A smart friend of mine, in a conversation apropos the financial meltdown,
recently wondered if people "aren’t reading too many newspapers and not enough
has a point.
So forthwith, a little history.
According to McKinsey in "Financial
crisis and reform: Looking back for clues to the future," the extent
of regulatory changes in the wake of recession is roughly proportional to the
severity and duration of the downturn. Specifically:
History provides three clear lessons: first, reforms followed every major
US financial crisis that led to an economic downturn. Second, the length and
severity of the postcrisis recession have historically been approximately proportional
to the degree of change that follows the recession. Finally, the resulting
shifts commonly extend well beyond the financial-services sector.
Relatively mild and short-lived recessions (1990, 2001) lead to only piecemeal
regulatory changes, while more severe downturns such as the Panic of 1857 can
produce nearly cataclysmic repercussions including, by some accounts, exacerbating
the regional tensions over states’ rights and slavery and precipitating, if
not exactly causing, the Civil War. Another historically revisionist
school of thought has posited that without the wholesale reforms of the New
Deal, the Depression could have led to insurrections.
But it’s worth putting this all in perspective. Here is the GDP per
capita, in real 2000 dollars, at the start of each of the following
downturns, and the total GDP contraction, in percent:
- 1764: £100, -50%
- 1837: $1,681, -4%
- 1857: $2,252, -2%
- 1893: $4,559, -14%
- 1907: $5,621, -12.5%
- 1929: $7,099, -29%
- 1990: $28,429, -1.5%
- 2001: $34,759, -.03%
- 2007: $38,148, -??%
In other words, we have a lot less to worry about than some of our forebears,
by a far sight. We could, for example, suffer a 20% drop in GDP per capita
before we’d be back where we were in the dark old days of 1990.
Also helping put some perspective on matters is an interview with
Richard Foster, a McKinsey director for over 20 years and coauthor of Creative
Destruction: Why Companies That Are Built to Last Underperform the Market–and
How to Successfully Transform Them. Here are a few highlights condensing
his views of the past 30 years of economic progress:
Q.: How does your vision of creative destruction apply to today’s
A.: Let’s start by looking back. In the 1970s, we had the “Nifty
50”–invulnerable companies that couldn’t possibly lose, and of course they
[…[ In the financial-services sector, the upheaval will create a
new generation of leaders. Fifty years ago, we didn’t have 8,000 hedge fund
managers. Then somebody said, “We can go short as well as long; we have much
better information than people did in the 1930s, and the information comes
to us instantaneously rather than days after the event. We can make a lot
of money modeling and leveraging that information.” So the hedge funds were
born. How many of those guys had been successful at mutual-fund management?
I don’t think any.
[…] In the book, Sarah Kaplan and I show that over the long term,
the market performs better than companies do. There can be periods–5, 7,
10, even 15 years–when that isn’t the case, but corporate performance always
reverts to a lower level than the market because the economy is changing
at a faster pace and on a larger scale than any individual company so far
has been able to do without losing control.
[…] The granddaddy of cycles in this economy is the equity premium,
which is the difference between the longer-term total returns to shareholders
and the supposedly risk-free debt rate. It is the premium the equity investor
gets for taking the equity risk. Looking back, we can see seven great cycles.
During the boom times, when the equity premium goes way too high, everybody
hocks everything to get in on the game, and this creates the conditions for
a crash. When the crash occurs, the politicians come in and say it was this
or that person’s fault. Then they create regulatory institutions, and virtually
every one of those institutions–starting with the Federal Reserve, in 1913,
as a result of the crash of 1907–has been quite productive for the nation
in the longer term.
[…] What do self-respecting entrepreneurs do when subjected to new
regulations? They learn the regulations backward and forward and then vow
never to start another business that falls within the scope of those regulations.
And so off the entrepreneur goes to find a new way. That’s one reason credit
default swaps eventually took the form they did–the other options were regulated.
The new entrepreneur often
seeks ways to innovate outside the scope of the newly established regulations.
In the beginning, all that works out fine. We have innovations, we love the people
who created them, they’re great heroes, the returns are strong, everybody says,
“I’m going to be one of those guys.” Eventually, all the truly good guys who
are going to get into that business have done so. The opportunity starts drawing
less savory figures–charlatans who overmarket, cut corners, establish usurious
contracts, and do other clever things to generate profit for themselves. They
end up bringing the system down. Then guess what happens? At the end of that
period, after the equity premium has soared and collapsed again, the government
steps in and regulates the systems, this time focusing on the last wave of abuse.
And then we start over.
But his conclusion is one with which I could not agree more resoundingly:
Q.: Capitalism has just taken a beating. What will the future look
A: The essence of capitalism is capitalizing–bringing forward
the future value of cash to the present so that society can grow more quickly
by taking risks. It goes back to the Dutchmen in the 16th century, sitting
at their coffeehouses in Amsterdam and Leiden, loaning each other money for
a guaranteed return. Someone said, “I’ll give you a little higher return
if you give me a piece of the action”–and equity was invented. That had the
effect of bringing forward, into real cash today, the net present value of
future earnings. That levered society and allowed it to grow at a much higher
rate than it would otherwise have. Equity was a very clever invention, and
we are not going to give it up. This is the way people are. This is the way
commerce works and will continue to work unless capitalism ends. And that
won’t happen, regardless of what you read in the press.
As my friend said, fewer newspapers, more history.
Finally, some words about strategy in
the midst of a structural dislocation. Times like these—especially
times like these—call for coherent responses on behalf of your firm to
the challenges out there in the marketplace. This, rather than any tepid
or hypocritical "mission statement" or allegedly scientific market segmentation
analysis that will be overtaken by events before it can be bound and distributed,,
is the type of strategy that actually has traction today.
And the essence of such a strategy is a thoughtful and reflective view on
the marketplace forces at work, and how they’ll affect your firm, your talent
pipeline, your geographic centers of gravity, and your client base. To
produce a coherent, nuanced, and dynamic view of what’s happening, there’s
no substitute for the hard work of thinking about this multi-dimensional chessboard,
with almost daily midcourse corrections based on new data points and new conversations,
essentially incoming at you all the time.
If we’re truly in the midst of a structural dislocation—where the linear
extrapolation of previous trend lines utterly breaks down—then it helps,
even if briefly, to rehearse how we got here:
- The ratio of consumer debt to disposable income went from 40% in 1952
to 60% in 1982 to 80% in 1992 to nearly 140% in 2007;
- From 1990 to 2007, the financial services sector expanded 250% faster than
GDP and its profits rose from the 1947–1996 average of 0.75% of GDP to 2.5%
in 2007; and
- Financial leverage among Wall Street’s five largest firms (Goldman Sachs,
Merrill Lynch, Lehman Bros., Bear Stearns, and Morgan Stanley) went from
the SEC-limited 12:1 in 2004 to 35:1 or 45:1 last year.
Pretty clearly, those trendlines cannot be linearly extrapolated.
Which brings us to the question: What now? What next?
Structural breaks of this sort take time to resolve themselves. New
business models need to be invented and fundamentally new flows of funds across
the global economy need to settle into their grooves. (Financing consumer
consumption in the US via indirect borrowing from China? As they
say in the schoolyard, "I don’t think so!") But it’s also worth
recalling that upon the ashes of previously impregnable industries have grown
vibrant and utterly familiar new names:
- The 1893-1897 depression signaled the end of the railroad boom but thebeginning
of the sophisticated consumer goods economy (Miton Hershey founded his iconic
brand then). GE was a product of the same period, capitalizing on the
coming ubiquity of electrical power distribution.
- Similarly, in the Great Depression, while steel, rubber, glass, and coal
were declining, yet another wave of mass market consumer brands was launching,
including kellogg’s. With increasing automobile ownership penetration,
motels and campgrounds took off. Ultimately, airline passenger growth
edged up from zero and radio and motion pictures became significant industries.
- Moving ahead to the birth of the internet, we can see in hindsight that
at first it tried to mimic pre-existing industries. Remember "brochure-ware,"
as the internet tried to mimic print? For that matter, early radio
mimicked vaudeville, and early TV mimicked the theater. It took radio
awhile to figure out that it excelled at sports, talk, music, and news; and
TV awhile to figure out that it excelled at serial drama, game shows, movie
re-runs, sports, and breaking and cable news.
What are the lessons, then, for us today?
To begin with,it can be dangerous to assume that more of the same
old will light the way forward. If a traditional pattern of commerce
has been pushed to its breaking point, don’t keep pushing.
If this means a fundamental re-examination of the way your firm is organized—what
its practice groups are, where your office are, what activities you take for
I suggest there’s no time like the present?
It’s not about cutting costs, but about doing things differently, and smarter. A
decent rule of thumb is this: Simplify.
Just because you’ve "always" done something, do you need to? Do
you need that committee? That organizational matrix layer? That
procedure? That all-hands communication?
Have you outsourced your cafeteria? (I hope so!) Your mail room and
your 401(k) administration? (Ditto.) Your word-processing? (On-deck
circle.) Your document review? (Time to think about it.)
Better yet: If you were the founders of your law firm today, what would
you do differently? Even firms we think of as legendary (Allen & Overy,
Latham, Skadden, Wachtell) essentially are within a couple of generations of
their founders. It’s not that long ago.
Put on the founders’ eyeglasses. What’s now out of focus?