Friday, October 31, 2014

Beyond market jitters.

Are we still vulnerable to a global economic collapse?

My father was born a few years before the 1st world war; survived the global flu pandemic before his 10th birthday; lived through the great depression and fought in World War II. It was the depression that drove him and many of his peers to seek their fortunes elsewhere than Europe. They were of an age group poised to find meaning in life, carve their own paths and seek opportunities in a world that had little to offer after the collapse of the New York Stock exchange in late October 1929, and precipitating the longest, deepest and most extensive global depression in history.

As one interested in both history and economics, I would often encourage my father to share his thoughts and experiences of that time. They may have lacked some academic and scientific insights, but they gave me a much deeper understanding of human conduct so often ignored in our economic discourse but that was so profound in those events. It was during one of those exchanges that in my zeal to demonstrate my intellectual prowess, I explained to him that the depression was caused not by panic, but by a crude banking system unable to back the volumes of transactions and a fiscal policy that should have allowed greater deficit spending to counter an inevitable cooling off of the economy.

“Rubbish!” he said. “Everyone in an instant said: ‘Oh shit!’”.

That was it. A miner’s logic that brooked no further discussion; a belief in a single consciousness of man that in that case could trigger a collective response in unison with two words reflecting panic and dismay. Of course, there was some truth to that. Although there had been “market corrections” for some days from September 4th 1929, no one could predict the 40% fall over a few “black” days in late October. Just as surprising were four runs on banks within a year. Consumer confidence evaporated; spending fell leading to a sharp fall in business activity, bankruptcies, job losses and a fall in wages, all of which accelerated the vortex of a perfect storm.

I may not share my father’s assessment of economic booms and busts, but since that conversation, those two words come to mind each time we are confronted with market volatility. Can we really be confident that with all of the modern financial engineering tools at our disposal we can avoid a repeat of that cataclysmic event? Was the 2008 “great recession” not simply a warning light that faded behind the subsequent financial and stock market hype that in turn belied a much deeper malaise and an ailing real economy? Are the old economic postulates governing the relationship between consumption, production, money, debt and investment no longer relevant? Is everything so rationally secure that we cannot expect spontaneous irrational behaviour?

In short, with adjustment especially in the financial markets inevitable, the question is simply whether it will be a correction or a crash, a creep or a leap.

One thing is certain: the structure of the global economy is vastly different today and while this era has produced new disciplines of knowledge and experts, not one seems to have captured an absolute truth. Evidence of this can be found in contradictions in reputable responses: from pushing more money into the system to increasing interest rates; and from government austerity to increasing deficits and perhaps even writing off sovereign debts. Despite having armed ourselves with incredible technology to rationalise; to gather and process information and perform nano-second trades or responses across the globe, the whole system is underpinned more than ever by two profoundly irrational forces – greed and fear.

The side effects of a new Prozac for economic depression are still mostly unknown. The Atlas juggler has three spinning clubs in the air: a financial system; government intervention and the real, productive economy. Each has its own high level of complexity and intricacy, with the interaction between them being even more uncharted and complex. Even a highly condensed treatment of all the factors involved is way beyond the scope of an article such as this. Unfortunately the devil is in the detail so at best I can present an over-simplified analysis of some key issues and focus on the global perspective which impacts on South Africa.

The financial system is awash with debt – approaching $200 trillion or some 300% of total global GDP. This has been the result of a post-depression banking system that can multiply credit and advance it to the productive economy – in other words increase the money supply. Cheap credit should encourage both consumption and production and therefore economic growth, which in turn enables a repayment of debt.

But this has not happened. Consumers are insecure, debt weary (see Moneyweb article here), and generally income besieged; business is reluctant to invest in productive expansion and declining interest rates encourage widespread incestuous speculation in financial instruments including stock markets and derivatives which at an estimated $700 trillion is 10 times larger than global GDP.

Any talk, therefore, of increasing interest rates sends these “markets” into a tail spin, spilling over into stock markets and the real economy by further dampening consumer enthusiasm. Paradoxically interest rates are the primary weapon against price inflation.

Governments are the biggest “debtors” (about half of the total) and encourage low interest rates not only because of the impact on their own budgets but on the same theory that cheap money promotes economic growth. In addition, increasing government deficit spending should translate into higher economic growth and more jobs. So with few exceptions they continue to run deficits constantly shifting norms of prudence. But for the most part in the developed world this spending has gone into propping up financial institutions, and not on job creating government projects such as building infra-structure.

Yet, the most important constituent of all, the real productive economy remains as capricious, perhaps even as unfathomable as ever. It is here where we capture the very essence of our economic co-existence, adding value to each other in the provision of goods and services; where we explore and innovate, transact and exchange; where we freely express our moods, fears, hopes, aspirations and expectations.

In our desire to control the uncontrollable we have created a massive imbalance between the juggler’s three clubs. By their very nature the financial and government constituents are largely parasitic, adding very little value or creating little tangible wealth in their own right and feeding off the host of the real economy. But they are needed in creating the conditions in which others: entrepreneurs; the creators and builders of business, value based investors and workers can get on with the value-adding process and create prosperity and abundance. The current malaise is simply repeating history’s lesson that the force of the real productive economy is powerful, inexorable and with a mind of its own that sometimes simply wants to blow off steam.

Restoring equilibrium could take years, maybe decades. Yet, a collapse of the size of 1930 is unlikely. That was particularly severe because the pendulum swung from inordinate euphoria to widespread doom and in an economic car with no brakes. In addition, while we may still lack the expertise in appropriately using all the levers, switches and buttons of the fiscal and monetary machines, we are getting to understand them better.

Can we abseil down the cliff or will we run out of rope? Hopefully the bottom is not too far, but what is self-evident is that greed and fear are totally inappropriate in such a pursuit. We need patience, prudence and fortitude – attributes that sustained my father’s generation in an age of deprivation.

Monday, October 20, 2014

The great contamination.

Have we polluted wealth creation to a point of self-destruction?

Adding value to each other is not only the essence of our humanity, it is the basic cell of our economic life. It has been the core of our coexistence from the Stone Age; the foundation of barter, exchange, trade and money.

It accounts for our supremacy as a species. It is powerful and robust, shaping systems or destroying them. It accounts for prosperity, is measurable, drives innovation, transformation and progress, and is the ideal template for self-empowering conduct. But it is not indestructible. If it dies, we die as a species. It has to be nurtured, protected, strengthened, and not contaminated.

Adding value needs an environment of maximum freedom of choice, many suppliers, competition, consumer awareness, free moving prices, stable money, and adherence to the natural laws of supply, demand and price. A very large part of all economic study, research, and theories revolve around these issues and I am sure you have your own view on the extent to which these rules have been broken both globally and nationally. Despite the fanatical stances many often adopt, there clearly are no absolutes and no universal formula that can be applied in all circumstances.

That may be a subject for a separate article, but for now let’s focus on the contamination of the wealth creation cell itself; where value gets added to accumulate into national prosperity and abundance. This is perhaps more important and far more in our direct control both as companies and individuals.

A dual economy

Can one have wealth without adding value? Yes, through debt. You can live like a king and amass a fortune on borrowed money if you have no concern about repaying it and leaving the problem to your children and their children’s children. That’s difficult for an individual, but less so for a company and certainly easy for a government or country in a flawed banking system. So we have created two economies: one based on production, the other on debt; one tangible and the other financial; one real the other virtual. Not only have they been drifting apart but the latter has begun to engulf the former with the main effect being greater global inequality (see latest Global wealth report here) and financial instability. (See IMF GFS report here.)

Perverting purpose

Existentially tangible wealth is always created by serving another. It has no concern about motive or purpose: it simply has to serve and be served. I have dealt with this subject frequently and remain convinced on two points. The first is that we have inappropriately attributed great individual and company achievements to profit maximisation. In all my years of exposure to the subject I have found very little evidence supporting that – indeed overwhelmingly the opposite. More evidence of this can be found in the philosophy of the latest business superhero, Elon Musk.

The second is that a service motive does not and need not detract from sound business practices. It is not “charitable” and “non-profit”. It has to stick to the rules of legitimate transaction to be sustainable.

There are a number of business behavioural models or hybrids of these models in wealth creation: profit driven; wage driven; both profit and wage driven; state driven and service or market driven. Being service driven is not synonymous with any of the other models. That speaks to sincerity of purpose and ultimately trust. You may not care, but you certainly have to behave as if you do. Being service driven focuses on contribution and wealth creation itself. The other focus on reward and distribution.

The accounting deception

I’m often amazed at how many “informed” people still believe that mathematically profit equals wealth creation, and that other constituents such as labour and state are a cost to profit and therefore a drag on wealth creation itself. That’s pure accounting nonsense! Value-added = wealth creation involving three contributors: labour (wages and salaries); capital (profits) and state (taxes).

This deception has entrenched capital supremacy and the “profit motive” as being the real and only driver of wealth creation.

Divisive abstracts

In my wood carver example, I made the point that wealth creation and its growth make no distinction between labour and capital. In that simplified example, they are indeed one. Of course the bigger the business gets the more roles have to be defined. This ultimately leads to the creation of abstracts such as labour and capital, falsely attributing to them a generic behaviour and inevitably creating a jockeying for supremacy.

That detracts from a common purpose of service and an obsession with wealth distribution rather than wealth creation. It becomes particularly destructive when you have wage and profit driven conduct like in South Africa.

The labour market myth

The standard view that labour is a cost and a drag to wealth creation enforces a commodity expression of labour and the concept of a labour market. Few people actually understand it because it implies buying and selling bags of kilojoules. For the most part, it is a myth! Yes, there is a market for skills, qualifications, and experience backed by a track record. These may guide a basic minimum and differentiated pay, but the most important part, and the real value of labour’s efforts are priceless. They are willingness, enthusiasm, reliability and those human attributes that will always set us apart from bags of kilojoules. In the end, an unwilling engineer has not much more value than an unwilling janitor. Even less so from a cost/benefit point of view.

The value of that part of human endeavour – as I say by far the most important – is best determined by a proven end result, the real contribution to value added. There is no stronger case for variable pay. It’s made even more imperative because the so-called market price for labour, restricted as it is to those less important features is itself severely flawed both by remuneration criteria and factors that have nothing to do with supply and demand.

Capital supremacy

It’s one thing to create an abstract. It’s another to deify it. That’s economic paganism. Again, it’s a subject I have dealt with extensively such as in this Moneyweb article here.

Creating an abstract assumes some generic behaviour. We know that’s false. Shareholder and investor involvement can differ vastly in size, term, motive and conduct. Despite that, one could argue that “capital” is more suited to a passive commodity definition than labour.

We have somehow accepted that the highest price customers are ultimately charged for a company’s use of capital – i.e. profit – is desirable because amongst other things it is by nature a permanently scarce resource, whose deployment creates jobs and wealth. The scarcity of capital is also a myth in part based on a theoretical distinction between money (debt) and capital (equity). Debt capital is the cheapest it’s been for many years, and there’s certainly no shortage of equity capital given demand for equity on stock markets, high levels of corporate reserves, a relatively low level of new venture IPO’s and rights issues, and share buy-backs.

Few investments are being made in new ventures, plant, production and jobs, not because of a scarcity of capital, but because of a lack of demand. That destroys the theory that jobs are created because of capital deployment. One first needs relatively debt free demand, then a desire to serve that demand, and then the deployment of both labour and capital in that service.

There are many points in this article that justifiably can be challenged. The question in the title, however, remains relevant. Are we not so overwhelmingly obsessed with wealth distribution (specifically wages and profits) that we have ignored wealth creation itself, the most important and meaningful of all?

Sustainable wealth is not created by debt, investment, and speculation. Nor is it created by the pursuit of either wages or profits. It is always the result of adding value to other people’s lives. Wages, profits and taxes are a consequence, not a cause.

We have known that since the Stone Age.

Tuesday, October 14, 2014

The magnificent metric

The simplest measurement in business is also the most important and powerful.

It’s been said (by Einstein I believe) that if you can't explain it to a six year old, you don't understand it yourself. That may say something about the comprehension of the child or the teacher, but the most important and powerful measurement in business will not suffer from a lack of either. It can be explained by a six year old to a six year old.

Here’s how it works: a young boy buys a top for R10 and plays with it in a school yard. A friend comes to him and after enquiring where he got it and how much he paid for it buys it from him for R12. The boy has created wealth of R2.

That’s it! Clear, pure, and profound.

It could have other accounting terms in this simplified example, but it also captures the most important one of all -- value-added, or adding value. It means wealth created and is calculated simply by subtracting what you paid others from the income you received from your sales. You may ask what value the top seller added. Measurably he clearly did, because he now has R12 instead of the original R10. But he did so in practical terms as well. He saved the buyer a trip to the shop, perhaps even showed him how to spin the top.

Increasing value added, or wealth created is just as simple. Let’s illustrate this in another more commercial situation.

clip_image002If this wood sculptor increased sales by 10%, his outside costs would increase by 10% and wealth also by 10%. If he gets an improved price of say 10%, outside costs stay the same and wealth created increases by 20%. If he reduces outside costs by 10% his wealth also increases by 10%. If he can achieve all three at once he could increase wealth by up to 40%!

Simple! Of course what goes into achieving this may not be, but in essence there are only three things you can do to increase wealth creation – sell more; get a better price; and manage outside costs.

The process of wealth creation and the method of increasing it are very simple concepts and have been with us since we first learned to barter or trade. This can and should be taught in very early childhood, because ultimately all economic activity is dependent upon it, including the sometimes ridiculously complex abstracts that we have created in our economic world and the basis of equally convoluted “investments” which some rather misguidedly believe are the real instruments of wealth creation.

Wealth creation does require a specific self-evident environment to flourish:

· Maximum freedom of choice

· Maximum number of suppliers and competition

· Maximum awareness and information

· Free moving prices

· A stable means of exchange (money) and

· Being informed by the natural economic laws of supply, demand and price.

Its simplicity may also detract from its importance and supremacy. It is the cell of our economic existence, upon which all other cells are built either directly or indirectly. In our wood-carver example, the people he bought the materials from added value in their own right by producing them, and the person who bought his carving would have earned income in similar pursuits.

Someone in that chain may have borrowed money, which ultimately will have to be paid or redeemed by income earned from tangible wealth creation. This shows how debt is (or should be) realistically linked to current and future tangible wealth creation.

If we add the wealth created by all of the people involved in the exponentially increasing chain of value-adding cells in a country in one year, we arrive at the bulk of Gross Domestic product which as we know, is one of the most important national measurements that affects a host of critical economic outcomes, assessments, policies, government finances, interest rates, employment and board decisions. You simply cannot separate this from the microscopic cell such as the wood carver.

The value-added measurement is a much neglected, but vital acid test for companies, especially if tracked over time. Consistently greater value-added, or regular increases in wealth creation say far more about a company’s overall sustainable health than some of the other metrics do, including profit. Most of those metrics are in any case extrapolations of value-added. Unpacking the constituents of those three lines for example, would have prevented the large Enron fraud at the turn of the century.

Taking our wood carver example again, he is both the owner and doer in the process; both employer and employee or to use the preposterous and highly counter-productive ideologically loaded abstracts we have in economic theory: “labour” and “capital”. Wealth creation stands apart from but not immune to our questionable separation of these contributors. In terms of wealth creation, they are one and the same, a partnership if you will, whose rewards are ultimately determined by wealth creation itself, or the value they have added to other’s lives, not what they can exploit from each other or flawed “markets” that give them a presumptuous inherent claim to a reward.

To summarise: there’s a very simple formula to prosperity and the economic circle of life: value-added = wealth creation = contribution = reward. In turn this encourages demand, which leads to value-added and closes the circle.

If we examine both the environment which wealth creation needs to flourish, and the cell of wealth creation activities, we cannot help but be astounded by how we have contaminated it, indeed made many cells carcinogenic through theories, abstracts and ideology. I will deal with these in a future article.

The wealth creation measurement is only one of three dimensions of adding value. An important dimension is that of transformation. By its very nature value-added means transforming one situation into another which in most cases is better and represents progress. The full dimension can seldom be captured in one event and at one time, and also has to be assessed by factors other than natural economic laws. Preventing environmental destruction is just one example.

The third dimension of adding value is the most important of all. It is about behaviour. It is about an attitude. It’s an attitude that should be taught and instilled at the earliest age; through simple things like helping a sibling, or picking up some litter.

It’s an attitude that rests on our empathic nature; should be ever present; ever willing to make a difference and exploring transforming one situation into something better. It is an attitude that is there when one wakes up in the morning with the question: “what difference can I make to someone’s life today?”

Economic prosperity and success rests firmly on three personal qualities:

· willingness to contribute,

· a passion for an activity and its transactional relevance

· and the ability to look beyond assured immediate self-gain.

These are the winning attributes of an individual, of a company and of a nation.