David Bruce Allen

Bogus Bonuses

President Obama called the bonuses paid to banking sector executives, "shameful". He then said,“There will be time for them to make profits, and there will be time for them to get bonuses.”

He was right about "shameful", but he fudged it on bonuses, as if there were good old days we could go back to when a CEO received an "honest day's pay for an honest day's work". In a complex economy, this is close to impossible. It is inevitable earnings of investment bankers, hedge fund managers and CEOs of large companies will depend far more on social norms than long-term economic performance. Don't get me wrong. The elite of big business and finance are talented people; there is, however, scant economic justification for the pay they receive.

Even when firms do well, pay is not truly linked to performance because firm success does not usually depend on asset specific human resources. In simple English, there are thousands of people who could and would do the same work as well for a lot less money. Economist call this market failure. The rest of us use words like "unfair", "it's all about who you know not what you know", and so on. Obama, in writing the new rules on employment in his administration, is trying to put a dent into this sort of "legal corruption". In publically traded corporations, this job belongs to the Boards of Directors; they have failed miserably despite reform by the major stock exchanges.

The "man in the street" firmly believes that the market for the big money-making positions is rigged. He is right. You need to be part of the right circles to bring in the big deals, big clients, and big payoffs.

No, this does not mean that you can be a dolt and run a successful hedge fund or be CEO of General Motors. You need to be smart enough and focused enough to get the necessary education and professional and personal polish to be accepted as part of the economic elite.

However, there are thousands of people who qualify, but don't get to the top. We are told that the weeding out is meritocratic and that the incentives and rewards for success are such that the best are tapped for the most important and most lucrative posts.

Unfortunately, management research shows little correlation between pay and performance, though this only covers those who are in the elite. It is difficult to compare the potential performance of those who don't make it to those who do. Anecdotal evidence from my 20 years of consulting and teaching, I have been involved in a number of CEO searches and replacements, I nearly always found men and women further down the food chain who I was certain could do the job just as well, or better, than the individual selected. I have confirmed this with other consultants and academics.

Social norms are a more powerful determinant of CEO selection and pay than individual or firm performance. Our problem is that we have constructed the wrong social norms.

Nonetheless, there are people who make millions and earn it. For example, I have argued that professional athletes are worth what they get paid. Christian Ronaldo, striker at Manchester United, put a price tag on himself the other day at 100 million pounds. There will be takers, I promise. Kobe Bryant and Lebron James are worth even more. In fact, the NBA had to invent salary caps to prevent the stars from taking all the money and ruining the game. Here we have market failure invoked to save an industry. It's a nice turnaround on CEO market faiture; in team sports the stars make more than their coaches.

Why are Ronaldo, Bryant and James worth so much? Quite simply, nobody else can do what they do as well as they do and there are hundreds of millions of people who want to see them do it. There are thousands, perhaps millions, however, who can do what John Thain did at Merrill Lynch, perfecting his toilet training in a $35,000 commode.

Fixing America: Obama's To Do list

The TO DO list for Barack Obama put together by our best and brightest is clear. When he gets the Oval Office on Day 1 on desk all he will be asked to fix ... everything.

We all know why there is so much to be done. The foundations of society are off kilter. Education and work, the two things that take up most our lives, need to be retooled -- from pre-school imagination building to post-doc innovating. We need to rethink what is worth doing and worth learning how to do.

Deciding what to do and to get it done will require a lot more than good ideas and smart people to implement them. Without clear values and objectives it is hard to know where to start and we run the risk that we will initiate well-developed, well-intentioned programs that end up getting up fighting with each other for resources and make matters worse. 

To make sure that we get it right, it would not hurt to remember how we got into trouble. 9/11 turned out to be the zeitgeist shift we knew it would be, but precisely in the wrong way. We had the worst possible gaggle of bunglers and thieves running the country when the American people needed to trust its leaders in the worst of times. As a reward for its trust, the American people got bonzied, lied to, their present stolen and their future buried in debt.

Obama, in his speeches, has made it clear that he understands this. He has also demonstrated that he understands that the Bush Administration's disdain for law, principle and logic was the dierct result of American society decades long confusion of meritocracy with social Darwinism, and personal merit with selfishness and greed. It took more than eight years of the  Bush Administration to build a vulgar go for it in your face culture.

Obama's humility and self-control was a welcome change. And I had hoped that the President-elect would also make as clean a break as possible from our political past. I have been disappointed. Via his appointments and his announced policies, Obama has decided that it is better to co-opt the devil that got us into the mess than send them into exile. Historians, I realize, will tell us that it is impossible to run a government without skilled managers from previous administrations. Perhaps, but that does not mean that nearly every key position must go to an ex-Clinton administration professional politician.

Nor does it mean we must go on a spending spree that tries to tackle every problem at the same time and appears not to express any particular set of values or priorities other than the diffuse notion that the crisis requires action. Action is required, but only in so far as they clearly respond to the values and the objectives that we have set out. (Herbert Simon's Administration Behavior, which I have lauded on more than one occasion, explains this quite well.)

Let me give an example of what worries me. Obama has committed to cutting taxes for the middle class to put more money in people's pockets and increase spending. Sounds greats. Only one problem. The people who actually have a job will do well with inflation and housing prices falling as long as they keep their jobs. If they lose their jobs, they won't be making any money to save taxes on.

Obama and his advisors seem to believe that they know how to tackle the recession. The truth is no one knows, and no one knows how long it is going to last. This means that we need to decide on what we want to fix in America and work on fixing that, invest our government money in doing those things so and not others. Once again, in his speeches Obama seems to understand the concept, but in his speeches, the priorities are set out too generally and there are too many programs being floated.

If we are to get our house in order, Obama needs to do just a couple of things very well. I will set out what I think those things are. If he does, who knows, maybe even get the economy will get back on track. Odd as it may seem, fixing the economy is likely to be the result of getting other things right. I don't believe it can come from a grab-bag of economic stimuli.

So here are the priorities.

1. Get out of Iraq and Afghanistan now. They are lost causes. The Bush Administration got rid of a brutal Saddam Hussein regime in order to turn Iraq into an American controlled sink-hole of death and corruption. Afghanistan is even worse. In addition to death and corruption, there is the flourishing heroin trade. Getting out of Iraq and Afghanistan will save American lives, billions and billions of dollars, and no longer give our enemies an excuse to kill and hate us. We will have more money to spend on fixing America, our military can recover from the disaster, we will feel better about ourselves.

Please note that I did not mention anything about the impact of our leaving on Iraq and Afghanistan. Strategically, it is hard to see how we would be worse off; among other things, pulling out of Iraq and Afghanistan might make managing the more important relationship with Pakistan much easier. Please keep in mind that Muslim terrorism is an even bigger threat to China and India and Europe than it is to the United States.]Morally, there are serious questions about responsibility. My answer is that it is hard to see how either Iraq or Afghanistan would be worse off if the U.S. were gone.

2. Provide all American children with the world's best health care and education. Poor children are being punished and it hurts us all. I am happy to pay for community health care centers, teachers for math, music, chess. We need to increase school days, after school activities. Local community funding for schools is way of guaranteeing inequality. The federal government must provide more equal opportunity ... and it will be expensive, especially at the beginning. I am happy to spend billions here. It's a great investment. Healthier and better educated children mean spending less down the road on fixing more messes, including prisons. It will also give Americans a sense that our society fairer. A large piece of America's discontent is that there is a perceived fairness gap that is based on real painful injustices. The benefits are incalculable. The American people are expecting Obama to act on these injustices starting with health care and education.

3. End U.S. dependence of foreign oil. Easy to say, hard to do. In fact, it is so hard to do, that there is the temptation to drop the idea and talk instead about a bunch of projects like efficient cars, efficient buildings, fixing America's infrastructure. This may lead, however, to the problem I set out before -- too many projects going after money and none of them done right and. There is no substitute for an old-fashioned mission. Fixing the economy sounds like a good mission, but the pieces are too hard to fit together because we don't know how it will work. Combating global warming isn't the right approach either; the danger is neither clear enough nor present enough for most Americans. Ending dependence on foreign regimes that are happy to bleed Americans dry seems to me to be the right approach: clear enemy and clear benefits. And it fits in quite nicely with getting out of Iraq and Afghanistan.

This is probably enough for Obama to do. I look forward to celebrating the inauguration with you next week.

Gaza

Like many of you, what little holiday cheer I had left was dashed by war in Gaza.

Sadly, Gaza is an old story. Another chapter out of the Old Testament, the New Testament, and the Koran and the nasty stories we learned as children. The ugly stuff starts with Eve ... and then there's lots of men betraying men, women egging men on to evil, and God punishing mankind for being naughty and stupid. God, it seems did not endow human beings with much of the rational decision-making that fill up the fantasy lives of economists. Fortunately, it wasn't all horrors. From time to time, God granted us a pious man or woman, and there were moments of joy, psalms were written, feasts were had, heads were anointed with oil, cups ran over. And there were many prophets who spoke to us, giving us advice. But then, after Mohammed, the God of the three great male monotheistic religions stopped giving us prophets. 

Yet we sorely need a prophet who can get us out of the Gaza Strip trap. What if I offered to take the job? 

I need to be careful. If word got out that I thought I had the stuff to be a prophet, I would be diagnosed as delusional though I am blessed with a good job, a loving spouse and children, though I generally make sense when I speak. The men in the white coats would drag me away though I insisted it was not my fault God picked me to have a heart to heart.

So let's play "what if". What if God came to me and said, 

"There is hardly a piece of my good Earth that has not been claimed, won, lost, regained, claimed again and so on and so forth by the nations of man. Whomsoever calls himself and his fellows a nation has built that nation by conquest and blood."

And I said to God,

"Like Gaza?" 

God assented, and I continued,

"I wish a plague on the houses of Hamas, Isreal, Hezbola, Iran, Egypt, Syria, Saudi Arabai, the United Nations, the brotherhood of man, and most of all the Palestinian rulers, starting with Yassir Arafat, the consummate crook who turned the Palestinian territories into a Hobbesian nightmare."

I went on, not giving God a chance to get a word in, and I asked, "What can we do? Why, Lord, have you forsaken us?"

And God had pity on me, and he said, "Oh ye of little faith. I have not abandoned you. I have given you the answers. Use your brain, man."

And I listened to God. First, I had to figure out where we are and how we got here. Since the founding of Islam in 622, Christians and Muslims have spent half of their time killing each other and the other half divvying up most of the planet between them. Only in East and South Asia did the Chinese, the Japanese, and the Indians manage to hold on to their own ancient cultures and religions. (Not that these are any less brutal or unfair.) 

The only serious competitor to the Christians and Muslims in the West, the Jews, were crippled by a no recruiting strategy, and ended up driven into disapora, sometimes tolerated, sometimes abused, mostly hated, until they were delivered into the hands of the Nazis, after which the Christians in the United Nations granted them a sliver of mostly barren land they call The Holy Land -- to relieve their guilt for the Holocaust.

As we know, unfortunately for the Arab Muslims living in Palestine, it was a raw deal. No one had asked them what they thought about giving the land they were living on to make the new state of Israel. They were forced out, and to the surprise of the Europeans and Americans, ended up in camps on the West Bank and Gaza instead of being "assimilated" in Egypt and Jordan. The Palestinians and their camps soon became trapped between the incompetent, medieval and cruel Arab leadership and the competent, modern and cruel Isreali leadership. Thus generations of Palestinian Muslims became victims in an increasingly Muslim world, while Israelis Jews became occupiers after 2,000+ years of getting their collective behinds kicked across the planet.

That's how we got to this losing proposition for Palestinians and Israelis. Is there a solution? If by solution we mean an end game, the answer is, Yes. At some point the Israelis will lose. It's a matter of demographics: 100 muslims to every Jew. God commands man to be fruitful and multiply. He knew what he was talking about. Numbers matter. 

And so, having followed God's command to think, after having exercised as much thought as I could muster, I said to God,

"The war may go on for decades yet. Perhaps not. Perhaps, a prophet ... Perhaps, a pill ... Perhaps, an ecological disaster."

I said,

"This is horrible! I don't know what the hell to do."

I fell silent, and as I got up to return to my ordinary life and kiss my daughters good night, God stopped me and said,

"Keep thinking."

Bailing out on the bailouts

 

 

Nice, nice, very nice;

Nice, Nice, very nice;

Nice, nice, very nice --

So many different people

In the same device.

 

-- Kurt Vonnegut

 

 

BACKGROUND

 

There are lots of smart people describing the mess we are in. I read The New York Times and The New Yorker mostly, where professional journalists have incomparable access to the world’s most important decision-makers and our best minds. These journalists, the media elite, work hard to do their job monitoring the elites of the other estates.

 

Thomas Friedman, of the flat world, is fixated on our collapsing infrastructure, fractured educational system, and inane business culture. His articles detail failure upon failure made palatable by a dash of optimism and a catchy title like "Time to Reboot America".

 

He and his colleagues, in an attempt to veil despair, regularly finish up their missives with a plea to the Office of the President-Elect to save our skins. Paul Krugman is a pro at it (see "Barack be good"). Though as a Nobel-prize winner he is smart enough to have figured out that Obama ain’t off to such a great start, vacationing in a luxury beach home, taking the Clintons and most of their team on board in this winter of discontent, and signing  up Rick Warren to inject a dose of insipid truth in our inaugural prayer.

 

We, the people, would like, and deserve, something better from our elites. For if the economy is in recession, we the people have fallen into depression. In the traditional season of religious celebration, American Christians try to cope with having supported a Christian government that abandoned the poor and justified torture; American Jews reel at the sins of Bernard Madoff and a Wall Street where too many Jews participated in the pillage; and American Muslims try to understand why in mosques around the world intolerance and terrorism are glorified.

 

[I have just portrayed Americans as caring and concerned. Some will find this absurd, or, perhaps, even disingenuous. But I assure you that the ¾’s of Americans who think the country is going in the wrong direction are not just concerned about money. They want peace, justice, and fairness, and still believe, wisely, that religious faith is a private matter. As I travelled in American east this summer and talked to people, what they were most tired of was the unbridled arrogance of the elites, their abuse for power and refusal to take responsibility for their actions. Sadly, Americans do not expect that things will improve, even with Obama.]

 

Yes, this is an unhappy season in America, and we are hurt and confused by the social, economic, and moral catastrophes of Iraq and Katrina, and the disaster waiting to happen in Afghanistan. And we fear that the bailouts will only help to keep the fools and knaves responsible in power.

 

 

THE RIGHT INFORMATION, THE WRONG STORY

 

In a fortnight, the bailouts have lost most support. The word coming out of Washington seems to be "what in God's name was Hank Paulsen thinking". Suddenly, everyone has figured out that putting money into third-rate automobile companies is an investment in widgets. The newspapers and blogs are split between liberals and conservatives complaining about the lack of controls, and liberals and conservatives bemoaning perennial government incompetence. And yet, the litany remains the same:  The bailouts are necessary... a necessary evil... better than... we would be worse off...

 

In print, on television, on talk radio, in the internet, the news and commentary is a non-biodegrable downer, the same story over and over and over, a Clockwork Orange remake.

 

The news is that President Bush, not content with destroying the American military, debasing the American legal system, plunged head-first into "saving the sinking system”. To make sure it went right, that the bailouts were "nonpartisan", he appointed Henry Paulsen, a seasoned veteran of the same corrupt crowd that got us into the mess, financial crisis czar. To make sure were not confused by a new style of government we got Katrina-inspired improvising, right down to the single entry creative accounting: Jot down on a restaurant napkin to whom the money was sent; the rest will take care of itself.

 

Nice nice very nice. It allows us, Obama supporters, to feel superior to the Bush republicans. But, alas, feeling high and mighty is just a second-hand emotion (my apologies to Tina Turner). The story leaves out most of the cast. The American Disaster Actors' Guild includes Democrats, Republicans, and Independents. Its members embrace all religious and economic faiths. They are financiers and lobbyists, lawyers and judges, filmmakers and fashion designers, politicians and professors, and not just two of every kind but enough to fill up the ballrooms of political party fundraisers and the client list of private offshore banks. Aboard the Ship of Fools, we find elites of every estate, who found in the economics of Friedman and Schumpeter the explanation of privilege as the necessary and just consequence of the system.

 

They are good people. They give much in charity, the Gateses and the Madoffs and Saudi “royal” family, the monopolists, the Wall Street insiders, the legitimate rulers of countries and the imperial CEOs. The richer they are, the more they give to those who have less and less. The more they give, the more they are honored by each other at gala charity events where they take pleasure in knowing that they have done well. And they bemoan that there are so many in need.

 

Starting with themselves, of course. They need the bailout. Not to save their businesses, but to save their souls... and their skins. They have done the math. They know that bailout is chicken feed alongside the trillions of wealth that these same honest men (and some women) generated buying and selling companies and swapping futures (our future). This while Americans got the lie of cheap home loans and overpriced credit cards and were asked at the same time to thank the people who it did to them for building a system that would allow any man or woman of talent to reach his or full potential.

 

It was a whopper of a lie, an economic Elmer Gantry of a lie, and anyone who could look at the numbers knew it. While rich got richer, the poor got poorer, their schools worsened, their health care worsened, and when Obama got caught off-camera explaining to a young campaign worker that those who had gotten the short of the stick take refuge in the guns and religion, the privileged elite and their victims both cried foul. Talk about a case of the Stockholm syndrome.

 

Well, the sad truth is that Obama was right and no one wants to know how bad things really are. The toxic assets have hit the fan, the detritus is spread around us, and all the elites have to offer is an Rumsfeldian “stuff happens” and a couple of bogus bailouts.

 

Stuff happens all right. Over the past quarter-century in America, the elites have promulgated 3 basic ideas or rules for living. First, risk is good. Those who take risk prosper. Let creative destruction live! Second, the "system" can handle any shock, any amount of chaos – the law of the market and meritocracy will keep us on course. The system, they say, is bigger than greed, stupidity and corruption. The system is a self-regulatory marvel, as irrefutable as St Anseln's ontological proof of the existence of the God. Third, the output of rules 1 and 2 is that those who end up with the biggest pieces of the pie obviously deserves to have them, while the poor shlubs who go bankrupt deserve to have to pay back what they owe the rest of their lives.

 

The system failed. Now what?

 

The answer proposed by the elites is bailouts and government stimulus packages. I say, NO, to the first and maybe to the second. The bailouts are a masterfully perverse way to maintain power. Please, don't be taken in. Neither the financial crisis nor the demise of the automobile industry was a case of a bizarre outlier bursting onto the statistical grid. As I have argued before, no black swan alighted on the entire financial grid and brought it down. No, this financial crisis is an old-fashioned Newtonian bubble that has gone bust in real not Einsteinian time. We have long understand how and why financial systems fail, just as we know that the automobile companies failed by making crappy cars. We also know how societies fail. To this we turn.

 

 

HOW SOCIETIES FAIL

 

"A society," Jared Diamond wrote, "contains a built-in blueprint for failure if the ELITE isolates itself from the consequences of its actions". [(emphasis mine) Diamond won the 1998 Pulitzer Prize in general nonfiction for "Guns, Germs and Steel: The Fates of Human Societies," and in 2005 published "Collapse: How Societies Choose or Fail to Succeed."]

 

Diamond's work has sought to explain the factors that cause successful societies to hit the skids. He has his big 5: self-inflicted environmental disaster, climate change, fearsome enemies, lost trade, the sins of elites. The Big 5 frequently interact, customarily with significant multiplier effects.

 

On the first four factors, Jared Diamond is brilliant. However, on the subject of elites and the various sins they inflict on the citizenry, he is, as we are, pretty much in the dark. Elites lose their way, and though we can explain what went wrong and how they screwed up, often it is hard to explain the enabling why. Cognitive psychology, following the failure of ego psychology to explain much of anything, has tried. It has not done very well either. Neuroscience would like to explain, but has not gotten very far. Philosophers I admire, e.g., John Searle, hope that neuroscience can someday help us figure it out, but I have strong doubts.

 

My aim is far more modest. I would be happy to find some relationships between causes (incentives) and outcomes and try to change the incentives, and together we may be able reinstitute the necessary checks and balances to constrain the behavior of the powerful as we seek to reinstill civic society values. In the tradition of American pragmatism – James, Dewey, Rorty – I seek to restore civil society to its lead role, assuring that government does it job making the rules that keep the playing field as close to level as possible. This means getting government back into regulation and restoring the checks and balances that might have prevented the privatization of war and prisons.

 

I would like to be hopeful. But I am afraid, however, that even Obama does not get it. By calling on the old Clinton team, he is depending on some of the same crew that got us into trouble. Though not in same league of bunglers and crooks as the Bush team, the Clintonians are still an arrogant bunch who believes that they deserve to lead. They lack humility, and even worse, they are short on ideas.

 

When the lucky ones among us – a.k.a. elites – believe that they merit power, and that their exercise of power is in the best interest of everyone, then the rest of us are almost certain to get the same bad old deal – more corruption, more failure, and…bailouts. The bailouts are to the American democracy what rigged elections are to dictatorships. We hear the ancient refrain of the powerful, the professional abuser stroking the hand the injured hand of the abused: “Stuff happens, I am sorry I hurt you, but you need me.”

 

The elites would like us to forget that the bailouts are the work of precisely those who shouted most loudly that market meritocracy is the best and fairest mechanism for distributing power and wealth. These are the same elites who assented when the personal bankruptcy laws were stiffened, who stood by when the rules of the game were rigged to allow banks to raise credit card interest rates at will, who dined with the lobbyists, who left government and to become consultants and write the government contracts; these are the wise guys who bought and sold the loans and derivatives that are all part of the same device.

 

Nice nice very nice. I began this post with a silly piece of verse from Kurt Vonnegut’s Cat’s Cradle. In Cat’s Cradle, Vonnegut invents a simple religion, Bokononism, based on an openly agreed to game of deceit in which everyone is willingly trapped because there is no other option. The end, inevitable, is an indifferent though good-natured goodbye to civilization. We know how societies fail.

Please do NOT Save: Why GM, Ford and Chrysler should not get our money

For years I believed that managerial incompetence in the U.S. automobile industry had no limits. I was right. But that was only part of the story. Now these giants of industry and their million lobbyistreplicant march on Washington is on the cusp of a monster bailout that promises to suck $15 - $25 billipn out of the American taxpayer in the first tranche. (This is peanuts, of course, compared to what was wasted on AIG, but I have already exhaled sufficient spleen on that topic.)

The three big automakers are singly and collectively underserving of a red cent, but the most undeserving of all is Cerberus, the savior of Chrysler. Cerberus is run by Stephen Feinberg, who by all accounts is smart and, by the standards of superrich hedge fund moguls, modest in his impudent arrogance.

Feinberg is said to run Cerberus like Jack Welch did G.E., driving his team of gifted super-managers in a never-ending quest for superior resource allocation and asset leveraging, squeezing value out of every activity. Mr. Feinberg apparently had worked magic since launching Cerberus in 1992 .. until he bumped up against the machinery of Detroit.

Since July, 2007, when Daimler handed Chrysler over to Cerebus for free, grateful to having the lemon off its hands, Mr. Feinberg’s men have managed to lose sales even faster than they cut costs. And now, having failed, Cerebus’s has become just another supplicant in Washington, spending millions on lobbyists, among them former V.P. Daniel Quayle, Cerebus’s “chairman of global investments”-

For the past several months, Cerberus has been marketing a  GM - Chrysler merger, despite resistance from management at both automakers. The principal beneficiary of the merger would be Cerebus, which would get itself off the hook on the simple (and correct) assumption that Congress is afraid to let GM enter bankruptcy.  

Curiously, Cerberus executives insist that money is not the issue. It is about what is best for Chrysler and best for America. As if they knew.

Like most Americans who are convinced that the executives who run American companies have no idea what is best either for their companies (which they should) nor for American (which is not their job), I cringe whenever CEOs start talking about selflessness and their contribution to society.

According to the polls, most Americans had a bad feeling about the bank bailout, and they don’t feel much better about the car bailout. Some, like me, especially dislike bailing out Cerberus, a privately-held company that has approximately 15 times the resources it has invested in Chrysler. It's hard to see any justification in not asking Cerberus to pay for its mistakes. I have not forgotten that Cerberus lobbied hard to undermine fuel efficiency regulations that were good for America, but that Cerberus believed were bad for Chrysler. Why should we now have to swallow nonsense about what Cerberus tells us is good for America?

Of course, my being annoyed at Cerberus is not an argument against the bailout. The bailout idea stinks on its own merit.

First, automobile industry executives from all the big three have demonstrated that they are incompetent and will not spend bail out money wisely. Second, Henry Paulsen’s crew is not of much use either; if they handle this as well as they handled the bank bailout, we can expect several rounds of the Big Three coming back to feed at the trough. Third, if Paulsen’s crew is incompetent, don’t expect Congressional oversight to be any better. Fourth, if Cerberus, GM, and Ford have collectively spent over $10 million lobbying for the bailout, we have every reason to assume that they will spend whatever else they need to “convince” Congress of lots of other bad ideas, including industry “self-regulation”.

With these considerations in mind, Let’s look at our options.

1.

Do what the car companies ask for. In the best case scenario, the American taxpayer hands over the $15-25 billion they want, negotiating all sorts of restrictions on executive pay and tight Congressional oversight. Even so, we would still then have to watch the same losers who got into this mess play at corporate reorganization. We end wincing and whining and whinging as we wait for the three-headed motorized monster to ask us for more money. It is hard to imagine a worse scenario. To be fair, there is an upside. Congress might call fomer V.P. Daniel Quayle, a top executive at Cerebus, as an expert witness at Congressional hearings that would be broadcast on C-span for all of us to watch. Perhaps , Quayle could debate Al Gore on carbon emissions.

2.

Take care of the auto workers. We could pay approximately 200,000 automobile workers currently employed at the big bad three $50,000 a year for 5 years  (cost: $50 billion) and send them out into the wild in search of life’s meaning.

Unfortunately, this would be considered a failure. It would be an admission of defeat, like pulling out of Iraq.  Surely, the unions would protest, and we would be told that life would lose its meaning for the now unemployed, but finally well-off, autoworkers. I am reminded of what happened in Great Britain when they closed down the coal mines and the poor coal miners were deprived of the opportunity to die from lung disease. Perhaps we can invent a fate for our autoworkers in which they do not lament the loss of spending the day working on an assembly line.

We would also have to deal with the 100,000s of other workers whose jobs depend directly and indirectly on the auto industry. Perhaps we could re-use, re-tool, re-invent, do some re-creative destruction. There is no easy way to calculate what would happen if we reinvented our energy and transportation industries. Could the same workers be put to building high speed trains, electric cars? Could they learn something new and useful? How long would the transition take, how painful would it be economically and socially?

3.

One possible answer to some of the questions raised is to have the U.S. government (or the Bill and Melinda Gates Foundation) invest $25 - 50 billion in a brand new automobile company with the mission to build fuel efficient, ecological cars people might actually want to buy. And given that government makes regulatory policy, we could hope for new highly restrictive environmental regulations that would just happen to favor our own new American car company. In the old days, this was called industrial policy. Sadly, though it sounds great, it usually fails. That’s because governments tend to screw this kind of thing up in the long run. (Japan made it work for a while.)  Though governments tend not to care about such things, most of our trade agreements prohibit such action.

4.

Now to my proposed option. BANKRUPTCY. This would require them to reorganize under the supervision of the courts, rather than under the supervision of a government guided by the insights of corporate lobbyists. Bankruptcy would cost the taxpayers nothing -- at least directly -- though it could result in serious ugliness, economic and social. Bankruptcy could turn out badly, though I hope not quite as badly as bailing out the car companies. It also means we can spend the money on something else.

5.

Finally, one more option. We could give all three car companies to Cerberus for nothing, taking them all private, with the condition that they hire Henry Paulsen tomorrow. We promise to give Cerebus 50% of the opportunity benefit of not having Paulsen spend U.S. taxpayer money from here to January 20th. 

Please let me know which option you prefer. Of course, if you have your own better option, let me know as well. Enjoy the show.

Other People’s Money: A Guide to this Financial Crisis and the Next One

When I was in college, I was one of those guys who only smoked O.P.s.

O.P.s are not a fancy synthetic drug. It’s shorthand for “Other People’s”. I never carried cigarettes, I always bummed, and when asked if I smoked, I answered proudly,

“Only O.P.s.”

Bankers do the same. They bet O.P. money. Before the financial revolution of the 1990's, commercial banks mostly bet that borrowers would pay back loans. In fact, most of the borrowers were also depositors, which meant that the O.P. money was circulating among the O.P.s. Banks were intermediaries among people and organizations that were mostly alike, mostly from the same place. Not a very exciting business.

In the old days, banks depended on a person called a loan officer who was responsible for saying yes or no. If a loan was too big, or there were special circumstances, there was a loan committee that made the final decision. But for mortgages, the most important loan any of us are likely to ever take out, the loan officer was enough. People had messy personal contact with other people who made decisions. This was unscientific and prone to breakdown.

In the old days of banking, as you will recall, the money the loan officer bet came from deposits, which meant the money belonged to the people who had lent their money to the bank under the proviso that they could have it back whenever they wanted it. As we might imagine, the depositors had a reasonable concern the bank might not take the proper care of their money. To assuage the fears of depositors, who historically had shown a nasty tendency to justifiable mass hysteria called bank runs, we worked out a neat little system.

Firstly, bankers and other business people managing other people’s money had a “fiduciary responsibility” – a mix of legal and moral suasion – to care for O.P. money. Secondly, as we mentioned earlier, loans were assigned to aº loan officer; when a bad loan got made, we knew who to blame. Thirdly, regulators monitored loan quality. Fourth, we invented obligatory bank deposit insurance so that if the bank went broke we could still get our money back.  

It wasn’t perfect, and we still had banking collapses and an occasional run, but most were simple affairs and deposit insurance worked. People’s savings did not go up in smoke. And when a bank went broke, or needed a bailout, it was always the same reason: Bad debt. In sum, it worked most of the time, failed some of the time, and we could understand, and manage, the complexity.

The financial crises of the second half of the 20th Century fit the model we understood ... and then along came Long Term Capital Management (LTCM). The LTCM crisis in 1997 was the first important sign that Mr. Greenspan's world of synthetic, risk-heding, financial innovation might prove to have a couple of glitches. LTCM was a hedge fund with two Nobel Prize winning economists, Myron Scholes and Robert C. Merton, on the Board of Directors. LTCM made some bad bets on fixed income instruments and the Federal Reserve Bank of New York had to put together a plan for a creditor bailout to protect the financial markets. LTCM was a hedge fund, not a bank, and it wasn’t depositor money at risk, but it was billions of O.P. money that if lost might threaten faith in the financial system.

What was different about LTCM was this freaky thing called systemic risk – the possibility that the interlocking pieces of the paper would come undone. Even weirder was that the risk to the system came from the top of the heap. The richest and smartest, though not necessarily the best and the brightest, could make a bunch of bad bets on Russian bonds and Royal Dutch Shell shares, lose a few billion, and that could ruin an ex-steel worker in Pennsylvania Dutch land who might end up with nothing more than his fractured family, his guns and his religion to live off of.

From LTCM to “The Crisis” was just a decade, and along the way the internet bubble burst and 9/11 reminded the first world  of that there is no such thing as the first world. "The Crisis" of 2008 is not just a couple of Nobel Prize winners with their calculators run amok. The Crisis is a stampede of hedges fund and big investment banks and GM, GE, and entire countries, like little Iceland, that bet on paper.

So how did do it? How did they achieve this collosal screw-up? This new-fangled financial crisis required the reinvention of commercial banking and investment banking, and a whole new way of running corporate finance and credit agencies. It needed the nurturing of the troupes of financial whizzes and pundits and neutered regulators and a citizenry numbed by AIDS, terrorism, avarice and good old-fashioned stupidity.

It required building an interlinking financial tower of Babel that no one, anywhere could actually get his or her mind around. This was no black hole, no black swan, but the biggest baddest white elephant we ever invented. And riding that big bad white elephant was the naked emperor …

The mechanics of the crash are simple enough. Remember the old game of telephone? This game started with the home loans. To multiply the home loans, we needed to reinvent commercial banking. This was done via three interlocking innovations: 1) credit scoring; 2) leveraging off-balance sheet assets; 3) securitization of mortgages and other financial instruments.

Now unless you were a finance person, you probably didn’t really care about this stuff before the crisis. Unfortunately, now that you do care, when it gets explained it sounds and smells and tastes like science fiction. Fear not, it is science fiction, and like all good science fiction there is a good story here; the intergalactic world of banking has its logic.

Which brings us to credit scoring. Credit scoring is a computer program that rates customers pretty much the same way fantasy football, baseball, etc., rates players. You plug numbers into the parameters, sometimes these are called statistics, and presto, a loan is approved or denied based on the facts. Credit scoring is simple, cheap, scientific, objective. Or so it seems. But what if the parameters are tweaked so any person with a social security number gets a yes? What if the credit scorers have all sorts of incentives to enter garbage statistics into the system? The answer is equally simple: Sub-prime mortgages. Or what we used to call, garbage loans. Garbage in, garbage out.

Now to the most obscure piece: off-balance sheet assets. An off-balance sheet asset is neither a loan nor a deposit, but one of those fancy, synthetic financial instruments (options and the like) that banks are supposed to use to help manage the risk incurred due to “the time dimension of money”. Isn’t that a great phrase – “the time dimension of money”? It is pure Einstein relativity stuff. You see, loans are long-lived slow moving things, while deposits are fast moving, in and out types. This makes life hard for bankers. The mortgages on a banks’ books are paid back over decades, but depositors can take their money whenever they please.

Figuring what to do about “the time dimension of money” is called asset and liability management. Off-balance sheet assets were supposed to make this easier by helping banks to regulate interest rate risk and cash flow. But what happens if the bank thinks it can make a lot of money playing with the off-balance sheet financial instruments, maybe even more than on the tradition interest rate spread between the loans and the deposits, and from fools who borrow money on their credit cards, or get nailed with commissions other people don’t  pay? What if there are some math freaks around who insist they can do it without any risk? What if there is no supervision and no capital requirements?

Which brings us banking innovation number 3 – securitization – the big bad boy of financial instruments. Remember, the bank has capital and cash tied up in 20, 30 and 40 year mortgages. The bank can free up that capital and cash by selling the mortgages to other people who implicitly trust your credit scoring, and the credit rating of the credit agencies who trusted your credit scoring.

And now the white elephant starts to feed. To make it easier for others to buy the commercial banks’ loans, investment banks help the commercial banks group them together, chop the future payments up into pieces, sell the pieces, and even invent new financial instruments that make bets on the value of the pieces “over the course of time” – the 20, 30 and 40 years that the payments are supposed to keep coming.  They then sell these instruments to other banks, pension funds, institutional investors, and so on all over the globe where there are mathematicians and finance people who claim to understand how a financial instrument might behave “over the course of time” and make their own bets about default risk, interest rate risk, and “the price of things reason cannot fix” to quote Blaise Pascal, the French philosopher and mathematician, who spoke of vanity, greed, the heart, and irrationality with wisdom 350 years ago, before there were computers that could demonstrate statistical correlations that don’t exist between things that will never exist.

Now, of course, the average bank official in the typical bank branch, the well-heeled trader working the Wall Street shuffle, the MBA whiz at the poshest investment bank, did not have the slightest idea what was going to happen “over the course of time”. But what he, she, they knew was that every day that fantasy finance lasted they could make a ton of money selling the financial instruments, selling more loans, inventing more financial instruments and so on in the biggest pyramiding scheme the world has ever seen. So they lent more and more money, sold more and more pieces of paper because they could. As they sold more and more, they needed more and more people to buy the loans that they could leverage into mor and more financial paper. They found out that smoking O.P.s can be just as addictive as going out and buying your own.

We cannot blame them (too much) for not seeing what was really going on.  Everyone was in on the game, everywhere in the world where there was money enough to ante in. The loan got broken up into pieces and sold all over the world, those pieces were linked to other pieces, so that everyone with assets of any kind, even those of us who don’t buy these pieces of paper, ended up linked into the same leaning tower of recycled paper that in its fall trapped everyone. Such collective disasters are customarily called “acts of God” for which there is no insurance – and no responsibility.

That’s how it happened. But weren’t there some people who saw it coming? Yes, there were a few. Some smart hedge fund managers saw that the paper was worthless and made paper bets that the paper was worthless and sold short. Selling short means is that you bet something will be worth less tomorrow than it is today. You bet the price of a share of a company will go down, the price of oil will go down, the value of a currency will go down, and so on. All that is required to make such a bet is to find someone willing to wager that the asset, whatever it is, will be worth more than you say it will.

 You might think that the short sellers would be safe. But what happens when the market for betting on what the asset will be worth tomorrow is various times greater than the market for what things are worth today? When that happens, all bets are “off”, all bets are speculative. The value of what you have today is based on the imagined value of some tomorrow that nobody has the slightest clue about. “The time value of money” is no longer measured in cash flow and interest risk, but in the systemic risk of politics, commodities, terrorism, home prices, and myriad other variables and interactions such that no one can see the trunk nor the tail of the white elephant.

Sound too apocalyptic? You read and hear that there were short sellers and banks that made money in the mess and that they are solvent, out of the woods. This was true, but not anymore. That’s because even the short sellers and the banks have to keep some assets. Finally, these assets are going down in value, too. The real estate, the companies, the currencies, the smart people bet on are now worth less as well … because as the paper collapses and burns, the debris and smoke damages everything around it. The collateral damage is systemic.

The only answer to systemic damage, we are told, is government. But as the government puts money into the big banks (today, the U.S. is saving Citibank), the banks survive, perpetuating the system of big interlocking financial institutions that got us into this situation in the first place. Instead of breaking up big banks, recapitalizing community banks, reducing the amount and velocity of paper and reconfiguring wealth creation as part of the “real” economy, government intervention is leading to increased bank size and consolidation in the name of creating viable financial institutions that are supposedly too big to fail instead of too big to let fail.

We are told that there will be more regulation of these big banks and that will protect us from another round of boom and bust and bail.

I hope so. But I can feel the White Elephant still clunking around and I don’t think I understand the mathematics of his next moves.

It’s enough to make you nostalgic for the bad old days. They were easier to explain. If it is a comfort, you can go to YouTube and listen to the Gregory Peck and Danny DeVito speeches from “Other People’s Money”, and remember what it was like when there was such a thing as the real economy and creative destruction killed bad old companies and new companies were born and we dreamed a collective dream called progress.

No car industry bailout ... unless they do it my way

On October 13th I gave my remedy for the car industry, ("GM and Chrysler: How the U.S. Chose to Fail"). My plan was probably over the top, but nothing I have heard or read since sounds even close to right. In fact, what I read and hear is so wrong-headed that I want to up the ante on my original plan. Here it goes.

In exchange for the taxpayers bailing out Detroit, we the people propose:

1. GM and Ford will promise even better fuel efficiency than we asked for before. 40 MPG by 2011 and 50 MPG by 2015. All models including SUVs. No nonsense about fleet averages!

2. Chrysler will be spared and be rechristened, Phoenix Motors. Phoenix will not make cars, rather the bailout money will go to developing technology for clean energy engines and systems. One big project ought to be refitting cars and buses for fuel efficiency and reduced CO2. Another ought to be developing high speed trains (target 300 MPG) as we spend billions on transportation. The train unit will be headquartered in New York City and staffed by hedge fund billionaires who agree to take 0 pay in service to their country.

3. No executive will make more than $500.000/yr., including performance-based pay. Designers and engineers who come up with real innovations will be rewarded accordingly -- as if they were the athletes who win the world championships in the big three sports.

I have lots more hare-brained ideas that could save the industry. I think them up as I type. And in the meantime, Washington and Detroit get nowhere because they refuse to accept that Detroit makes lousy cars and management stinks. To reinvent this business we need to kill it and then fumigate.

And one final key measure: Any and all ideas proposed (or supported) by Henry "Hank" Paulsen will be rejected out of hand.

Alan Greenspan: Confessions of an Innocent Mind

In his testimony before the House Committee on Oversight and Government Reform, former Fed Chairman Alan Greenspan spun a yarn in which he was an innocent fool of ideology who got blind-slided by reality. Below, two of Greenspan's wonderfully revelatory statements.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,”; and

“This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.”

Readers of this column, know that I have criticized Mr. Greenspan for having been an acolyte of Ayn Rand, the astonishly bad novelist/economic philosopher. Author of two of the 20th century's most read, horribly written and longest novels, Atlas Shrugged and The Fountainhead. (Both novels still sell over a 100,000 copies of year.)

Rand is the progenitor of an equally bad, simple-minded and utopian philosophy which she called "objectivism", but was nothing more than the idea that the few of us with the guts to be heros need to be left alone and that for this to happen government has to wither away. Ms. Rand insisted that she believe in reason. This is nonsense. Ms. Rand was a hero-worshipper, a utopian romantic who considered loving herself the greatest love of all.

What does this tell us about Mr. Greenspan -- and several other liberal economists that I have had the pleasure of conversing with about matters of public policy. They believe in the Enlightment idea that reason is natural and that human beings will choose what is best for them.

Unfortunately, this idea ignore three rather important problems human beings face: 1) short-term and long-term needs and desires may differ; 2) we have more needs and desires that we can act upon; 3) inevitably, we must discriminate between conflicting needs and desires; 4) we sometimes get the facts wrong upon which 1-3 depend.

In cognitive science, Herbert Simon, used the term "bounded rationality" to describe how difficult it is make clear-headed decisions and why classical economics provided a much too simple explanation for human behavior. In my view, Simon was much too generous. The problem with the "classical model" is that it runs away from the irrational. In the words of John Searle, the philosopher, "the classical model can not describe its irrationality".

And so, poor Alan Greenspan is shocked and overwhelmed by the inexpicable, the irrational and sometimes destructive behavior of markets. Of course, markets don't behave at all. People behave, seeking ends, rathional and irrational, reasoned and unreasoned, conscious and unconscious, with outcomes that are predictably unpredictable.

At 82 years of age, Alan Greenspan has finally found out that life is complicated. I envy his 82 years of blissful innocence -- an emotional risk-management edifice he happily confused with intellectual truth.

GM and Chrysler: How the U.S. Chose to Fail

In the on-going melodrama "How the U.S. Chose to Fail", the demise of the U.S. auto industry over the last quarter-century may just be the key piece.

Forget about the financial crisis for a moment. We will get over that. But the self-immolation of the automobile industry congers up visions of Jared Diamond's sad tales civilizations gone done the tubes in "Collapse: How Societies Choose to Succeed or Fail"-

In the blog on Sept 27th, 2006, I wrote,

Some would have us believe that the problem for General Motors and Ford is the pension burden. While the pensions are costly, this is not reason GM and Ford don't sell enough cars. We are frequently reminded that GM and Ford sell big gas guzzlers. This is true, but they have a complete line, and American small cars are are not competitive either. We have been told that American workers could not manufacture quality cars. But the Japanese car plants put the lie to that idea.

Of course, we know the real reason: Awful management. Awful management that manufactures mediocre cars. The verdict is in: the American cars that General Motors and Ford make in America are mediocre. In Consumer Reports' list of the best cars for 2005, in all 10 categories the winner is a Japanese car. Not one U.S. car made it. Not one! The bottom line is that Japanese cars are better. To that we can add that European cars are more stylish, and Korean cars are less expensive.

Since then, things have only gotten worse. The proposed $25 billion bailout won't fix things either.

Now, as a last resort, GM and Chrysler are in merger talks. When I teach mergers in strategy, I use a matrix where we match up big and small companies and good management and bad management.

Take a guess what's the worst option: two big, badly managed companies decide to merge as they run away from their problems.

Do I have a better idea. Of course, I do.

Chrysler should be liquidated; the sooner the better.

Now to General Motors.

1. GM should close its Chevrolet, Buick. Oldsmobile, Pontiac divisions. (I can see Alfred P. Sloane, Jr. grieving). Get rid of Saab, etc.

2. Spend whatever it takes to turn Saturn into a brand that can compete with Toyota, etc. Saturns sells only cars that get a minimum 30 mpg. Make sure the world knows it.

3. Cadillac will go head to head with Lexus, BMW, etc. The odds are awful, but there is no choice but to try.

Sound crazy? You got a better idea? You think the "visionaries" who are running GM have a better idea? Do you think they have any ideas at all?

Getting "hot" over greed: Defining the financial crisis

A Dear Reader of my recent post "CEOs and greed: tell me something I don't know" asked me why I left out the AIG story, the one where the managers go and spend millions at a spa just after the government has ponied up a $85 billion bailout. My reader wondered why I did not explain in detail what they drank, what they ate, the tab for champagne, and who knows, maybe they even got in a little lap dancing. My Dear Reader wanted me to crank up the energy and get readers on board.

My Dear Reader is right that I would get more attention if I spelled out gory details of the mind-boggling AIG greed. We, the people, have been "educated" to get hot (stimulated, titilated, and angry) over this stuff. But I resist, I refuse, I object. It's a prurient high I don't want to offer up to My Dear Readers nor to myself. It's the American Puritan tradition in me that resists inauthentic joy.

This goes for watching T.V. news. as well. I am appalled, horrified, embittered by t.v. news. As soon as I hear the word "accident" or "terrorist attack", I know I am going to get an object lesson in the importance of having a strong stomach and how to identify detached body parts. I remember, as you do, the incessant replays of 9-11, the planes crashing over and over into the Twin Towers and us with our eyelids stuck open a la Malcolm McDowell in Clockwork Orange .. without the Beethovan. Yes, we were sickened; yes, we wanted to respond. But all we got operant conditioning outcomes: numbing impotence and sleepless anxiety.

Of course, the networks did not do anything illegal; we were being "informed". And if in the process, our hearts and minds were damaged, whose fault is that? If we had been stronger, we would have shut off the television, closed the "Department of Homeland Security" (a Soviet-style sound-bite ministry of fear) and turned out in mass demonstrations against the war in Iraq and the crime of torturing prisoners. We would have elected John Kerry, no savior of course, but at least not four more years of Bush incompetence and corruption.

Not that we weren't angry, of course. We just could not overcome the feelings of impotence and anxiety. And though the saner, authentic part of us yearned for public dialog about the horrors of Iraq and the decline of America, we watched on television the death and destruction and we did precious little about it.

I deeply dislike t.v. news -- all of it from Fox to CNN. I dislike pornography for similar reasons. Both damage our innate authentic response to experience.

As I have commented elsewhere, if you are watching pornography and not doing "it", that's pretty bad because that ought to make you wonder why that you're watching it and not doing it; if you are watching it because you need it in order to do it, that's not so great either. What happened to passionate, joyful sex between consenting adults who found sufficient material in their own bodies to work with?

So there we have it. None news news and none sex sex. Non news news inures us to the issues that matter and to the hurts and problems we can do something about. And as for sex, which ought to be the source of our greatest physical joys is just another commodity. Woody Allen was wrong when he said that When sex is good it's good and when it's bad it's still good. Bad sex is bad for us just as violence masquerading as news is bad for us.

When we are battered with violent images and when we participate in gratuitous sexual acts, we lose our ability to recognize and engage in authentic information and experience. In effect, we sacrifice our freedom of will.

My argument may sound a bit "touchy feely" for some of you; I recognize that the reductionist categorization of complex human experience. In particular, I realize that sexuality is unfriendly to moralizing. And yet, I believe that the argument is mostly right.

If I am right, where does this message lead us? In America, experience as greed became the substitute for what the great Greek philosophers called "happiness" and the American Declaration of Independence wisely termed our "inalienable right ... to the pursuit of happiness". Happiness is an outcome, not a feeling. Greed is a feeling, a superficial response to experience that only offers temporary satisfaction, like pornography. Greed has no long-term objective, and as such worries little about who losses out as greed has its way.

When there are enough powerful people whose brains are wired so that they confuse Greed with Happiness, we the people get screwed. As the financial crisis unfolds, the daily news now brings us the spectacle of the powerful getting "hot" as they see the great unwashed "deservedly" go down the tubes.

This is my definition of the financial crisis.