Not a Great Depression, a Great Rebalancing
Posted on Edge Economy: October 14, 2008 2:57 PM
Over the last few days, I've had numerous emails from you asking: is the global financial system actually going to melt down? Will the various bailout packages on the table work?
Let's use those questions to dive into two of the five steps in the next-gen business construction kit we discussed here recently: how the macro landscape is changing, and what new DNA is.
Here's the good news. We're probably not in for a full-blown depression—one characterized by 25% unemployment, for example. We're probably in for a protracted period of stagnation and malaise. Japan's been going through one for the last two decades, and the Japanese banking crisis is the closest parallel to today's global pandemic.
Here's the bad news. Macroeconomists have a checklist of policies for fixing depressions, but not for reversing stagnation. Japan, for example, has been caught between the devil and the deep blue sea; it can't fix its economy without literally tearing it apart, and rebuilding the private sector from the ground up.
The reason is that stagnation isn't a financial phenomenon, but an institutional one: it's a product of bad DNA. And so a resolution to the macro crisis demands nothing than less than new DNA across every segment and sector of the economy.
Let's reverse that insight to sharpen it. The striking thing about today's economy isn't that lame, soul-crushing industrial-era business is imploding into a black hole of economic nothingness. That was predictable. Rather, it's that while the so-called value created by, for example, investment banks, is proving to have been largely an illusion, revolutionaries bringing new DNA to the table are able to create authentic, durable, meaningful value.
By radically redefining how economic activities are organized and managed, a new generation of revolutionaries is rediscovering the long-lost art of real value creation. We've discussed many of them: Google, Threadless, Apple, and Zara, to name just a few.
But what does new DNA look and feel like? How is it different from industrial-era DNA? To many of you, DNA is still dauntingly abstract. So let's dig into the buzzword that the suits use to describe the crisis—deleveraging—to understand how it points to specific needs for better ways to organize and manage the economy.
As numerous observers has rightly pointed out, we face a great deleveraging—a tsunami of debt is being sucked out of the financial system, as confidence in counterparties implodes.
But that's just the gloss of financial mechanics. What does the great deleveraging really mean, beneath the technicals of, well, debt reduction? The answer is simple. The inescapable flipside to unsustainably cheap debt is that equity has been unsustainably costly.
I don't mean that in a naïve financial sense—stocks are overpriced—but in an economic one. The dirty secret of the global financial system—and the credit crunch that broke it—is that equity is an increasingly costly and inefficient mechanism for organizing corporate governance.
Consider a foundation of modern finance: Myers' pecking order model. It holds that companies finance themselves using a pecking order: retained earnings first, then debt, and finally, as a last resort, equity.
Why does Myers argue that boardrooms choose equity last? Because equity is the costliest form of finance. Managers can't often communicate information to shareholders efficiently or credibly; managers have to bear the costs of negotiating and bargaining with shareholders; and shareholders constantly have to monitor managers, and search for better-performing equities. Conversely, debt offers simple, direct benefits, like tax shields.
See what that logic implies? It's simple. That debt can add value to a company, but equity rarely can.
And so it's little surprise that we saw a massive—and massively unsustainable—explosion in debt. When one entire category of financial instrument is so inefficient, the endgame was inevitable.
When issuing, distributing, and managing equity is riddled with information, negotiation, bargaining, search, and distribution costs, is it any surprise corporate governance is breaking down? Frankly, no: the natural outcome of steep information costs is adverse selection—markets for lemons. In this case, the steep costs of equity selected lemon managers and lemon shareholders alike. The playing field has been tilted steeply in favour of cronyism, ponzi schemes of leverage, and shareholders asleep at the wheel.
Here's the point. The great deleveraging is really a great rebalancing: a rebalancing of the roles of equity and debt in the global economic system. Though in hindsight, it's easy to see that debt was unsustainably cheap, it's the flipside that reveals a source of tremendous institutional decay: equity has been unsustainably costly.
That's a major component of rotting DNA. And our challenge is reversing and renewing it, to build a better economy.
How might we begin? To rebalance the value equation of debt and equity, our challenge is to build a financial system where equity can also add value to corporations, instead of being simply a burdensome tax managers reluctantly pay to access capital. To do that, we have to reduce and reverse the costs that make equity relatively unattractive in the first place.
That means better mechanisms for managers to communicate information to markets. Why do we rely on heavily footnoted reports issued once a year in a world moving at lightspeed? When Yahoo finance chatrooms regularly move markets, it's a clear signal that the informational interface between managers and markets is in a state of terminal obsolescence.
That also means reducing the costs of negotiating and bargaining between managers and shareholders. Why does management only meet with shareholders a handful of times a year—if that—in an always-on world...and often adversarially to boot?
And it means better ways for shareholders to compare expectations, define outcomes, and measure performance—not just against competitors, but for buyers, suppliers, complementors, and customers. Didn't Enron—let alone Bear Stearns, Lehman Brothers, and GE's "earnings management"—teach us that profit is an illusion, and that it is more meaningful numbers and concepts which fuel long-run advantage?
That last point should square the circle. In an era where our economic institutions are fast becoming value destruction machines, it is revolutionaries who can reimagine what the corporation should be who will be able to seize paths to new sources of advantage. Innovators who can, for example, renew obsolete industrial era DNA by reconceiving today's toxic relationship between managers and investors will be able to evade and reverse the costs partially fuelling the macro crisis, and discover new sources of advantage built on more liquid, transparent relationships between investors and managers.
And that's vital. Bailouts can only stanch the bleeding—a full-blown recovery depends on better DNA. Without it, the picture is crystal clear: a future where advantage accrues to no one is as bleak and arid as an economic desert.
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