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Foresight

April 9th, 2008

My interest in economics was first piqued decades ago. I saw clearly the aftermath of unexpected economic volatility, and particular the wrenching impact of economic manipulations through money, banking, or trade. It was not pretty, although it occurred to me that the outcome didn’t have to be ugly.

Owners who got into trouble were my motivation. I found it gratifying to get them out of trouble. It seemed to me it would be even better to keep them out of it altogether.

There is an owner’s story I heard much later in my career, but it seems to me the epitome of everything I’ve seen before and since about things that goes wrong. We had become good friends, and so he unfolded his story for me. I could see it happening, I could anticipate what had gone wrong before he confirmed it in his telling. I wish I had been there in time, and said so. He told me we would not have listened.

I find no comfort in being proven right by a disaster. It is been the challenge of my career to make the information I offer compelling to people like my friend before the disaster. It is so much better for both of us if I am vindicated by my client’s success.

***

I want to say this carefully: managing a business is important, but it ranks dead last in the creation of wealth and avoidance of economic loss. In fact its techniques are often contrary to wealth creation, because management is about control, tighter costs, more volume, fewer mistakes, narrow focus, and so on. All these are contrary to true economic gain, which is dependent on innovation. And they miss true economic loss, because they’re not looking outside the firm from where it comes. For management to work, it has to be consciously subject to these two realities that fall outside its function, and indeed its ability to function.

I once that small business was beset by uniquely bad management. I meant no criticism, because I didn’t think the problem was solvable: managers with superior education and training are financially impractical for small companies. However, wise judgment apparently takes something more than education and training. As happens time and again, economic foresight escapes even the best, brightest, and biggest, as the spotlight of publicity has recently shown. Bear Stearns’ shareholders have a front row seat. In 15 months their shares went from $165 to $10.

That is where economics enter.

The field of economics began when some smart people noticed that some decisions that were good in the short term turned out very bad in the long term. In the short term, P=Vu. P, the price of doing something, is about equal to Vu, all the costs of doing it (including a sufficient return on capital, or profit). The problem is this: P never equals Vu for long enough to safely ignore the rest of the formula, whatever our short memories tell us. The whole formula goes like this: P=Vu[(Sy, U),t(n-1, n+1)]. Price = Value modified by Supply and Uncertainty over time; this is discernable historically (n-1) and can be anticipated and prepared for in the future (n+1).

P=V is a rule of thumb; we use it because it’s fast, easy, and familiar. But it assumes that (Sy,U) does not affect the outcome. And it won’t today, and mostly likely won’t next week. Thereafter? N + 1; it certainly will, at an uncertain but insufficiently distant date.

Think about the supply of credit, which is also making some headlines. The availability of money, the conditions of borrowing (collateral, money down, etc.), and interest rate are all parts of it. It is a common and insidious player in terms of its influence on decisions. Abundant credit drives prices up, but those don’t change the economic use value. When the government inflates the supply, always for a good cause of course, it falsifies our simple P=V calculation. It is a sound calculation except it ignores S when the supply inevitably contracts later on (n + 1).

No one is immune. Some owners avoid investment or borrowing when they sense the growing risk of a mature boom. By this they assume they’ve escaped the risks from, to follow our example (I have countless others), a credit-driven distortion. They won’t. Yes, they’ll avoid the collateral erosion and the liquidity crunch by loan call. But when I have diagnosed these ostensibly conservative firms I find them neither established nor conservative. When you under-invest, you become under-competitive. The law of economics dictates the need to adjust again and again. Others don’t stop invention and innovation just because you have. In the failure to invest you also have the loss of an idea, and so the loss of the future. In wisely escaping the most discernable effects of economic volatility, they fall prey to economic change.

***

My friend’s crisis had its roots in the 80s. He was probably right — I would not have persuaded him. Now the tools of my trade are better. The picture of the future can be painted with more than words of wisdom from sound economic reasoning. Data can fill factual gaps that were impractical to crunch 25, even 15 years ago. We have learned, or relearned something as well. Data can hide things that pictures, charts, and graphs, can easily reveal. Benoit Mandelbrot, a mathematician famous for his work on chaos theory, drew pictures of his math for the same reason. Would I have convinced by words, reasoning, data, and pictures? He was well-educated, a man of broad experience and clearly a man of vision (a true entrepreneur). I like to think I would have.

Today I would approach the matter by extending the analysis deep into history, t(n-1). Unfortunately, business is not known for its interest in history. The other morning I heard an analyst say that he hadn’t seen anything like the current conditions in 25 years. Since he was talking about a combination of high inflation and recession, I thought is history was too short. The 70’s saw plenty of both. Are we so much smarter now that this is ancient history and doesn’t matter?

The business of business is maintaining and increasing profits. Without profit we don’t survive. If we’re profitable today, we can take care of tomorrow…tomorrow. We solve problems, plug leaks, correct the wayward, and tend our networks, and should see some profit.

Like Bear Stearns. They did those things, and brought considerably greater expertise to bear than most of us will ever have at our command. No one can argue the business they were doing was unprofitable. It was different that the business they did before, we all knew. It was new innovative products, we all knew. But different words for the same things and calculations by spreadsheet instead of pencil and napkin do not revoke the laws of economics. Fool with credit supply and soon enough everyone things the future is all up. Uncertainty disappears. It is nice to think the future is always upward, but it is not always so. The ramped up credit supply did not make housing affordable. Finally, the unaffordable reality intruded and pinned the bubble to the floor.

So that you don’t miss the point because of my focus on mortgages, examination of economics runs to the question: Where were the executives at Bear Stearns (and many others, excepting Goldman Sachs)? What is the CEO’s job if not to consider and prepare for the future?

On the other hand, the executive who wrestles with the future will hear rumblings for “neglecting” today’s problems and profits.

How can I say the future is foreseeable? We in small business have tools now that were unimaginable or at least impractical before the last 25 years. Alas, even these are “impractical” for the hardnosed businessman. Tools don’t give answers, they raise hard questions. You will take some hits to the shins because your gaze is ahead, not at your feet. My best advice is to strap on the shinguards and look. For those who need justification for such a “speculative” process, surely the answer is to make good decisions. What decision matters that is not about the future? In fact, when is a decision ever not about the future? And what decision is ever proven right until the future passes?

As it happens, the success of this foresight doesn’t depend on the executive’s being exactly right –- one only needs to be more right than the competition. The potential is not speculative when the competition is locked into fixing the problems of the day. They aren’t even looking.

***

I asked him why he thought he would not have listened. “We were the golden boys. Everybody knew it and said so.”

For a brochure on Turning Points, P=Vu[(Sy, U),t(n-1, n+1)], which shows how we look to the future, call or e-mail us.

Next salon is April 29, 2009 4:30 to 5:30 on this subject.