Thursday, 30 October 2008

£4bn of capital for small firms

Alistair Darling has announced £4bn in money from the European Investment Bank to help small firms access credit over the next four years.

I wrote a few weeks ago about the economic justifications for this and those comments still stand. However, I'm surprised - and impressed - with how fast the government has moved. The money is apparently already available, through Barclays.

Barclays of course is one of the banks which did not require public capital earlier this month and so, arguably, was not subject to the condition of making funds available at 2007 levels - though it has strengthened its balance sheet with additional private equity.

Even before this announcement Barclays has certainly been making some credit available over the last couple of months without unusually onerous conditions. So if anything this could be a better than usual time for creditworthy businesses to raise funds. Not what you would expect given the headlines in the financial press.

Could this be, paradoxically, a real opportunity for small companies to invest and gain market share against bigger ones? The last major change in the economic environment - the dotcom boom - certainly provided some advantage to new and innovative firms.

If this money is used well, a new generation of young companies will grow up through the recession and position themselves as future powers of the economy. If 10,000 companies each borrow and invest £100k this year, expect at least three of them to be future members of the FTSE 100.

This single policy could go down, along with the independence of the Bank of England and the minimum wage, as one of the best economic decisions of the Blair and Brown governments. Does Peter Mandelson get the credit? Alistair Darling? Gordon Brown? I hope someone does, because the positive economic impact of this will far outweigh any negative effect of the much-criticised CGT and non-dom changes last year.

Time and growth

In two opposing ways, time is affecting global growth.

The first is scary. So much of global growth is based on investment (50% of GDP in China!) that we are spending a huge proportion of our current efforts in hope of future return. The problem with future expectations is that they are incredibly volatile. Unlike ongoing present-day commitments or projects, our expectations of the future can easily change by 50% - in either direction - overnight. All it takes is a message in the media, spreading from one journalist or blogger to the next, and within a few days everyone thinks a disaster is coming.

If a third of everything we do is based on working towards potential future returns, and our expectation of those returns falls by half, suddenly most of that investment no longer seems viable. This is the terrifying prospect - imagine a 20% fall in economic activity within a year with all the multiplier effects that would have. Enough to stop you wanting to get out of bed in the morning.

Naturally I don't think it will be that bad. One reason is that expectations can rise as easily as they can fall. A narrative of hope can develop to show us why the future is still going to be great, and investment will return.

The other and more interesting factor, is the counterpart of time sensitivity. That is the lead time on investment. Fortunately, things still take time to build. Therefore people are already committed on long-term projects and developments which need to complete (because most of the money is already spent, so the cost of completion is justified by even a reduced future return).

In an extreme example, if all our projects take ten years to complete, we would have several years of continuing investment before seeing any real downturn. Of course we would then take years to get back up to speed again, so this phenomenon is not an unalloyed good. Happily there are a range of different lengths of projects - but in any case many firms have a sufficiently sustainable business to get through the next couple of years at least.

Maybe by that time we'll have figured out where this narrative of hope is going to come from. Perhaps an Obama presidency in the US will provide something; maybe it will be from another source. But humanity has a pretty good record in this respect.

Thursday, 23 October 2008

Physics by press release

Jonathan Amos at the BBC has an article about a car that's planned to achieve a speed of 1000 mph:
" its maximum velocity, the pressure of air bearing down on its carbon fibre and titanium bodywork will exceed 12 tonnes per square metre."
Wow, that sounds pretty heavy.

But normal atmospheric pressure on a square metre of your ordinary Ford Fiesta, or indeed your skin (if you have a square metre of that) is about 10 tonnes!

Careful in copying what the press releases say - it may not be as exciting as it sounds.

Wednesday, 22 October 2008

Ron Baker on hard times

Ron Baker of Verasage asks in a posting this week "what the burning platform will be that will, ultimately, force firms to give up the Almighty Hour" - will it be the recession or something else?

The recession - like any change in the economy - accelerates capitalism's process of creative destruction, putting more pressure on broken and unworkable models than on better ones. However I agree with him that, on its own, that will not be enough to trigger the change.

A combination of factors will contribute to this - and their combined strength will determine when the tipping point is.
  1. A recession, by making buyers risk-averse, will encourage value pricing because it acknowledges and reduces the buyer's risk
  2. New information technology enables better measurement of the value generated for clients, and therefore allows prices to be based more directly on it
  3. Competition will operate - once a significant number of supplier firms start to offer structured or value-based pricing, it will become hard for others not to
  4. Clients will be educated - there is a suspicion that value pricing is just a way for suppliers to get more for the same service. In fact structured pricing incentivises suppliers to deliver more of what clients want, which is in the client's interest; but this message will take a while to be widely accepted
  5. As more professional knowledge firms productise their services (e.g. the following two firms: Betternest in architecture and Jigsol in accountancy), value pricing on those products will be easier to adopt than in traditional services. Competition and commoditisation in a cost-competitive marketplace will drive this move to products instead of services.
My original post on structured pricing is here, and this one is about structured pricing in the property sector. I presented the latter at Agency Expo in London last week and 100 estate agents came to find out about it. I am writing an article for Negotiator magazine (also aimed at estate agents) next month - so if professional services isn't ready, at least some industries are interested.

Sunday, 19 October 2008

Stunning Obama September numbers

The Barack Obama campaign had already let it be known that September was their best month so far... beating the $66 million raised in August.

Some rumours said over $100 million - others thought that $80-85 million was a reasonable number based on the rate of growth from July to August. One clue was that in certain states Obama was outspending McCain by a 3-1 margin - which, considering the RNC's $80 million advantage over the DNC at the end of August, seemed surprising. Well, the answer has just come out in a video, emailed to Obama's mailing list.

The total sum is over $150 million. I thought the leaks might be underplaying it a bit, but not by this much. This includes 632,000 new donors and the average contribution was $86. Amazing figures. This election gets more extreme every day - what a great spectacle American democracy is.

The DNC also raised $49 million compared to the RNC's $77 million (no doubt including some money that might have gone to McCain had he not opted into public financing).

Apparently the Obama campaign has already bought so much TV time that it is having difficulty booking any more ad slots. This is why they have bought half an hour of prime time network TV a few nights before election day, and David Plouffe in the video talks about combatting the McCain campaign's robocalls - so perhaps that is somewhere the money can be spent. Maybe some of it will be donated to the financial sector bailout.

Saturday, 18 October 2008

Saturday morning commentary:

  • An amazing retirement letter from hedge fund founder Andrew Lahde
  • How to get up early, and a nice (completely uneconomic) story of swimming in the Lake District, from Tim Harford
  • A plan for the digital economy to help kickstart the economy (not yet much of a plan but interesting to see what comes of it), on top of bringing forward several billion of capital spending from 2010-11 to the current year.
  • Gordon Brown's reservations about "the weaknesses of unbridled free markets". For me, these can be summarised simply: the prisoner's dilemma, the agency problem, asymmetric information, transaction costs and a collection of problems related to unpredictability and risk. Hopefully the solutions will not be worse than the problems. Another post on this later today.
You can access about four FT articles before you need to register for a trial subscription, so the links above should just about use your quota.

Monday, 13 October 2008

Credit insurance trap

Imagine a simple financial system with just three institutions: A, B and C. Let's say that each has capital of $1bn, gross assets of $10bn and gross liabilities (excluding shareholder's funds) of $9bn. Half of each bank's assets are mortgages and half are interbank loans. Of the liabilities, $5bn are interbank loans and $4bn are depositors' accounts. Finally assume there's a regulatory minimum capital limit: 8% of total assets.

Now imagine that A starts to offer credit insurance on the debts of B. C has lent some money to B, so it decides that it would be smart to insure it; and takes out a $5bn policy from A.

As this is a competitive market, B and C soon start to offer insurance too. A buys a policy from B insuring A's lending to C, and B insures its debt to A with C.

Now say there's a 10% decline in the housing market. A's gross assets are written down to $9.5bn, eliminating half of its capital base and breaching regulatory limits. This counts as a credit event in B's insurance policy and it claims $1bn from C from its $5bn policy.

C has to recognise this loss, creating gross liabilities of $10bn to set against its depleted assets (don't forget it had mortgages too) of $9.5bn. C becomes insolvent.

This certainly triggers a payout on A's policy held with B, and it claims $2bn. B's liabilities are now increased to $11 bn against $10bn of assets (including the $1bn it is due from C, written down to $0.5bn as C is unlikely to pay up in full). B is insolvent too, and even more so.

By the time C gets around to claiming $2.5bn on its insurance from A, making A insolvent too, all three banks are out of time. The public sector - or possibly Warren Buffett - is the only agent that can step in and rescue them. All deposits and debts are guaranteed, all three banks are nationalised and the accountants spend half an hour cancelling out the cross-holding of debts and insurance; leaving the following:

A: capital $0.5bn, assets $4.5bn, liabilities $4bn
B: capital $0.5bn, assets $4.5bn, liabilities $4bn
C: capital $0.5bn, assets $4.5bn, liabilities $4bn

The public sector privatises the banks again, raising $1.3bn to help pay for the 2012 Olympics (the accountants charged $100m for their services and A, privatised first, charged $50m to underwrite each of the other flotations). The banks, protected by government guarantees, start lending to each other again. Once the housing market recovers they're back in the same position as before, but somehow the Treasury has extracted half of the total equity from shareholders along the way.

Windfall taxes? Who needs 'em.

Insolvent - who's insolvent?

In 2000, the IMF added up the reported trade balances for every country in the world and discovered that total world imports were $172 billion greater than total exports. Discounting the prospect that aliens are using their unfair price advantage (presumably they are not subject to payroll taxes) to steal our jobs, the idea that the world as a whole could run a trade deficit is of course absurd.

However, the idea is resurfacing in much recent comment about the world financial crisis. Even the excellent Martin Wolf is talking about "a growing crisis of insolvency" and this is becoming a common theme: we thought we had an illiquidity problem, but now we find it's an insolvency problem.

Well, it's not. Insolvency is the inability to pay debts as they fall due. The total amount of debt in the world is zero - every debt is owed by one party to another party, in equal amounts. Just like the total trade balance of the world is zero, the world does not have any debt and therefore cannot be insolvent.

Of course, individual institutions can be insolvent - as can, conceivably, a whole collection of institutions such as the financial sector. And this certainly causes problems. But let's not pretend that somehow the whole world has fallen into a black hole of debt which needs to be filled by printing money.

Money and debt are just ways of making a claim on someone else's future work or resources. These claims are a useful tool in coordinating the use of resources to make us all happier. But no amount of debt (or money) can in itself create or destroy the productive use of resource. Ronald Coase showed that (apart from transaction costs) the actual ownership of resources is irrelevant in determining the most efficient way to allocate them to produce economic output. The expansion of debt - or default on it - therefore causes no economic problem in itself.

The public sector interventions (OK, I'll let you call them bailouts) are presented by some as an expensive use of public resources to somehow fix an insolvent economy. But if the economy is not insolvent, all they are actually doing is transferring a set of claims from one party to another. It is likely that this will vastly reduce transaction costs - imagine 300,000 Icesave depositors all individually pursuing Icesave's creditors through the courts - but, in reality, it actually doesn't cost anything. The only issues are: (1) the extent to which we lose the useful tools that are embodied in monetary incentives and (2) the equity of resource allocation in the resulting system.

Therefore, look at these bailouts as cutting the Gordian (or Gordian Brownian) knot of complex financial transactions; and potentially, a way of reallocating resources in a fairer way. But don't lose sight of the valuable knowledge embodied in that knot. The ties of debt, obligation and payments that kept flowing through our hugely complex financial system until a few weeks ago are a brilliant collective invention, one that helped us all to get 50% richer over the last ten years by using our resources more cleverly. We need to allow complexity to exist in our lives in order to live better.

Tuesday, 7 October 2008

Finance is...

"Finance is the web of intermediation binding economic agents to one another, across both space and time." Martin Wolf in his FT column on 30th September.

It's interesting to consider how bankruptcies or insolvency of financial players can cause a recession. After all, a debt has two sides - and if it is uncollectable, the money hasn't disappeared - it's just been transferred to one party at the expense of another. If Lehman Brothers goes bust because it can't collect $40bn of debts, then presumably the debtors (or their employees, or suppliers, or the people they bought their houses from) have gained $40bn; Lehman shareholders have lost $10bn and Lehman creditors have lost $30bn. At first glance, the economy is no worse off. Indeed even the creditors aren't as distraught as they appear, because some of them now have a claim to pursue against the lucky debtors.

And that's true, insofar as money is an asset in itself. The total amount of money in the economy has not changed and total cash wealth is preserved. However, the real damage is to the productive potential of the economy.

This potential is the capacity for firms and people to produce things of value for each other, in excess of the value used up in producing them. The amount of valuable things produced in the world is around $50-60 trillion each year. Quite a lot, though it's divided between 6.5 billion people, so we each get around $8000 worth.

For comparison, what's the total amount of money in the world? Using what's called M4 money supply in the UK, M3 in the US and EU, and M3+CDs in Japan, we can find or estimate some figures for the end of 2007:
  • US: $12 trillion
  • EU: €8.5 trillion
  • UK: £1.5 trillion
  • Japan: 1.5 quadrillion yen

These four economies represent about 70% of the world economy so it's probably reasonable to assume they contain 70% of world money supply - though admittedly the debt characteristics of other economies are a bit different to these four. We're just looking for a ballpark figure though.

Total world money supply therefore - €42 trillion, £33 trillion or $58 trillion. About the same as a year's economic output. But tiny compared to the net present value of the world's economy. Assuming a discount rate of 7% and zero growth, the NPV of the world is over $800 trillion. Assuming 2.5% growth, it's $1300 trillion. This, in a sense, represents the total real wealth of everyone in the world. But - and we'll come back to this later - this is based on the effective, productive application of resources (including human effort) continuously over time. Any downtime when resources are not being used is a permanent loss to total world wealth.

So, if the total amount of money in the economy doesn't change, does that mean economic output is not affected either? Unfortunately not.

The function of money in economic output is as a coordinator. It provides the reservoir that allows person A to do some work today, and their work be available for person B to use next month when they're ready to provide something for person C. It sends the signal to tell B that A was the most efficient person to do the work rather than D, and therefore allocates more work to A while D finds a different job. And it allows me to work hard today, accumulate a claim on future resources, and "spend" my work next year, or after I retire - while in the meantime I lend that claim to someone else who can use the resources productively.

For this coordination, it doesn't really matter who owns the money. It just matters that it can get to where it's needed at the right time, and that it retains its value reasonably well. And in a well-functioning credit system, that is rarely a problem. The people who can best use the money tend to be ones with reasonably good credit, and so people are willing to lend to them. And when the people with money don't know the people who want it, banks provide the matchmaking function in between. If those with the money (who we call lenders) are too far away from those who need it (borrowers) then a single bank is unlikely to have relationships with both. Simple matchmaking then doesn't work, so instead we have a network of intermediaries through whom the money flows.

But this relies on the intermediaries themselves being trustworthy. If they're not, then the banks won't lend to them, and if the banks themselves are not secure, the lenders won't allow them to matchmake their money.

So a potential borrower who could make good use of resources can't get them; resources, and people, sit idle; and that valuable, irreplaceable productive time is lost forever - real wealth is destroyed. The lender can't put their money to use anywhere and they earn no interest. Average world interest rates (the amount of value generated by money) are maybe 4% - so lenders could be losing $2.5 trillion in interest by holding back their money. But more importantly, the NPV of the world is falling daily. If we lose one year of growth against a 2.5% trend, world NPV is reduced by $32 trillion.

And all of this is not because we don't know how to allocate resources productively, or because innovation has stopped. It isn't even because the people providing intermediation have disappeared, or forgotten how to do it. It is simply because nobody can trust the intermediaries to transmit money to borrowers and bring it back again intact. And this is a self-perpetuating, vicious cycle because nobody will start trusting if nobody else trusts. Like the prisoner's dilemma, or like an insurance policy, the system can only operate if everyone joins in at once.

Against this background, almost any amount is worth paying to restore trust and have the system work again. It looks like governments - and perhaps Mr. Buffett - are the only institutions we have enough faith in to make this happen. Governments, which, curiously, are another self-sustaining confidence trick - we only let governments have authority over us because everyone else lets them too. Money itself, and the idea of the debt that taxpayers are taking on in these rescues, are all bound up into the same network of bubbles. But if we still believe in that trick, maybe it has just enough con left over to spill into the financial system. We better start falling for that one again or we're all in trouble.

Saturday, 4 October 2008

European small business fund

There's a proposal today for a £12bn "small business fund" to help companies across Europe through the current crisis. As owner of a small business, I would naturally be grateful for access to such a fund - but is it economically sensible? Let's look at how it could be structured to make the most impact with the minimum of interference with market mechanisms.

  1. Access to credit. Probably the most obvious area where small companies may be suffering in the current environment. This has always been a constraint for small businesses, and the UK government already has a good system to address it - the Small Firms Loan Guarantee Scheme which guarantees loans by banks to small firms. It was expanded in the 2008 Budget and the criteria for accessing it were relaxed. The economic justification? First, that the external returns to the economy for supporting the foundation of new businesses exceed the risk-adjusted returns available to capital. So if the Government can help me get a £20,000 loan to start a business, the knock-on effects in employment, innovation, competition and tax revenues will be much greater than the risk the government takes by insuring the loan. Second, that the market is illiquid - because the resources that the banks have for evaluating, funding and securitising corporate credit are expensive, and geared towards multi-million pound credit lines or corporate bonds - and are not worth applying for small loans. The state can intervene to open up this market and reduce transaction costs.

    In the current credit environment, these problems are exacerbated. Although an accountant did tell me the other day that the banks, unwilling to lend to each other, are keen to lend to quality corporate borrowers instead. I'm not sure how accurate that is - the banks are clearly keener to lend to the ECB than to corporates. A version of this scheme across Europe therefore seems to make sense.

  2. Anti-contagion. There are lots of businesses which depend intimately on each other for income, with lots invested in complex supply chains and 'soft intellectual property' built into their relationships. One example from my own business looks like this:

    Freelance programmer <- Inon <- other software company <- property management company <- management consultancy <- oil company <- petrol retailer <- consumer If any one company in this chain has liquidity problems, all the others below it will suffer. Some of them are operating on a thin equity base (very common in small businesses which tend to reinvest most of their profits) and so they could be at real risk. Naturally, if any of these businesses lose their clients and are not viable, they should be allowed to fail. But if a business fails for the sake of one or two months' revenue, thus destroying several years investment in intellectual property, training, employee and client relationships, this is wasteful. The intellectual capital and goodwill invested in many of these businesses is not recoverable in a liquidation, so a solution that allows survival in some form is economically preferable. How could this work in a government-sponsored fund? One way is to provide credit insurance for long-term supply contracts, if it could be implemented with minimal moral hazard. This would allow each party in the above chain (or even just one of them) to insure against the failure of its customer, thereby protecting themselves and everyone below them. Another mechanism is to provide coordination for the pooling of risk. Government could play a role in bringing together several software companies or several property management companies, so that if one comes under pressure the others can take it over or work with it - preserving the intangible investment in each. Naturally the merging companies would need to reduce staff numbers, but they would generally be able to preserve most knowledge within the combined entity. This is exactly what the authorities are doing for banks - could they also manage it for industrial companies?
How far would £12 billion go?

Extrapolating the small business figures from the UK (3 million businesses) to the rest of Europe, we could estimate around 20 million across the EU. (in fact this paper says 23 million)

Around 90% of these consist of just one person - and it seems more logical that the fund would be focused on companies with employees, for political reasons as much as economic ones. So maybe 2 million businesses would be eligible.

Assuming 75% of these do not need any assistance, the £12 billion would be available to 500,000 businesses - an average of £24,000 per company.

While £24,000 on its own would make little difference to the viability of a firm, if targeted accurately it could unlock a lot of private sector leverage. A £24,000 loan guarantee premium would allow a company to borrow £100-200,000 - enough to allow them to invest seriously in marketing, product development or systems for growth. £24,000 of coordination or marketing support might help a company to access 100-200 new opportunities for mergers, other cooperation or new business.

It's hard to know whether government is an effective mechanism for distributing this support, but if the resources are not available from the private sector then it may be a viable alternative.

Edit: it turns out the plan is for early release of a planned £12bn small business fund from the European Investment Bank. Indeed Brown is now requesting the entire £25bn fund be made available. This would be loan money direct to small businesses, so the equivalent of a £48,000 loan for 25% of all businesses in the 27 EU countries - or, say, £240,000 if only 5% of businesses are eligible/apply for it.