Analytics and Forecasting

Our radar has failed

17 Oct 2008  

Once again, our radar has failed.

The current financial meltdown is much more than a serious financial crisis. It’s even more than a crisis of confidence. It’s no less than a fundamental abuse of information and its pivotal role in our economy.

When our economy started in pre-historic times, we bartered for goods and services. Then money was invented—first stones, then metal coins, then paper—and finally, ledger entries. No less an expert than Walter Wriston (then president of Citibank) said over twenty years ago that the fundamental financial resource is now information.

Modern information technology long ago dwarfed earlier record-keeping methods. A typical teenager now carries with her several times the amount of data contained in the Encyclopedia Britannica. And these technologies gave us assurance that, to paraphrase the Who, “We could see for miles and miles.” With modern technology and record keeping methods, the story went, we could undertake transactions of far greater scale, scope, and complexity than ever before. And the “systems” would warn us if anything was wrong.

Of course, nobody would be stupid enough to trust their financial well-being to an all-powerful information technology (!), so we collectively hired people to watch the systems and tell us if anything went wrong. Lots of people: the Securities and Exchange Commissioners who design and manage the rules under which transparency was supposed to be achieved; the public accountants who certify that statements have been prepared according to those rules; the rating agencies analysts who rate debt, in effect telling us how likely we are to receive our interest and principal from those to whom we lend our money; the sell-side analysts, who recommend which stocks to buy; and the buy-side analysts, who help us buy stocks for our pensions and retirement accounts.

In effect, money had become information, and information moved faster than ever before. Ergo, money moved faster than ever before. So fast that it began to blur—it became hard to tell at any given day and time exactly who owed what to whom. Then it began to move even faster—so fast that it seemed like it was in two places at once. Thanks to modern inventions like hyper-leverage and derivative contracts, we had transcended the laws of financial gravity!

Except that, of course, we hadn’t. Like in a game of musical chairs, we’ve come to a pause. Everybody adds theirs up, and asks for a reconciliation—and there isn’t enough to go around.

The stock markets of the world have lost more than $10 trillion in market capitalization during the past year. (That’s 10,000 billions, for those of you not intimidated by large numbers.) Was that money stolen? Does somebody somewhere have it and is enjoying it at our expense? With the grossly excessive Wall Street compensation of the past decades, there is certainly some of that—but not nearly enough to explain the shortfall.

What I’m proposing is that the massive multilateral devaluation of just about everything at the same time could be our collective way of admitting we were double-counting all along. It’s as if the money was never really there in the first place.

With US commercial banks on average leveraged at around 10:1, and investment banks leveraged at 30:1, “double-counting” would seem comparatively conservative. Were we playing with lots of Monopoly money that never really existed?

I teach a management clinic called Financial Literacy, which explores how to use financial statements to discern rival strategies and navigate amidst changing business conditions. The underlying assumption of my course—and of our whole economy—is that we all have a complete and accurate set of financial information at pretty much the same time. This assumption forms the foundation of the “efficient markets hypothesis”, which is widely accepted as the keystone of modern financial thinking. It underpins our system of whole capital markets, and allows us to be comfortable with entrusting our hard-earned money to those markets’ managers.

So firmly is this principle established that asymmetric information—where some have it and some don’t—is illegal. People have been sent to jail for trading on non-public “insider” information.

The current massive simultaneous devaluation of just about everything has exposed the entire system of information and data on which our economy rests as, at best, unreliable. We’re flying at 50,000 feet at 600 miles an hour in the clouds—and our radar and other instruments have failed.

My Knowledge Value Chain® model depicts the relationship between information and corporate value-creation. One of the key lessons of the KVC is that if one layer fails, all higher layers are far more likely to fail. Data is the bottom-most layer in the model, the foundation of the entire “pyramid”. When the data about underlying assets such as mortgages and mortgage-backed securities was essentially found to be false—requiring serial massive write-downs in many leading financial institutions—not only did those institutions fail, but the whole financial infrastructure is in danger of failing along with them.

When people—and I include institutions here, they’re run by people—can’t trust the numbers, they can’t trust the capital markets. When they can’t trust the markets, they will not invest in those markets. If they don’t invest in the markets, the markets will freeze up. When the markets freeze, business can’t operate and will itself freeze—and that is exactly what is happening.

Lately my “our societal radar is failing” theme has been called on so regularly, that it no longer seems like an alert. Recently it was Enron, before that, 9/11, before that the “dot-com bubble”. I’ll explore possible reasons for the persistence of this theme in future posts.

In spite of all this, I remain optimistic. As an eyewitness to the 9/11 World Trade Center collapse, I can tell you that while it seemed that a chapter in history had come to an end, we did finally pick up the pieces and come back to Life again. It was not easy, we are not there even now, and it has taken much time and effort.

We simply must do better. It will take a massive effort to find out what happened, and to build the safeguards necessary to ensure that it doesn’t happen again. I’ve been working on a set of principles that I believe should guide us in our quest for better information about our economic world. Stay tuned…

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