Today is the anniversary of the Wall Street Crash in 1929, which was the greatest stock market crash in the history of the United States. To commemorate the financial history we look an extract of Humanity’s Lucky Clover by Vadim Makhov on ‘How To Avoid Bursting With A New Financial Bubble’.
“The 2008-2009 global financial crisis only aggravated the problem and contradictions inherent in the global financial system but did not change its essence. Any change I the current expectation of the future (that future being, by definition, uncertain and multivariate) still affects to a large degree the estimates of expected cash flows and will, therefore, continue to contribute to the emergence of financial bubbles. Apart from figures and ratings, risky investment decisions need to be counterbalanced with common sense.
It is widely known postulate in the corporate finance world that the managers of heavily indebted companies, when acting I the interests of their shareholders, often favor risky projects (Brealey 1980). With the debt leverage growing and the prospect of future financial flows becoming vaguer, the managers’ predisposition towards risk becomes even greater.
Recently, venture capital, which is an integral part of the financial market, has been increasingly used to finance such risk. The basis of any financial system is the observance of clear rules based on mutual confidence established between financial market participants. But what if the rules are broken? Then clients do not trust banks and funds anymore and take away their money, while banks do not trust clients and refuse loans. All parties are ‘sitting’, as it were, on their money.
As the recent financial crisis has shown, governments choose the simplest possible way to make up for a lack of money in their countries’ economies by simply printing more of it. As former US President Ronal Regan aptly noted on one occasion, “…the Government does not solve problems, it finances them.” The global crises, that broke out 2008-2009, was successfully ‘quenched’ with money. Having noticed a fall in the monetary aggregate M2, Ben Bernanke, the then head of the Federal Reserve System, compensated for the lack of money in the economy with printed dollars. The alternative would have been a repeat of the Great Depression.
But as soon as the crisis of confidence in the banking sector was over, money gushed once again into the system from banks and funds resuming their operation and started to raise the pressure. Once again, the architects needed to find a connected pot to keep saving in safety. Some of the industries, based on the technologies of the future, will, no doubt, act as the new pot and the pressure will be brought back to normal. Meanwhile, the number of start-ups is growing, and so are the numbers of risky and adventurous projects that have found funding.
The excessive liquidity is manifested in the form of debts made by venture capital funds and equity raised by high-risk and established companies. They are cyclical in nature, which means that after receiving money injections for some time, many high-risk companies will only be able to pay interest alone, as a result of which companies and funds, trying to avoid going bankrupt, will have to take new loans regularly in order to repay old ones. The top management in such circumstances will go for more and riskier projects which will benefit shareholders as a result of capital reallocations made as part of modifying the financing structure.
This process may even be relatively smooth for a while, but just as long as interest rates do not go up. A slight rise or drop in a high-risk firm’s cash flow will be sufficient to turn inevitably its financing into a financial pyramid. In that case, there may not be enough money even for the regular payment of interest. A Minsky moment comes. The inflated bubble must burst and the pressure in the ‘financial pot’ drops, together with the market participant’s confidence.
Generally speaking, it is quite possible that the 2008 crisis could have been predicted. However, it only became evident at the very last moment that the economy would collapse, and the central banks of developed countries would have to take unprecedented measures.
The Minsky moment reminds us that it is not enough in breakthrough areas to gather engineers, scientist, and entrepreneurs in a company. It also has to be ensured that the capital structure of the emerging innovation company is strong enough to survive a fall in the ‘financial pressure’.
CONCENTRATION OF COMMON SENSE
Of course, not every high-risk company is a poorly estimated speculation, not at all. Verinata, for instance, has a great idea behind it: to decipher the DNA of unborn babies through quite a harmless manipulation involving taking the maternal blood and finding the fetal DNA. The company operates in the highly attractive personalized medicine industry which, once successful, will enable doctors to recommend each particular patient a course of treatment and prevention based on their genetic data. What threats might confront this business, as the population (and hence the number of potential patients) is increasing daily? The main risk to the success of such a company is not posed by the particular market it operates in, but by the condition of the common financial market, i.e. by the current financial ‘pressure’.
How do investors reduce such risks normally? They act on the well-known advice given by Paul Samuelson (author of Economics): “Since we cannot predict the future, we diversify.” The trick of substituting uncertainty by the concept of risk, proposed by Frank Knight long ago, does work to some extent (Knight, 1921). By putting eggs in different baskets, investors reassure4 themselves that they eliminate the risk of loss, even when investing some of their funds in the riskiest projects (explicitly reckless undertakings to a certain extent).
The high-water mark of this approach was formulated by William Bernstein. According to his concept (Bernstein 2000), an investor who has invested 25% in reliable bonds, 25% in large companies’ shares, 25% in high-risk shares (these exactly are found in innovation industries), and 25% in well-known foreign companies’ shares, is highly likely to have protected himself from potential loss.
Bernstein’s main idea was to concentrate common sense and use arrays of information available to us today. His approach to processing information required in selecting business (ones based on competitive business schemes) resembles the four-leaf clover model. Though, instead of four leaves, he distinguishes four types of knowledge: knowledge of the theory of finance, knowledge of the history of markets, knowledge of investment psychology and knowledge of how the industry in which money is to be invested works. This proves to be sufficient for many companies and even individuals, to manage their money effectively or earn a decent pension.
That said, for a particular investor, it is sufficient, as it safeguards them against loss to the market. As the GDP per capita in the world is increasing in real terms by 2% annually, 2% of real earnings, purified from inflation., are required in order to guarantee a ‘sufficient’ level of wealth preservation. However, this approach is based on the assumption that there will be those who provide 2% growth (Bernstein 2000). Will the technologies designed to ensure new growth be ‘supportive’ or ‘disruptive’? Will they undermine the basics of the existing ‘fundamental economics’, or will they support it?
OVERCOMING DECREASING RETURNS ON CAPITAL
The persistent pursuit of sustainable growth by financial institutions has already resulted in the appearance of a number of impressive theoretical insights. A little-known economist Paul Romer authored an article (Romer, 1986) in which he formulated the thesis that it is possible to overcome diminishing returns on capital if the capital is considered as a broad term and includes human capital (Sharaev, 2006, p.91).
An increase in workers’ capital-to-labor ratio creates opportunities to train workers and gain and accumulate new knowledge. New Knowledge is thus converted into productive force and is accumulated in the same way as financial capital.
Some interesting and very important consequences are derived from Paul Romer’s approach. The first was formulated by Romer himself and states that, with the capital-to-labor ratio growing, the total output of the economy increases as well, and does so at an accelerating pace, which, in its turn, leads to even higher capital-to-labor ratios. This ‘economic perpetual motion machine’ may seem amusing at first, but think about it for a second: how many times have you changed your computer or operating system over the last 10 years? With each such change taking place, the content of your work (not your performance) is likely to have remained the same. This model explains the increase in the sales of such companies as Microsoft or Apple.
The second consequence logically derives from the first. To ensure economic growth, it is necessary to re-equip existing jobs, but also to increase their numbers. To do this, it is necessary to increase the frequency of sales (of products or services), thus making them less material. Global companies charge a relatively small but constant rental fee, annually releasing updates and new product versions. If you think that this only applies to software for office computers and CAD tools and machines for developers, you are mistaken. An increasing number of modern machines and mechanisms are provided with ‘intelligence’, and then the performance of the hardware is improved further by updating its ‘brain’ or installing more advanced replacement parts.
The apotheosis is reached with the appearance of a new phenomenon – reinvention. It is about trying to ‘re-embed’ inventions that are already well known in the economy. Apple is making another attempt of this kind with its iWatch and as the company turns to electric vehicles. Everything will be enmeshed in sensors until we get to the latest level – the sensory world level where absolutely all things and people are interconnected and act as a supernet, ‘a network of networks’. It is the supernet, or the ‘fluid net’, that will limit further growth of population, as education does today. For example, the average woman in Nigeria gives birth to six children over the course of her life, but, according to recent research, around 50% of Nigerian women ages 20-24 have high school education today, which immediately reduces the figure by two thirds – down to two children.
In March 2014, Intel, the world’s largest IT company, announced that its strategy would be focused precisely on the internet of things. Jason Waxman, Intel’s senior project manager for cloud technology, stated that Intel wanted to focus on ‘smart’ things and wearable and automotive electronics. In his opinion, there will be a market for about 50 billion ‘smart’ devices in the coming years. The profit, as you might have already guessed, will come with the development of software. Waxman himself asserts that one can be sure that every dollar of royalties paid on the software will bring four dollars for the hardware.”
Want to learn more?
Humanity’s Lucky Clover by Vadim Makhov is available to buy here.
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