‘Caveat Emptor’ no help to investors

In the wake of the 2008 financial crisis, the conventional wisdom is that financial markets need to be more tightly regulated. That is certainly true, but the problem is as much about who is doing the regulating as it is about the regulations themselves.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act represents America’s biggest financial regulatory reform since the Great Depression, but its success will ultimately depend on having competent and honest regulators who cannot be compromised by lucrative employment opportunities dangled by the regulated.

The dominant global financial players’ failure to rein in their greed set the stage for the last economic crisis, and it was hardly the first time; under-regulated markets went on a murderous rampage.

Common-sense regulation ensures that a buyer can be confident that the item being purchased possesses all the advantages the seller claims, and that any disadvantages are clearly identified. This allows the buyer to make a rational decision about whether the item is actually worth the price. Many libertarians assume sellers will always inform the buyer of pertinent factual information because the seller knows that economic success ultimately depends on a reputation among potential buyers.

At the other extreme is the idea that sellers are inherently Times Square shell-game scammers who can’t be trusted to provide clear, honest, information about their products’ advantages and disadvantages, so  the buyer must accept sole responsibility for obtaining all necessary information about whatever products he or she may purchase. This is the spirit behind the popular Latin phrase: “caveat emptor,” or “let the buyer beware.” Responsibility for regulating private firms rests with government agencies staffed by highly qualified managers and analysts who regard “public service” as the noblest of callings and their surest path to heaven. ·There are at least two real-world problems with this concept.

The first is that it depends on a large supply of trust fund babies to staff these government agencies free to devote their professional lives to “public service.” Sadly, the supply is nowhere near sufficient. Most of the intelligent and well-educated people they require emerge from graduate school burdened by crushing student loan debt that forces them to opt for the most lucrative job they can find.

The second problem flows naturally from the first. Many gifted, well-educated, young people see government regulatory agency job as stepping stones to lucrative private sector careers. They can develop useful contacts with key players with the firms they are supposed to regulate and impress the contacts that their “hearts are in the right place” as far as the regulated firm is concerned.

So it’s scarcely a surprise that there’s a parade of people marching back and forth between lavish private sector executive suites and the basic steel-desk offices of agencies like the Securities and Exchange Commission.

If we want federal regulatory agencies that prevent financial debacles, we have to end close the revolving door.

To make that work, we will need to address the economic concerns of gifted but highly indebted people. We could pay them much higher salaries for government jobs or subsidize their student loan burdens in return for their committing to careers in public service. Perhaps we could make up some of the difference with generous pensions, health benefits, and perhaps even offer them college scholarship for their children.

It’s awfully hard to be serious about regarding financial markets when you need a program to tell the regulators from the regulated.

originally published: August 31, 2013

The charms of group purchasing

One thing almost all industries share today is pressure to cut costs in an economic environment where demand is stagnant. Many companies have responded by substituting capital for labor and outsourcing jobs offshore. But collaborative purchasing has also emerged as an effective cost-saving strategy, and not only for the private sector.

Over the past two decades, procurement and supply chain management have risen to the top of the management agenda for private-sector managers seeking to rationalize their cost structures. Among the advantages the private sector has over government are much more flexible procurement regulations. Aggregating purchases is relatively simple in the private sector and presents such an obvious savings that few operating managers resent its imposition.

By contrast, government procurement regulations reflect the American cultural bias that it is better to spend $100 on gold-plated oversight procedures than to risk letting a single dollar slip away to a supplier who may not truly deserve it. This commitment to a squeaky-clean procurement environment tends to relegate public agencies to the end of the line when it comes to implementing new tools and technology.

The inevitable result is that operating costs are higher and service is poorer than it could be. Also, government procurement is often a powerful tool for advancing political interests like supporting the local economy, often at the cost of capturing major savings.

Experienced managers know that flexibility is necessary in negotiating and administering contracts with suppliers if the results are to pay meaningful dividends. This can often mean a heavy emphasis on interpersonal relationships and the use of negotiated contracts rather than arms-length competitive bidding.

Traditional critics of the public sector like to call this “honest graft,” which just plain smells bad to much of the American public regardless of its real-world benefits. They fail to realize that what really counts are results, not civics class myths about what constitutes “good government.”

Sure, chicanery has a long tradition in the rough-and-tumble world of American capitalism and appears to be unavoidable. After all, you don’t survive long in business by acting like a Sunday school teacher.

No area of government is more interested in reducing costs than the transportation sector, where demand for new assets is high, federal funding has stagnated and revenue from sources like the fuel tax has been eaten by inflation. As a result, states’ Departments of Transportation (DOTs) have had to scale back on capital replacement and focus a larger portion of their funding on preserving existing assets.

Many state DOTs need to be grabbed by the lapels and given a good shake by a new generation of leaders who understand that working in an era of constrained resources requires them to create customer value without relying on the federal government.

Fortunately, a number of DOTs realize that joining their counterparts to do collaborative procurement represents an opportunity to reduce costs without jeopardizing service delivery. Under collaborative procurement, several entities combine their purchasing efforts to secure a selected group of products and services with commonly accepted specifications. The goal is to leverage the aggregated purchasing  power to save money and obtain favorable terms and conditions from suppliers. The initial focus is on demonstrating success in a few discrete spending categories that illustrate the practice’s larger potential.

Collaborative procurement certainly faces potential impediments, such as antiquated state laws and regulations. The time has come to rethink existing rules that constrain a tool that can result in better quality at a lower cost. If allowed to be judged on its merits, collaborative procurement will become the new status quo in the public sector.

originally published: August 24, 2013

Reasons for hope in Detroit’s bankruptcy

Once the symbol of American industrial power, Detroit filed for bankruptcy last month. The causes of the largest municipal bankruptcy in American history are clear, but there are also reasons for hope.

The federal government is unlikely to bail the city out, as it did for financial institutions and the big three automakers, because the fallout from Detroit’s bankruptcy is not expected to affect other cities and states. Detroit, unlike American banks, is not too big to fail. But bankruptcy offers the city an opportunity to nullify ridiculous labor contracts and reform pension and health care agreements.

Detroit was once the center of an economic miracle. In the 1950s it was one ofthe nation’s wealthiest cities and by the early 1960s automobile manufacturing accounted for half of Michigan’s gross domestic product.

But by 2008, automobile manufacturing’s share of Michigan’s GDP had declined to less than 5 percent. Detroit, the cradle of the automobile industry, developed with its expansion and also suffered as a result ofthe industry’s  decline.

The scale of the city’s decline is amazing. Detroit, which had 1.8 million residents in 1950, currently has about 700,000. The property tax base has been gutted. Large parts of the city consist of abandoned residential buildings and industrial sections that resemble war zones. Many of the remaining residents are essentially deprived of many basic public services like police and fire protection.

What set Detroit on the path to extinction? By the late 1960s, management at the big three automakers had become insulated and more interested in maximizing their own value than delivering value to customers. The 1973 OPEC oil embargo resulted in increased fuel prices and provided an opening for Japanese automakers to flood the American car market with cheaper, fuel-efficient alternatives. Many Americans soon became convinced that Toyota, Honda, and other Asian-based manufacturers offered better quality for their dollar than did domestic vehicles.

In an effort to preserve profitability in the face of a dramatic loss of market share, the big three’s less­ than-sure-footed managers evolved defensive business models that emphasized selling fewer vehicles at higher profit margins. This increased their dependence on SUVs, high-performance cars, light trucks, and similar gas-guzzlers that faced less Asian competition. As long as gas prices remained relatively stable, as they did through the 1980s and 90s, their strategy seemed viable.

But beginning in 2001, rising gas prices again cut the legs out from under the big three’s business models. Demand for fuel-gulping vehicles plummeted and sales started falling. This trend was compounded by the financial crisis in the fall of 2008. When the global recession took hold that fall, sales plunged, including a 32 percent drop in October alone, to the lowest level in 25 years. The big three had to depend on multibillion dollar taxpayer assistance to survive.

But it was not just the auto industry’s collapse that killed Detroit. Decades of mismanagement, fiscal and political ineptitude, municipal corruption and racial tensions exacerbated middle class flight, sending the city into a death spiral. Anyone who could get out did; since 2000, Detroit has lost a quarter of its inhabitants.

Detroit has also long been governed by a Democratic machine controlled by the city’s powerful labor unions, which mustered voting blocks big enough to ensure that only Democrats got elected. The result is that almost half of the city’s $18 billion in debt consists of unfunded pension obligations and retiree health benefits.

But there are hopeful signs. The automobile industry is again profitable. Businesses are slowly moving in and the city is becoming more attractive to entrepreneurs. Young people are returning to live downtown. Developers are buying office buildings and large tracts of land and turning them into living, office and retail spaces. The downtown sports teams sell out and firms such as Blue Cross/Blue Shield, Quicken Loans and others have recently arrived.

Building on these signs will require both city and big three leaders to resist the temptations they succumbed to in the past. Instead of quick profits and machine politics, the focus must now be on giving middle-class families a reason to return.

originally published: August 17, 2013

Applying Radford’s ‘Economic Organization’ to economists

Since the days of Adam Smith, more nonsense has been written about capitalism than any subject except religion.

During the 19th century and the first half of the 20th century, economists from David Ricardo to Alfred Marshall raised the status of the free market, guided by its miraculous “invisible hand,” to something like a beneficent secular priest that was supposed to rule worldly lives.

Beginning in the latter part of the 20th century, things got even worse.

Ivory-tower economists started developing a host of “rigorous” quantitative models that claimed to show how markets actually work. Tagged with such intimidating names as “The Efficient Market Hypothesis ,” “Modem Portfolio Theory,” “The Capital Asset Pricing Model” and “The Black- Scholes­ Merton Option Pricing Model,” they focused primarily on markets for common stocks and other financial securities assumed to represent the closest real-world approximation to the free market ideal.

And they were all wrong. They were based on a misapplication of Gaussian statistics, epitomized by that overworked bell-shaped curve, which supposedly demonstrates that female college students have less aptitude for math and science than males. For good measure, they also used antiquated principles of Newtonian physics that had long been discredited.

But these theories still became conventional wisdom among Wall Street rocket scientists during the 1980s and ’90s. Not to mention winning for several of their developers the Nobel Prize in economics, despite the havoc they raised for the financial firms that actually tried to put them into practice.

It may come as a surprise to many, but markets are not artificial hothouse entities. They are, in fact, entirely natural and instinctive products of everyday human pragmatism.

Nowhere is this illustrated more clearly than in the informal markets that developed among American and British bomber crews in German prisoner-of-war camps during World War II. It’s the basis for a fascinating article by British economist R.A. Radford titled “The Economic Organization of a P.O.W. Camp.”

Prisoners received weekly food parcels from the International Red Cross that typically included Spam, powdered milk, jam, chocolate bars, soap and five packs of cigarettes. With lots of time on their hands and regular weekly deliveries of identical parcels, the POWs began trading these goods among themselves.

In a surprisingly short time, each barrack became a hotbed of informal “barter markets.” These activities soon expanded to include trading between barracks and even featured “bid and offer” notes for various goods that aggressive POWs looking for trading action would pin to the bulletin boards in each barrack.

As volume grows, the barter system is an awkward way to conduct trading activity. But human ingenuity quickly solved this problem by pricing all goods in terms of a single good, known formally as the “medium of exchange”- in other words, money. The POWs instinctively chose cigarettes as their money, since each Red Cross parcel contained five packs, with 20 cigarettes in each pack.

Once the POWs had a reliable and widely accepted form of money, their trading activities increased by leaps and bounds. Soon they allowed for credit, futures markets, arbitrage, investment, entrepreneurship, rules and institutions to facilitate market activity, and- because there were nonsmokers- savers. There was something universal and spontaneous about the development of a market economy.

After the war, these thoughtful members of the greatest generation went to college on the G.I. Bill and built highly successful careers. The descriptions of markets in their college economics courses bore little resemblance to how markets actually worked naturally in their POW camps. From which we can learn a great deal about how markets really work in a world of full-blooded human beings.

originally published: August 10, 2013

Privatization: Old wine in new bottles?

Privatization, or public-private partnerships, is an arrangement under which the private sector becomes involved in the financing, design, construction, ownership, and/or operation of public facilities or services. The underlying concept is that both the public and private sectors can benefit from cooperating to provide services and/or facilities.

The concept is a valid one, as long as public officials consider privatization’s impact on tomorrow’s taxpayers, not just what the effect will be during their own terms in office.

Privatization is more common than most people realize. Governments routinely use private firms to prepare engineering and architectural designs for public facilities. Essential public services such as electricity, gas and telecommunications have traditionally been provided by private firms that function as regulated monopolies. Public-private partnerships are as American as handguns.

But the concept of private firms operating public libraries, prisons, sanitation services, toll roads or other functions normally associated with public agencies is newer. Contemporary privatization represents a collaborative effort, with the public and private sectors sharing risks, rewards and responsibilities.

Interest in privatization is increasing, partially driven by fiscal challenges. The assumption is that private firms can often deliver these services for less, even though they must pay taxes and make a profit ­ expenses that public agencies do not have.

How is this possible? There are at least five factors that can work in a private firm’s favor:

Higher salary and incentives: A public agency’s salary structure and inability to offer things like stock options may make it impossible to attract a sufficient number of talented managers.

Faster procurement: Public purchasing processes are often constrained by regulations originally implemented to prevent fraud. Purchases can take an inordinately long time to complete.

Economies of scale: By providing the same service to a number of public entities, a private firm can develop both market power and specialized expertise. This can be particularly critical for high-technology services.

Less restrictive work rules: Public sector collective bargaining agreements often saddle public agencies with work rules that prevent implementation of new and more efficient procedures. Private firms are often in a better position to negotiate rules that promote efficiency.

Availability of tax deduction: Finally, private firms have access to two federal subsidies that are not available to public agencies: tax deductions for accelerated depreciation on capital equipment and interest payments on borrowed funds.

Sadly, the nation’s most restrictive anti-privatization law all but prevents Massachusetts taxpayers from reaping benefits from public-private partnerships. Under the so-called Pacheco law, named after its author, State Sen. Marc Pacheco, state managers must overcome virtually insurmountable obstacles before contracting out any service currently delivered by state employees. As a result, few privatizations have even been attempted during the two decades the law has been in effect.

The privatization debate has waxed and waned since 13 colonies became the United States of America. Should we let government take care of our problems or should we rely on private enterprise? As governments struggle to figure out how to handle mega-problems created by a stagnant economy, the prudent use of privatization is more important than ever.

originally published: August 3, 2013