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All of our Knowledge has its origins in our perceptions Print E-mail
 
“All of our knowledge has its origins in our perceptions.”
Leonardo da Vinci
There are times when the earth shakes beneath our feet so violently that we lose contact with terra-firma and we feel true fright. But somewhere deep inside us the desire to know outweighs the fear and we begin to learn. At ICM we sit in morbid fascination as the financial system spasms and attempts to remake itself. Massive destruction of global wealth has followed a cataclysmic seizure in the credit markets. Trust in and among commercial bankers barely exists. Investment banking as we have come to know it has vanished. The lines between socialism and capitalism have been blurred. In a world so dependent upon highly levered, finance driven growth and consumption this crisis is nothing short of an 8 on the financial Richter scale. We have every right to feel less secure and a vast responsibility to indulge our curiosity. To engage our curiosity regarding economics and markets we require structure in our paradigm that promotes order and sequence. Those who see cause and effect most clearly are spared unnecessary bruises. In ICM’s paradigm capitalism is a system created by man that mirrors nature. It makes sense that man; a creature of nature would be bound by its rules in his constructions. Man’s intellect and the forces of nature co-operate and do battle to produce a rewarding and occasionally unstable economic system. Capitalism is capable of producing tantalizing prosperity and fearsome poverty. It is this dichotomy that has led so many to pursue the study of economics and business cycles. The inevitable result has been man’s attempt to alter the forces of nature at work in the capitalist system. We seek to tinker with the “free market” business cycles just enough to prolong and magnify prosperity and limit the pain of poverty. Our goal is to accomplish this tinkering without disrupting the eco-system or the well being of the general population. In this regard ours is a history of prolonged apparent success dotted by terrifying bouts of failure.
Hubris in the Forest
 We love Leonardo because he adds the structure to our paradigm that we require. His concept of “connessione” displays his appreciation for the interconnectedness of all things, of “systems”. Nearly thirty years ago, before trading children for hair I had the good fortune to frequent the Yellowstone Basin, a huge eco-system nestled at the intersection of Idaho, Montana and Wyoming. In 1988 the Yellowstone eco-system exploded into flames. A lesson in “connessione” was being presented that would offer the curious an opportunity to bank a concept for future application. The Yellowstone fire of 1988 is useful in conceptualizing Schumpeter’s theory of “Creative Destruction”. It will illustrate the connection between the cycles of nature, the economy and the capitalist tinkerers. At this juncture in the evolution of our financial system few ideas may be more useful. We must refocus from what has been destroyed to what will emerge in its stead. For thirty years the wisdom of the forest service and east coast pundits declared that wildfires were bad for the eco-system, bad for the interests of timber companies and property owners and therefore should be aggressively suppressed. Man would tinker with the natural  order of the eco-system, presuming to understand and improve upon the creator’s work. The suppression policy appeared effective. Over a period of 25 years fires were minimized and resources protected. Suppression was thought to be so well managed that staffs were reduced to match the perceived risk of fire danger.  In the midst of celebrating success two points escaped the policy wonks. The first was that a vast amount of fuel was accumulating in the aging forest. The second was that naturally occurring fire played a crucial role in regenerating life in the eco-system. The perfect storm was gathering for a catastrophic event that would push the Yellowstone eco-system into a radical correction. What started as an isolated collection of small fires would be whipped into a frenzy by warm and constant winds across a land crisp from long drought. A contagion overtook the eco-system. The fires grew and multiplied often generating firestorms that produced lighting but no rain, a self-perpetuating “negative feedback loop” assuring massive destruction. Tens of millions of trees burned. At its worst the fire spread between 5 and 10 miles each day. The US military was summoned to fight the blaze. The night sky was lit by the fury of a system badly out of sync. Thick smoke hung over the mountains through summer and fall.
The blaze skipped about the eco-system burning a patchwork but leaving great swaths of forest unharmed. Ash and organic remains dropped to the charred forest floor preparing a fertile bed for the ultimate recovery. The lodgepole pine forest that blankets Yellowstone released cones filled with seeds to the fertilized ground below. In a form of natural conservation the lodgepole’s cone only releases its seed when subjected to the extreme temperatures like those of a wildfire. From destruction comes efficient regeneration.  The intense flames had only disrupted the top few inches of soil preserving the base from which recovery would bound.  Twenty one years later the only lasting scars in the eco-system are from the fire lines cut by courageous men and women to slow the spread of the fire.
Lessons Learned and Re-Learned
It is hard to strip nature from capitalism. Our’s is a system that celebrates “natural selection” and the “survival of the fittest”. It is a system of cycles that mirror the seasons. It is designed to reward the survivors and expunge failure .The victors lead the way to prosperity while the vanquished vanish. It is a system so pure in its simplicity and elegant in its natural form one may wonder, “Why tinker with success?” Scarce and dear capital resources are steered toward opportunities vetted for potential success. Success is often rewarded with great wealth. We can profit as entrepreneurs or piggyback as shareholders on another’s success. This is great stuff. Where do I sign up? But this beauty comes at a cost. Capitalism is inherently unstable. Long periods of relative prosperity are interrupted by the natural forces of creative destruction despite our best efforts to the contrary. Minsky taught us that prolonged periods of financial stability actually breed instability. Investors become complacent and misprice risk.  Perfect storms are often made infinitely worse by the very policies designed to prevent them. The conditions that produce the perfect storm are frequently born of an accumulation of well intentioned policy failures. These policy failures produce “unintended consequences” and provide fuel for the inevitable fire. Sometimes apparent success can be more dangerous than failure. Alan Greenspan piloted the Federal Reserve when the stock markets plunged in 1987. His quick response to the crisis helped reduce the risk of a prolonged bear market and recession. The markets recovered and the new Chairman became the anointed one, loved by investors and politicos alike. Greenspan had decided that recessions were bad for the economy and that they must be aggressively suppressed. This point was difficult to dispute after the brutal recession of the 1980’s. In the decades that followed the oracle used a potion of cheap money and market friendly policies to steer the US around the worst of capitalism’s fury and promoted prosperity at the expense of destruction. The risks presented by moral hazard in credit markets were ignored in exchange for reduced volatility. Emboldened by success the oracle pushed into new territory counseling lenders, investors and international markets that securitization and leverage could be combined with little increase in risk while magnifying rewards and economic growth. According to the Chairman and the new paradigm devotees on Wall Street we had entered a new, more advanced phase of capitalism, one where the claws had been removed. This unbelievable change was in large part due to a radical new discovery. Financial derivatives would circumvent the laws of capitalism and redefine risk.  Fear not if you failed to understand the black box derivatives; suffice it to know that the oracle and his gifted compatriots had prevailed in redefining “free markets”. The Greenspan Fed tinkered as no Fed had tinkered before with the cycles of capitalism. Misguided policies allowed dangerous fuel to accumulate on the balance sheets of banks, mortgage lenders and consumers. Securitization and leverage assured a contagion of a magnitude we are only beginning to appreciate. The global financial community is caught in the tenuous web of counter party risk and spreading catastrophe. The leverage and derivatives Greenspan so publicly espoused and so poorly understood have contributed mightily to the perfect storm in the financial markets and the malfunction of the global economy. Suppression of market corrections and recessions pleased speculators, bankers and borrowers but also served to evade the purifying and regenerative flames so important to a healthy capitalist system. Policies aimed at softening the blows of creative destruction weakened the economic infrastructure by allowing failure to perpetuate, crowding out the evolution that accompanies entrepreneurship. Because the cycles have been disrupted the intensity of destruction has not been sufficient to release the seeds of new growth, until now. We are still in shock and obsessed with resuscitating the failures rather than identifying and promoting the entrepreneurial solutions that will carry us into the future.
New Solutions
Capitalism is an evolutionary blood sport. It is designed to have winners and losers. Business models become obsolete and are replaced through economic advancement. Old bulls are driven from the herd by younger ones. No matter how hard Hank Paulson tries to fight it my guess is that new mechanisms of capital formation and the social structures that will support them are already germinating just below the scorched surface of our financial system. New institutions will be born and a set of regulations to govern their activities will follow. A revised financial structure will rise from the ashes. It is unlikely that Hank Paulson and his Wall Street generation will be both part of the cause and the solution for this historic recalibration of the global financial system. Their thinking is locked in the past. The “too big to fail” doctrine that has made certain private financial giants systemically critical must be re-evaluated. Size didn’t save the dinosaurs.
The blaze skipped about the eco-system burning a patchwork but leaving great swaths of forest unharmed. Ash and organic remains dropped to the charred forest floor preparing a fertile bed for the ultimate recovery. The lodgepole pine forest that blankets Yellowstone released cones filled with seeds to the fertilized ground below. In a form of natural conservation the lodgepole’s cone only releases its seed when subjected to the extreme temperatures like those of a wildfire. From destruction comes efficient regeneration.  The intense flames had only disrupted the top few inches of soil preserving the base from which recovery would bound.  Twenty one years later the only lasting scars in the eco-system are from the fire lines cut by courageous men and women to slow the spread of the fire.
Lessons Learned and Re-Learned
It is hard to strip nature from capitalism. Our’s is a system that celebrates “natural selection” and the “survival of the fittest”. It is a system of cycles that mirror the seasons. It is designed to reward the survivors and expunge failure .The victors lead the way to prosperity while the vanquished vanish. It is a system so pure in its simplicity and elegant in its natural form one may wonder, “Why tinker with success?” Scarce and dear capital resources are steered toward opportunities vetted for potential success. Success is often rewarded with great wealth. We can profit as entrepreneurs or piggyback as shareholders on another’s success. This is great stuff. Where do I sign up? But this beauty comes at a cost. Capitalism is inherently unstable. Long periods of relative prosperity are interrupted by the natural forces of creative destruction despite our best efforts to the contrary. Minsky taught us that prolonged periods of financial stability actually breed instability. Investors become complacent and misprice risk.  Perfect storms are often made infinitely worse by the very policies designed to prevent them. The conditions that produce the perfect storm are frequently born of an accumulation of well intentioned policy failures. These policy failures produce “unintended consequences” and provide fuel for the inevitable fire. Sometimes apparent success can be more dangerous than failure. Alan Greenspan piloted the Federal Reserve when the stock markets plunged in 1987. His quick response to the crisis helped reduce the risk of a prolonged bear market and recession. The markets recovered and the new Chairman became the anointed one, loved by investors and politicos alike. Greenspan had decided that recessions were bad for the economy and that they must be aggressively suppressed. This point was difficult to dispute after the brutal recession of the 1980’s. In the decades that followed the oracle used a potion of cheap money and market friendly policies to steer the US around the worst of capitalism’s fury and promoted prosperity at the expense of destruction. The risks presented by moral hazard in credit markets were ignored in exchange for reduced volatility. Emboldened by success the oracle pushed into new territory counseling lenders, investors and international markets that securitization and leverage could be combined with little increase in risk while magnifying rewards and economic growth. According to the Chairman and the new paradigm devotees on Wall Street we had entered a new, more advanced phase of capitalism, one where the claws had been removed. This unbelievable change was in large part due to a radical new discovery. Financial derivatives would circumvent the laws of capitalism and redefine risk.  Fear not if you failed to understand the black box derivatives; suffice it to know that the oracle and his gifted compatriots had prevailed in redefining “free markets”. The Greenspan Fed tinkered as no Fed had tinkered before with the cycles of capitalism. Misguided policies allowed dangerous fuel to accumulate on the balance sheets of banks, mortgage lenders and consumers. Securitization and leverage assured a contagion of a magnitude we are only beginning to appreciate. The global financial community is caught in the tenuous web of counter party risk and spreading catastrophe. The leverage and derivatives Greenspan so publicly espoused and so poorly understood have contributed mightily to the perfect storm in the financial markets and the malfunction of the global economy. Suppression of market corrections and recessions pleased speculators, bankers and borrowers but also served to evade the purifying and regenerative flames so important to a healthy capitalist system. Policies aimed at softening the blows of creative destruction weakened the economic infrastructure by allowing failure to perpetuate, crowding out the evolution that accompanies entrepreneurship. Because the cycles have been disrupted the intensity of destruction has not been sufficient to release the seeds of new growth, until now. We are still in shock and obsessed with resuscitating the failures rather than identifying and promoting the entrepreneurial solutions that will carry us into the future.
New Solutions
Capitalism is an evolutionary blood sport. It is designed to have winners and losers. Business models become obsolete and are replaced through economic advancement. Old bulls are driven from the herd by younger ones. No matter how hard Hank Paulson tries to fight it my guess is that new mechanisms of capital formation and the social structures that will support them are already germinating just below the scorched surface of our financial system. New institutions will be born and a set of regulations to govern their activities will follow. A revised financial structure will rise from the ashes. It is unlikely that Hank Paulson and his Wall Street generation will be both part of the cause and the solution for this historic recalibration of the global financial system. Their thinking is locked in the past. The “too big to fail” doctrine that has made certain private financial giants systemically critical must be re-evaluated. Size didn’t save the dinosaurs.
 The Greenspan doctrine that asserts that asset bubbles are too difficult to identify and too risky to tame seems quaint in light of today’s financial quagmire. Chairman Bernanke will need vision unknown to his predecessor to help guide America’s financial system into the future. At the moment our leaders are busy scrambling, doing the things they are programmed to do. They are cutting borrowing costs, adding liquidity, buying failed investments and even buying shares in private banks, all on the taxpayer’s dime. The Treasury and the Fed are pumping money into a banking system awash in liquidity but unwilling to lend. The free market expressed as “mark to market” accounting has thrown financial institutions into capitalism’s black hole. In the vernacular of economists money supply velocity is zero. Dollars are not changing hands. Even the Fed cannot force banks to lend. Capitalism is showing us that we cannot tinker with the system free of consequences. Man has been reminded that he is part of nature not above it.
The Drumbeat of Global Recession
 The global economy has been thrown into a tailspin by the policies that have promoted an unsustainable expansion in consumption by Americans and production by our trading partners. Shame on all those pundits who have said the trade imbalance does not matter. It was in fact another sign of a sick eco-system. A global recession is the most likely outcome of today’s financial crisis. The US economy has been the driver of highly levered consumption. We own very little and finance almost everything. Our trading partners are guilty of blindly building factories, expanding the means of production to satisfy bloated demand while lending America the money to continue this rather short-sighted ponzi scheme. Those who have promoted the concept of decoupling, specifically that the developing economies of Brazil, Russia, India, China et al. can extract themselves from the current crisis and avoid recession regardless of America’s plight are dead wrong. America and Europe are positioned to absorb the brunt of the slowdown while China and oil rich nations will fare best. America is the world’s largest debtor in a global credit crisis. Our current account deficit will worsen as our national debt balloons. It is perhaps capitalism’s greatest paradox that credit is always there when you don’t need it and seldom there when you do. As we have written in past commentary it will be difficult for the traditional tools of financial and economic stimulation to gain traction. The collapse of the “shadow banking system” has left a void that rate cuts and cash injections are unlikely to reverse. A massive deleveraging of balance sheets is under way. The finance based sector of the economy must downsize to match supply and demand. The real economy will shrink, most likely through a moderately deep and prolonged recession. 2009 will bear testimony to the wisdom of today’s bailout measures.
American Hegemony under the Gun
The dominant role of US finance in the global economy will surely be challenged. The new rich of the world are not burdened with the  legacy costs of the American financial system. They do not need to tear down old infrastructures to build the new. It will be far less costly for the next generation of financial models to come from Asia or the Middle-East. It is my hunch that the new financial model will consist of substantial parts sovereign wealth funds and private equity. The investment banking model is dead. Moral hazard will be squeezed out by fierce competition and capitalism will exhibit the rough and tumble nature that juxtaposes risk and reward, prosperity and pain. For America this change will probably not take shape until we have flushed massive capital down the drain in a largely wasted effort to resurrect obsolete business and investment models. Our hope at ICM is that this process will be short lived as it will place America at a competitive disadvantage
Cultivate Change
This has been ICM’s battle cry for over a decade. We have urged clients to see things in a different light. The narrow , self-centered interests of Wall Street have been revealed yet again. The Street is in the business of producing and distributing financial products. Sales forces are seriously conflicted. This is a business model in need of comprehensive overhaul. Investing public funds will become more complex and riskier in the years to come. Opportunities for success will be shrouded in the uncertainty of the future and obscured by the smoke and mirrors of the well crafted sales pitch. Caveat Emptor my friends! Understanding one’s local economy in the context of the new financial paradigm will be critical to budgeting, long term planning and financial success. Access to credit may be impaired for the next budget cycle, particularly for those municipalities with declining fund balance. Protecting financial strength will be critical. The challenges presented by sudden dramatic change can be daunting. At ICM we will stand side by side with our clients facing the future head on with eyes wide open. Our curiosity and commitment are unwavering. Our goal is your success.