Saturday, October 18, 2008

Fareed Zakaria on the bright side of the Crash of ’08

The lemon yellow Newsweek cover caught my eye. As intended.

Bright side of the Crash of '08?

I couldn't resist. Happily, Fareed Zakaria had some interesting things to say.

Some highlights (emphases mine):

There Is a Silver Lining |Fareed Zakaria |

... The average household owns 13 credit cards, and 40 percent of them carry a balance, up from 6 percent in 1970...

... Every city, every county and every state has wanted to preserve its many and proliferating operations and yet not raise taxes. How to square this circle? By borrowing, using ever more elaborate financial instruments. Revenue bonds were backed up by the prospect of future income from taxes or lotteries. "A growing trend is to securitize future federal funding for highways, housing and other items," says Chris Edwards of the Cato Institute. The effect on the projects, he points out, is to make them more expensive, since they incur interest payments. Because they "insulate the taxpayer from the cost"—all that needs to be paid now is the interest—they also tend to produce cost overruns...

... Boykin Curry, managing director of Eagle Capital, says, "For 20 years, the DNA of nearly every financial institution had morphed dangerously. Each time someone at the table pressed for more leverage and more risk, the next few years proved them 'right.' These people were emboldened, they were promoted and they gained control of ever more capital. Meanwhile, anyone in power who hesitated, who argued for caution, was proved 'wrong.' The cautious types were increasingly intimidated, passed over for promotion. They lost their hold on capital. This happened every day in almost every financial institution over and over, until we ended up with a very specific kind of person running things. This year, the capital that remains is finally being reallocated to more careful, thoughtful executives and investors—the Warren Buffetts … of the world."

... Curry points out that "30 percent of S&P 500 profits last year were earned by financial firms, and U.S. consumers were spending $800 billion more than they earned every year. As a result, most of our top math Ph.D.s were being pulled into nonproductive financial engineering instead of biotech research and fuel technology. Capital expenditures went into retail construction instead of critical infrastructure." The crisis will stop the misallocation of human and financial resources and redirect them in more-productive ways. If some of the smart people now on Wall Street end up building better models of energy usage and efficiency, that would be a net gain for the economy...

How's the story go? India creates software, China creates hardware, and the US creates financial instruments?

The 13 credit cards/household is so high I wonder if it's really true. On the other hand, I buy the stories of state budget trickery. I wonder how long that will take to unwind.

For me the best part of the essay is Boykin Curry's description of how an economic bubble destroys the leadership of publicly traded companies living in the bubble. In a bubble irrational bets pay off, and rational behavior is a ticket down the org chart. Eventually only the crazies are left at the top.

I would like to read more about the people who are the winners of the financial carnage. I suspect some actors are doing rather well right now.

Update 10/19/08: See the comment from Cathy. The "13 cards" statistic may be true. I believe Cathy is right when she guesses many people collect cards for a transient 10% purchase discount, but then never intend to use them. Of course a number of people will end up using those extra cards when they run into financial trouble, which will lead to misfortune all around.

So are these 10% purchase discounts really a good idea for the stores? I suspect it's marginal, but the risk and incentives have been outsourced through a long and disconnected chain of commerce -- so the true cost is probably hidden. Accounting uber alles, again.


Anonymous said...

I think 13 cards sounds right if it includes cards you never use (like store cards that give you 10% off when you sign up). I use 2 cards but my credit report shows 7.

JGF said...

Excellent observation.

I'd never have thought of this because we never do the 10% discount thing -- too complicated, we don't need the junk mail, too hard to track the cards, can mess up credit ratings, increases the risk of missing fraud, etc.

I added an update to my post. I suspect if one really analyzed these 10% discount schemes we'd discover a fractal miniature of the collapse of the world's financial system in the 10% credit card explosion.