are getting progressively worse at offering on-the-job training as cost constraints cut in), then they have a 12 month window to sell the house, get retraining (for which the government should be stumping up some grants - with a specific focus on small business) and find work before the offer of the revised mortgage elapses. In the meantime they can live in their family home without financial cost or penalty.
Step three: Part 3. If the breadwinners nominate to put their skills to work in a new business, they can remain in the house for up to 5 years without financial cost or penalty. The government charges the bank their half of the settlement in the mortgage value. However, from the date the family announces that they're going into business, the government starts accruing interest against the property's unfunded equity based on the current interest rate paid by the respective central bank's lending authority (in Australia, that's the RBA, in the US, the Federal Reserve, etc). So in our example, the unfunded equity is $235K. If the family CAN afford mortgage payments after establishing their business, they can then opt at any time within that 5 year window to have a NON-guaranteed mortgage for the current unfunded value of the property opened with the lender of their choice.
Step three: Part 4. If the family is not in a position to take on a new mortgage after 1 year (jobseeker path) or 5 years (business start-up path), the government forecloses on the property, pays out the existing equity in the home and the family will then be forced to restructure their lifestyle accordingly.
What are the benefits of this approach?
- Families can restructure their skillsets and secure new income without needing to run down existing equity.
- New business ventures will blossom and start adding real value to the economy that is not based on highly leveraged "paper" money (i.e. undercollateralized bank credit).
- Banks and the Government are forced to come to the table and provide compensation, or at least lessen the burden - for lenders as a result of the hardship that their collective policies have wrought.
- If banks are able to find a clean path for disposing of "toxic assets", they will be better placed to ride out the bump, and will not be so reliant on public companies to fund their recoveries through dividends. This will lead to economic growth, and a measured recapitalization of publicly listed corporate equity.
Solution 2: Macroeconomic reform of business structures and regulation
The other thing that governments will need to do is find a way to decrease their reliance on public companies (which I believe are on a fast track to failure anyway) and start pouring money into small-to-medium sized privately held businesses. There are a number of options here, all of which could support the establishment of a business sector based on real products and services, not paper-money and the over-inflated egos and reputations of the Wall Street CXO alumni club.
Capital injection
One of the biggest hurdles to getting into business is the need for capital. Banks have traditionally been a source of this resource, but it comes with strings, interest payments, and credit checks. The latter means that people starting a business from scratch without savings (or securable assets) behind them are very unlikely to be able to transition out of full-time employment into running their own business. If that person has just received a decent payout from their empoyer, it's a little easier, but still not a foregone conclusion that they can survive the start-up phase of a business. Our respective governments need to demonstrate an appreciation for the fact that courting large (typically publicly listed) companies to set up shop in their jurisdictions is no longer a viable way of securing higher employment. Trickle-down economics is a demonstrable failure, as it is simply resulting in off-shoring and job-shedding in developed economies. There are notable exceptions, but these are few and far between.
So - how can governments help asset-poor people start up potentially profitable businesses?
How about a holiday?
Well... in the past, governments have given big business tax-holidays. Why not extend the same courtesy to small business, and grant new business operators a 5 year amnesty on tax up to a threshold level of declared profit?! This would allow new business operators the luxury of significantly higher income when they need it most, and to also pay themselves and their staff a livable income while doing so. While this is not strictly speaking a capital injection, it allows the business operator to reinvest in their business, grow their customer base and employ staff.
Employment bounties
One of the things big companies have been able to do in the past is hold the spectre of job losses over the heads of the governments of the jurisdictions they operate in and demand support when times are tough. The car industry has been rorting the system in this way for years - governments are finally starting to get over it, but if these clowns can extort money out of governments for keeping jobs, why shouldn't small business operators get a cash bonus for creating jobs?! (This should include subcontracting services out to other small businesses!) Of course, there needs to be a caveat here. These bounties should carry with them an annually reducing liability, such that if the employee is fired within 5 years, a proportion of the bounty needs to be refunded. This gives businesses a disincentive to hire and fire people in rapid succession to cash in the bonus each time. For sub-contractors, the bounty would be pro-rated based on the percentage of the contractor's time spent working for the business operator - e.g. Say I sub-contract a web developer to do create and maintain some sites for me. I engage him 1 day a week, so I get 20% of the hiring bounty. However, if I only need half a day a week the following year, I refund half of the 20% bounty to the government. There's some fiddling with the minutiae that needs to be done with this idea, but it's worth looking at.
Rent assistance and property reform
One of the biggest barriers to entry in small business is being able to obtain business premises to work out of while also having to pay for residential premises. Running a small business out of a rented residence usually violates tenancy agreements, and running a business out of a self-owned property zoned as residential only typically violates zoning laws. What this means, is that new business operators are usually required (on top of their capital investment expenses) to rent commercial premises at significant cost. If governments could provide assistance for new small business operators to obtain reasonably priced commercial premises to work from, this could be a great means of incubating those businesses. There are a couple of ways this could be done.
Firstly, cash grants to cover the first 5 years of operation, starting at 100% of the rental cost in the first year of operation then diminishing by 20% of the current premises rent over successive years. This allows new business operators to set up in a professional shop-front or workshop environment in an appropriately zoned area without having to incur a capital cost.
Secondly, governments could commission the establishment of business incubation sites, where a standardized set of offices, workshops or warehouses could be let rent free to businesses in their first year of operation, 20% of market value rent in the second year, and so on. This has the same effect as the grant concept, but has the added value of a standardized offering (thus simplifying the administration of the program) and avoiding abuse of the program through business operators renting unjustifiably expensive premises.
Finally, there are some local councils or state legislatures that allow people to live in their work premises without zoning issues, but these are not as widespread as is necessary to support an economy running on cottage industries and small businesses. Very few business premises have all the facilities to support residency (i.e. bathroom with shower/bath, kitchen), and very few residences are built in such a manner that they can support a professional business image (traditional commercial street frontages, etc). Governments need to do more work in this area. There are vast tracts of land currently being renewed and redeveloped in response to population growth and cultural changes - adding a number of mixed-use premises into new developments should be a mandatory requirement for developers. These premises should support local commerce and employment in new housing developments, and also provide a much needed focal point to these kinds of new communities. Governments should also support the use of more mixed-premises zoning along or within easy access of major roads.
Provisional tax
A common taxation practice in western economies is to charge companies "provisional tax" after their first year of operation. Often, this means that the provisional tax is due within a quarter, to 6 months (depending on jurisdictions) of payment of their first year's tax liability. If there is less tax due at the end of the second year than was paid in the first, the taxation office refunds the difference and charges provisional tax for the following year at the adjusted rate. Provisional tax is admittedly a sure-fire way of ensuring that tax revenues are collected consistently, but from a business operator's perspective, they are a barrier to entry, as it becomes a cashflow drain when the business needs cashflow growth! Governments of the world - please make provisional tax go away if you haven't already. If you don't get a critical mass of new businesses up and running in the next 12-18 months, you can kiss your economies and sub-10% unemployment figures goodbye. If you can get revenue earning jobs into the system, you will collect more tax through GST/consumption/sales/VAT schemes than you'll need to spend on unemployment benefits and reskilling your workforce.
In Closing
The day of the megacorporation is coming to a close. There will be a few public companies that will ride out the loomingcurrent recessiondepression (who are we kidding - its a depression and its here right now!), but they will never be the powerhouses of innovation and employment that they have been in the past. The malfeasance of the banking industry and the unbridled greed of the Wall Street CXO culture has led us to a future where we will look for boutique brands made by local manufacturers rather than buy from the huge corporations who have sold out our futures and their own. The fates of our local (and global) economies are in our own hands. If we continue to embrace the myth of the lifetime salariman we are destined to lose. The only way to guarantee our future prosperity is going to be to become more risk tolerant, more entrepeneurial, and more supportive of our local small business communities. This is where financial and industrial globalisation has led us, and we need to embrace this future. The alternative is stagnation, state run enterprise, and a loss of freedom and culture. We can learn from the French in this new commercial revolution, and embrace the values of liberté, égalité, fraternité. Our trading partnerships will become as important as our customers, and the new production lines will need to span tens, hundreds, even thousands of small businesses - each doing their part and doing it well. We have learnt our lesson from the industrial revolution, but its time to return to the cottage, and work together for a brighter future.
Ged - out.
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