When our economy hit the wall in the last quarter of 2008 we, like so many businesses, reacted normally; we reduced the number of payroll employees and hours as much as possible,  eliminated some of the days we used the cleaning service, had other services requote to reduce prices, eliminated vehicles, and such marginally productive outlays such as freebie pens and calendars to hand out to customers.

After cutting the most obvious costs, the next step was to examine prices and find points where we could expand margins. In a competitive world where everyone is desperate to make a sale  and some competitors even sell below cost in order to generate cash to pay off loans, this is not easy, but if you look carefully and segment your market wisely you will find opportunities.

There are some expenses you find difficulty cutting. When business was good you felt comfortable signing a 6 year lease for 8 trucks, but now with reduced volume you only need 6 trucks and the truck leasing company will not let you out of the lease.  But in two years those leases come due and you may re-examine your leases- either staggering them or reducing them.

You start to realize how much time and money it takes to collect a four hundred dollar receivable that is over ninety days old and you eliminate slow paying accounts, and  you eliminate bounced checks with check verification systems. You get smarter, able to transfer wasted time from blood sucking, slow paying business to solid customers who respect commitments and the terms of the credit agreement.

You shed the marginal mentality of taking business that in isolation covers its marginal cost but not its share of fixed cost. If you accumulate too many of these orders you will lose money, You learn to just say no.

And when you buy 8,000 gallons of diesel a month you will become very conscience of how you buy your fuel and what the expense is for delivering small orders. Delivery charges and fuel surcharges become acceptable.

When the price of your products declines you rapidly realize the other side of the inventory profits you booked during  the price increases a year before.  When you have to sell your product for less than you paid for it you cannot  lay off enough workers or cut enough expenses to avoid losing money.

Everybody in your business faced the same realities and made the same adjustments.  The biggest difference was often the amount of debt incurred at the time business headed south.  Those with too much debt are either closed or sold.  I was raised in a culture to avoid debt and it served us well in this economy.

Eventually the prices stop dropping and you have cut enough expenses that the bleeding stops and you become profitable on a much smaller volume. Afterwards you wish you had made the cuts faster and earlier, but you did not realize how long the bad economy would last. But just as my dad spoke about the Great Depression for the rest of his life, we will remember this economy for a long time. We will be reluctant to add expenses, rely on rosy forecasts, and commit to long term contracts without protection clauses.  The cost cutting ( those truck leases renew in a few years) will continue even after we are profitable.  We will continue to simplify, consolidate, and reduce paper work.  We will not return to rationalizing crappy business and bad habits.

I reminisce on the last two years for two reasons: it may explain why a recovery from such a severe economic blow will be slow, and this experience and reaction stands in distinct contrast to much of the behavior in the government sector.   We in private business are unable to ignore reality and survive; those in government, with the power to tax and print money, can ignore reality for a considerable period of time…….  but not forever.

What is certainly clear is that again and again, countries, banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits. Many players in the global financial system often dig a debt hole far larger than they can reasonably expect to escape from, most famously the United States and its financial system of the late 2000s.  Government and government-guaranteed debt (which, due to deposit insurance, often implicitly includes bank debt) is certainly the most problematic, for it can accumulate massively and for long periods without being put in check by markets, especially where regulation prevents them from effectively doing so.  Although private debt certainly plays a key role in many crisis, government debt is far more often the unifying problem across the wide range of financial crisis we examine. As we stated earlier, the fact that basic data on domestic debt are so opaque and difficult to obtain is proof that governments will go to great lengths to hide their books when things are going wrong, just as financial institutions have done in the contemporary financial crisis.

From This Time is Different- Eight Centuries of Financial Folly by Carmen M. Reinhart & Kenneth S. Rogoff

HKO Comment- financial regulatory reforms after the Great Depression centered on greater transparency and separating basic banking needs from larger speculation.  This was largely undone by changes under Clinton reducing transparency for derivatives and the final collapse of the wall between banking and investment speculation.  What the authors suggest is needed after the recent crisis is a an extension of the transparency to government debt and government sponsored enterprises such as Fannie Mae.

The default belief  of our economic history of the last 100 years has been an acceptance of the dynamic growth of capitalism punctuated by excesses of market greed that have to be corrected by the singular wisdom of government regulation.

On closer examination many of those moments of market greed and excess look more like incompetent government meddling caused the problem.

During the Depression of 1929 we saw 10,000 banks collapse in the United States. Yet during that same period the number of bank failures in Canada were zero.  Was Canada spared the depression that engulfed the United States? No, but Canada was spared a regulation that prevented banks from crossing state lines.

Bending to pressure to protect local banks from encountering big business center banks, they got relief and protection from the Federal government in the restriction of interstate competition.  But that also severely limited their flexibility in dealing with a crisis, a limit that did not exist in Canada where risks were spread over larger areas and underutilized assets could be easily relocated.

Yet to respond to the bank failures that the government largely caused they created the FDIC (Federal Deposit Insurance Corporation).  FDR opposed the FDIC because he saw it would create a sanction for reckless behavior and penalize prudently run banks.  FDR capitulated in a compromise and the FDIC began by insuring deposits for $2500 in 1934. It was raised to $5,000 in 1935, $10,000 in 1950 (Truman), $15,000 in 1966 (Johnson), $20,000 in 1968 (LBJ again), $40,000 in 1974 (Nixon), and then $100,000 under Jimmy Carter in 1980.  Bush raised it to $250,000 before he left office, but it is due to revert back to $100,000 in 2013.

Ten years after Carter raised the limit we experienced the Savings and Loans meltdown, caused by the excessive risk taking in that industry. The government again intervened and created the Resolution Trust Corporation (RTC) to dispose of failed thrift institutions taken over by regulators after January 1, 1989 in an orderly manner.

The FDIC created the moral hazard FDR feared. It privatized the profits and socialized the risks.  This behavior was repeated, but on steroids, with the implicit assumption of risk by Fannie Mae and Freddie Mac.

Housing was deemed a federal priority, and helping the poorer people get into housing has been a priority since Fannie Mae was created again by FDR in 1938.  But housing prices were highest and least affordable in select areas where local ordinances had restricted supply and raised prices far more than in areas were market forces prevailed.

Tax policies such as mortgage interest deductions and preferred capital gains treatment increased the demand for housing. The Community Reinvestment Act, passed under Carter but exploited under Clinton and Bush, pressured banks to make mortgage loans to less and less qualified buyers. Fannie Mae guaranteed loans, clearing the ratings agencies which had a government protected franchise; to give higher ratings than these mortgage backed securities could have conceivably obtained on the merits of their assets. This widened the market for these securities and caused even more money to be driven into the housing market from all over the world creating the bubble that had to burst.

To compound the damage the government required a mark to market rule for valuing these mortgage loans at the worst possible time; when no market existed.  The market to market rule causes valuations to go to extremes, high and low.  This caused capital to dry up and regulations required banks to rebuild capital reserves instead of making loans. Then at a time when information was critical to valuing these securities, the government suspended short selling, a critical source of such information.

During the recent financial disaster, Canada did not exhibit near the real estate collapse we did in the United States.  In Canada they had far less exposure to sub prime loans, large down payments were still required while we all but eliminated down payments for the poorest home buyers in the name of ‘compassionate conservatism’, and mortgage borrowers in Canada were still held personally liable for their loans. Canada had tougher and more prudent lending standards, but they avoided the fiasco foisted on us by well intentioned but misguided moral supremacists on the government payroll.

The government in the U.S. inflated this bubble as eagerly as any on Wall Street, but our government “had a much bigger pump”.

Seventy five years ago we could have looked to our northern neighbor and learned better behavior instead of demonizing capitalism. Today we can learn the same lesson, but again we seek to demonize the private sector for conditions created by incompetent government regulation. Wall Street clearly has its demons to account for, but its greed was enabled and often encouraged by incompetent regulations and policy that has a long history.

As we crave more government oversight we should ask who will oversee the government that has demonstrated such spectacular failure.

From Thomas Sowell’s Intellectuals and Society

“In short, many things that the Federal Reserve, Congress and the two Presidents did (during the market crash of 1929) were counterproductive.  Given these multiple failures of government policy, it is by no means clear that it was the market economy which failed.  There is of course no way to re-run the stock market crash of 1929 and have the federal government let the market adjust on its own to see how that experiment would turn out.  The closest thing to such an experiment was the 1987 stock market crash, similar in size but not in duration to the 1929 collapse.  The Reagan administration did nothing, despite outrage in the media at the government’s failure to act.”

“What will it take to wake up the White House?” the New York Times asked, declaring that ‘the President abdicates leadership and courts disaster.”  Washington Post columnist Mary McGrory said that Reagan “has been singularly indifferent” to the country’s “current pain and confusion.”  The Financial Times of London said that President Reagan “appears to lack the capacity to handle adversity” and “nobody seems to be in charge.”  A former official of the Carter administration criticized President Reagan’s “silence and inaction” following the 1987 stock market crash and compare him unfavorably to President Franklin D. Roosevelt, whose “personal style and bold commands would be a tonic” in the current crisis.”

“The irony in this was that FDR presided over an economy with seven consecutive years of double-digit unemployment, while Regan’s policy of letting the market recover on its own, far from leading to another Great Depression, led instead to one of the country’s longest periods of sustained economic growth, low unemployment and low inflation, lasting twenty years.”

We tend to look at our economy as a diversion from the norm after a record financial set back.  But the economy we are in may well be closer to the norm.

The former economy was distorted by government policies that incentivized more money to go into housing than would have likely happened in a freer market. Banks were incentivized into putting large amounts of capital into securities that were not as secure as they were promised.

That is not to say that booms and busts are all the fault of government policies. Free markets do not totally counter the extremes of greed and fear; they just flush them out quicker.

Government policies want to protect us from the pain of adjustment to normal, but these policies only serve to make the recovery take longer, or worse, they avoid the recognition and correction of the extremes that caused the crash, ensuring a bigger crisis later.

This last crash was largely due to the failure to fully address the failure of Continental Illinois, Long Term Capital, and Enron. By blaming the greed of a few individuals we neglected to address systemic failures and regulatory shortcomings.

The prior market was one where the lessons of transparency and disclosure learned after the Great Depression were ignored.  The ability of a home owner to afford a house was ignored in deference to the ’social justice’ of promoting home ownership.

We now insist on down payments that put some of the owner’s skin in the game.  By being forced to seek growth that can be sustained by realistic cash flow, growth will be more sustainable.

Companies are now forced to control expenses, improve margins, and make a wiser and more realistic assessment of risk.  This is what used to be considered normal.  It only seems difficult and painful after a period of easy money, distorted incentives and unsustainable policies.

We are in a period of deleveraging.  It will be painful and some sectors will be hurt more than others.  The more the government tries to protect us from the pain of adjustment, the longer the adjustment will take, the longer unemployment will remain high, and the higher the deficit will grow.

Smaller businesses will suffer more, leaving less competition to the larger companies.  Larger companies will do better, income discrepancies will grow and the tax burden will become less progressive. This is the opposite of what one would expect from a president that wants to share the wealth.

This is the result of legislating so much drastic change that economic and business decisions are frozen in the headlights of uncertainty. Adding such uncertainty to the pain of deleveraging will cause this economy to stagnate for years.

The longer the economy stagnates under the burdens of higher taxes and more regulations, the more that stagnation will become the new norm like it is already in Europe. The potential for long term damage to our economic system is significant.