Creative Destruction

For a capitalist economy to function, creative destruction must prune the weak and inefficient to enable the strong to survive. Unfortunately, years of monetary intervention and market manipulation by the Federal Reserve and U.S. government has sustained failing institutions and created an unsustainable dependence on cheap financing. It was inevitable that this charade would unravel as it was impossible for the Federal Reserve to sustain such low interest rates without fueling uncontrollable inflation. Efforts to save the people from the hardships of the tech bubble, which was at least in part sustained in its waning years by the Federal Reserve’s coordinated bailout of Long Term Capital Management’s dramatic implosion, extended the existence of companies doomed to inevitable failure. At the same time, people began to believe that, under the guidance of our super-human leaders, we have successfully tamed the business cycle and permanently eliminated the risk of recession. Counterparty risk was ignored, leverage was increased, and overconfidence abounded.

People continue to ignore the cruel hard fact that not everyone can be saved and that the status quo if often not the best outcome. Weak companies must be allowed to fail so that the strong and the innovators can survive. Similarly, individuals that utilized excessive leverage to speculate on real estate or maintain an unsustainably lavish lifestyle must not be rewarded for their lack of judgment. A clear relationship between risk and reward is what minimizes the potential for excessive speculation, over-investment in failing institutions, and painful economic downturns.

As Tom Petruno recently penned in Saturday January 24ths Los Angeles Times:

Technology workers, perhaps more than others, understand the concept of "creative destruction." The term was popularized by the Austrian economist Joseph Schumpeter to describe the forces perpetually at work in a healthy capitalist economy.

The idea is that an economy should be forever renewing itself thanks to innovation, albeit with considerable pain along the way. In other words, new technologies are wondrous -- unless you're stuck selling technologies made obsolete by a smarter competitor.

Here's a thought: One reason we're facing such a large Darwinian wave in the economy may be that the easy money of the last two decades delayed creative destruction that otherwise would have occurred.

As long as credit was more than ample, many businesses and technologies could hang on despite being under heavy attack from more innovative rivals.

Amid the financial-system crisis, credit has evaporated. That's a death knell for weak businesses, large and small, that were over-leveraged and are struggling with plummeting sales as consumer and corporate spending shrinks.

The relative lack of credit, however, also obstructs the "creative" part of the creative-destruction continuum: Many firms that should be survivors of this debacle can't get the basic funding they need to carry on and position themselves for an economic upturn, wherever it is on the horizon.

We must embrace the forces of capitalism and the creative destruction that ensues. Further attempts to prop up failing companies and individuals will just prolong the recession and postpone the necessary economic adjustments dictated by decades of excessive leverage and easy monetary policy.

Karl Marx' Road to Communism

"Owners of capital will stimulate working class to buy more and more of expensive goods, houses and technology, pushing them to take more and more expensive credits, until their debt becomes unbearable.The unpaid debt will lead to bankruptcy of banks which will have to be nationalized and State will have to take the road which will eventually lead to communism."

Karl Marx, 1867

Politicizing the TARP

The deafening grumbling emanating from congressional Democrats regarding the use of TARP funds demonstrates that they are out of touch with the economic realities and wish to morph what was a financial market stabilization tool into a personal slush fund for kickbacks to special interest groups. Rather than focusing on stabilizing the financial system as a foundation for future recovery, many in Congress are intent on dictating the behavior and decision making of the people through financial incentives (bribery in the form of tax cuts, “economic stimulus”, etc) or even outright coercion.

While many financial institutions that have received government funds are guilty of reckless speculation and lending, government officials determined that allowing another institution the size of Lehman Brothers to fail would destabilize the entire financial system due to the complex web of counterparty risk and financial agreements. Since the capital infusions have occurred, politicians have demanded that banks use these funds for new lending. It seems that they quickly forget that government lending mandates played a significant role in creating the subprime market and low down payment requirements that contributed to our current dilemma. Banks obviously are continuing to lend to credit worthy borrowers. In an efficient lending environment, each incremental loan would be granted to a slightly less credit worthy borrower. Given the levels of toxic debt that saddle many of these financial institutions, it is perfectly rational for them to conserve capital and improve their balance sheet while reducing credit availability to marginal borrowers. The politicians are intent on artificially inflating lending activity by forcing banks to provide credit to less than worthy borrowers. How quickly they forget the long run result of such reckless behavior.

The onerous terms being proposed for taking TARP money will cause financially sound institutions to balk at government funds. These institutions, the most capable of expanding credit and leveraging government capital infusions, realize that if government dictates their lending guidelines they will surely be doomed to failure. Alternatively, the bailout being proposed for “homeowners” that have borrowed beyond their means will ultimately be little more than a band-aid on a gaping wound. Individuals and banks alike must reduce their debt burden and reevaluate how they will employ their precious financial resources. If government continues to dictate the terms of business and distorts the economic incentives that balance risk and reward, then we will surely be condemned to a long term recession that ensnares innocent bystanders in its grasp.

Out of Touch: U.S. Airlines Face Declines in Traffic

The holiday travel season is marked by throngs of travelers scurrying about the country to reunite with loved ones. This year, however, the crowds mask growing weakness in air travel with the IATA reporting a 4.6% drop in November passenger traffic and a 13.5% decline in cargo traffic. Just as the U.S. automobile manufacturers have claimed to be innocent victims of a growing credit crisis, it would be easy to argue that the airlines too are suffering the consequences of Wall Street excesses and the corresponding global recession. Business travel is undoubtedly down (just ask all those insurance salesmen at AIG who are no longer permitted to attend fancy meetings at beach resorts). Similarly, cargo shipments have certainly diminished with the slowing economy and global de-leveraging. All of these challenges are simply diversions that cloud the underlying issues with poor customer service and unreliable execution. In many ways, the airline industry confronts similar issues as the domestic automobile industry. Large investments in fixed assets result in relatively inflexible supply. Rather than focusing on customer needs and rethinking their corporate strategies, both industries have resorted to forcing this supply through the pipeline (fleet sales for the domestic automobile manufacturers and complex discounting / fare structures for the airlines) while cutting costs in areas that would improve customer satisfaction. Let’s examine some of the great value propositions that surely attract customers to the airline industry:

• Compressed leg room in coach, often to the point that passengers are unable to move for the duration of their flight. Ironically, activists argue for elimination of similar treatment for farm animals, yet humans, allegedly possessing common sense, knowingly cram their bodies into coach seats like chickens in a coop. Then again, it is painfully obvious that coach passengers are viewed as little more than cargo to the disinterested airline industry.

• Surcharges for every “service” provided by the airlines are now compounded by aggressive attempts to force passengers to check bags (and, of course, pay for the service) and pay for food and drinks (despite being locked in a tin can for hours and often delayed due to mismanagement or inadequate network resources). TSA prohibits you from bringing liquids on board, so the airlines have a captive market to force dehydrated passengers to pay for beverages.

• Unreliable service due to poor labor relations (and unrealistic unions), overwhelmed “hub” airports, and frequent maintenance issues. Whether it be the unavailability of operable aircraft, an absent flight crew, or excessive scheduling of flights at peak hours, it is virtually assured that you will be delayed if you depart at all. To compound this atrocity, airlines refuse to adequately compensate displaced passengers and shrug their shoulders when passengers fail to make connections. With no accountability, airlines continue to abuse the diminishing goodwill of passengers.

While I am sure there are many more examples of the shoddy service provided by our domestic airlines, I think it is clear that coach service has been completely written off as little more than a bus ticket. The airlines need to completely rethink their pricing methodology and service levels in order to restore the goodwill of frequent travelers and establish a sustainable path to profitability. Absent serious strategic reforms, it is inevitable that frequent travelers will forego the headaches of air travel whenever possible, leaving airlines grasping for price sensitive customers, further eroding their fiscal position.