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The coming collapse in business spending – made visible today

15 October 2008

Smart managers react quickly and strongly to changed conditions.  Unfortunately, when those conditions are a systemic event visible and affecting everyone their actions re-enforce the event.  Positive feedback.  This creates much of the business cycle’s volatility, the big swings.  The “dampeners” of Keynesian economics, contra-cyclical monetary and fiscal policy, fight these in order to maintain equilibrium.

We see this a work in this “bootleg” summary of a recent presentation by Sequoia Capital, one of America’s A-team venture capitalist firms (originally posted at the subscription-only site TheFunded).  Their companies will cut expenses — operating expenses, people, and capital investments.  This in turn will force other companies to cut.  Your expenses are my revenue, another example of Keynes’ paradox of thrift.

Thanks to globalization, the world has synchronized into one business cycle.  So this cutting is happening right now in every nation.  This will be the first global recession, not including wars (the third world and communist states did not participate in previous cycles).

I recommend reading the full set of notes.  The slideshow at the end is one of the best overviews of the economy I have seen this year.  Not deep, but it touches most of the key points.

Here are three excerpts from “Inside Details of Sequoia Capital’s Doomsday Meeting With its Companies” by Om Malik, posted at Giga Omni Media (daily news about emerging technology) on 9 October 2008.

(1)  {These} are drastic times and that means drastic measures must be taken to survive. His message to companies was don’t worry about getting ahead, instead, “We’re talking survive. Get this point into your heads.” He warned that companies need to be cash-flow positive, and if they are not, then they need to get there now, because raising capital without being cash-flow positive is going to be tough. He was warning that there will be a price to pay for those who hesitate to act.

(2)  This could be a 15-year problem, he said. This comment was accompanied by many slides that showed historical charts of previous recessions averaging 17-year cycles. He pointed out that the issue here is not the equity markets but the credit market, and that will take a long time to recover. He was ominous in warning the startups that this is a global issue, it is not a normal time, and is a significant risk not just to growth but to personal wealth.

(3)  Recommendations

  • Cut spending. Cut fat. Preserve capital.
  • Throw out the models and spreadsheets, because all assumptions will be wrong.
  • Focus on quality.
  • Reduce risk.

The brief explanation of the Paulson Plan, in pictures

See “Banktron“, posted at Sinfest, 12 October 2008 — I highly recommend reading this!

Afterword

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these, such as the causes of the present crisis.  I have been writing about these events for several years; since November 2007 on this site.  As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest these days:

Key posts about the financial crisis

  1. America has changed. Why do so many foreigners see this, but so few Americans?, 1 October 2008
  2. A sitrep on the financial crisis: why has the treatment been so slow, so small?, 8 October 2008
  3. Forecasting the results of this financial crisis – part I, about politics, 13 October 2008
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12 Comments leave one →
  1. 15 October 2008 6:16 am

    Not all sectors of the economy will be hit hard. Health care is holding up fine so far, as we see with {snip} earnings releases and the healthy premium {snip} paid for {snip}. Federal nationalization of health care may provide further Keynesian support to this sector. {FM note: no investment details, please; they tend to hijack threads and are too off focus for this site}
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    Fabius Maximus replies: Agreed; not all sectors of the economy are cyclical. Isn’t this is obvious to everyone? However, for the cyclical sectors the big effects of the recession probably just started in September. The decline in economic activity starting with 2007 Q4 was gentle, buffered by household borrowing and the Q2 tax rebates.

    Like

  2. OldSkeptic permalink
    15 October 2008 8:35 am

    Anthony, sorry to disagree. If the US health system is nationalised (or properly Govt controlled) then health expenditures will drop dramatically, though health will actually improve.

    This seeming paradox comes from the fact that nearly all OECD countries (and quite a few others) have State controlled health systems (of one model or another). They all spend less (in $ and as a % of GDP)and ALL have better health outcomes. Take Australia as an example, out health spending is 2/3 of the US (in % GDP terms, even lower in $ per person terms) than the US, but we leave the US far behind in every health statistic (infant mortality, lifespans, etc). In fact Cuba, which spends a fraction of the US in $ terms ($ per person) has health statistics equal to, and in some cases better than the US.

    This is actually an opportunity for the US, it has 2 huge areas which are either mind bogglingly inefficient (e.g. health) and/or superflous to the real economy (e.g. defence and ‘national security’). Done carefully (and I mean carefully) this represents potential sources of financial, technical and human capital that can be exploited for rebuilding industry and manufacturing.

    Example, could the US get back into the booming area of bulding fission reactors (e.g Russia has $80B of orders at the moment and this will multiply, plus Frace, Japan, etc)? Yes, but given current shortages of the correct technically trained people it would have to raid the weapons industry (it takes a long tme to train the physicists, engineers, technicians, builders, etc .. but retraining and redeploying people trained in similar areas is much easier).

    Rough times ahead, everywhere, but people need to start thinking about the other side and planning for it. This applies to just about every country, they have to look to their human and technical capital and work out how to apply it carefully to set the scene for recovery and future growth, otherwise we don’t face a U (down then up) we could have an L (down .. forever).

    Like

  3. Celebau permalink
    15 October 2008 10:40 am

    I wouldn’t necessarily hold up Australias health system as a model. It does have its flaws. Whilst the article is old (2005) this will give you an idea of the balooning health budget (over time) in Australia:

    http://www.ada.asn.au/LatestComment_files/Comment%20-%20Defence%20Budget%202005-06.htm

    Maybe Australia needs something along the lines of its Superannuation scheme but for health – but thats too far off topic.

    The united states could decomission a large number of its nukes and burn the fuel to generate power. It generates security benefits – whilst it could be argued the energy benefits are temporary. Nevertheless the FAS has a very good article:

    http://www.fas.org/press/_docs/Toward%20True%20Security%202008%20.pdf

    Like

  4. 15 October 2008 11:03 am

    Fabius,

    I love your work. It is brilliant, and helped bring a military historian up to speed in other areas, especially economics.

    But, I have to ask this question. If Fabius Maximus were President, what would he do to fix the economic crisis? (by the way, I did the same for donvandergriff.com blog a couple of months ago with 12 steps to fix our problems).

    The first two I would do would be, fix the energy crisis with a Manhatten project for energy. Two, I would pull our troops out of Afghanistan and Iraq, return them home.

    You should write a column on it.

    Take Care, Don

    Like

  5. 15 October 2008 11:37 am

    “Maybe Australia needs something along the lines of its Superannuation scheme but for health – but thats too far off topic.”

    Off topic to be sure, however moot, since given the economic paradyme shift underway, the US has few options. Scoialsed medicine is not an option, given the ruinous economy, somewhat self inflicted.

    Yet, I find it interesting how Americans constantly derate the concept of scocialised medicine. True no system is perfect, and you’re listening to someone with experience in both the US & Canadian systems.

    Yet something like 2 million Americans are covered by the US militaries healthcare program, so what the heck do you call that ? I call it state provided health care and a component of the burgeoning “warfare state.”

    And yet Americans individualy are ready to fight, kill, and die in the cause of fighting scocialism and it’s close cousin communisim. Under the guise of coveted Freedumb !
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    Fabius Maximus replies: Please be careful how you refer to Americans, as if we are some unitary entity that thinks and speaks as one. “how Americans constantly derate” should be “some Americans.”

    Like

  6. Celebau permalink
    15 October 2008 12:20 pm

    Dont get me wrong, I am not opposed to some form of government support for healthcare. At the moment however wait times for anything but emergency surgery in Australia are pretty bad unless you have full private cover. Its because of underfunding and arguments between the states and federal government.

    Compulsory superannuation in australia is 9% and there has been talk previously of increasing that to 15%. Voluntarily you can contribute as much as you want, although you would be mad to do so with the roller coaster ride on stock markets at the moment. I would be in favour of having a 2% or so compulsory contributions on top of the existing, that can be accessed at will when needed for health purposes.

    Governments could then fund hospitals properly and provide a safety net to those who need it.

    Governments need to think more creatively rather than make excuses.

    Like

  7. 15 October 2008 2:26 pm

    Great Sinfest “Banktron” cartoon. Unfortunately, perhaps like a lot of folks, I’d actually like to see Banktron take more out of the wallets of the rich Really Smart Guys who have been getting huge bonuses for years for approving ever more, ever riskier loans.

    For me, the Paulson Plan link didn’t work.

    I fear his plan will, indeed, keep comatose zombie banks on taxpayer-funded support — because I think ‘all’ the big banks are insolvent. (So I prefer a plan that buys more … real assets, not paper).

    On the one hand, I don’t believe American voters will ‘tolerate’ a 15 year problem. On the other hand, the ‘excessive debt’ problem won’t be solved without solving Social Security. (In this view, having the crisis now might even allow enough time to solve THAT iceberg before full impact.)

    Like

  8. Duncan Kinder permalink
    15 October 2008 2:45 pm

    One aspect of the current economic situation is that not only the banks but the insurance industry has been afflicted by exotic financial instruments. This is likely to have broad implications. Hopefully our auto insurance will remain able to respond to any accidents we may have.

    As applied to our medical discussion, I would not be surprised if the medical insurance industry should share in this malaise.

    More broadly, the current financial situation has thrown a serious cloud over the financial risk management paradigm which has propelled the American economy over the past several decades. Turning medical care over to the insurance industry has been a subset of this broader trend to turn things generally over to financial risk management.

    As this financial risk management paradigm continues to collapse, people who now deplore the asserted waiting times of Australian and other such systems may well come to long for such waits.
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    Fabius Maximus replies: Let’s not go crazy. This is just a financial panic, followed by a recession (a normal cyclical event). America is still out there. It infrastructure, its industry, its people. Also, Australia — with many of the same problems as America — is likely also to be hit.

    Like

  9. Nicholas Weaver permalink
    15 October 2008 4:58 pm

    Tom Grey: I don’t think a lot of the big banks are really insolvent. The FDIC/Fed regulation of real banks is far more strict that the regulation which the (now late) investment banks had, and as a result, I don’t think that Wells Fargo, BofA, Citibank, etc are insolvent. But they view their counterparties as POTENTIALLY insolvent, freezing the system.

    However, I too am worried about the paulson’s plan structure of “Just Give Em Money”, because I suspect some of the smaller banks which would get money ARE insolvent (the FDIC doesn’t shut a bank down until the public believes a bank is insolvent). Additionally, a vote on the board could do such things as cut dividends to 0.

    EG, why SHOULD Bank of America, when it is trying to raise capitol by selling more stock, have a non-zero dividend payment? The banks for reasons of share price are unwilling to reduce dividend to 0, but if the fed had a vote, it could force banks to reduce dividend to 0: a move which has a short term detrimental effect on the stock price (and therefore executive compensation/wealth), but should have a long term benefit if the bank is solvent.

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  10. 15 October 2008 5:36 pm

    The reason I think the Big Banks, too, are insolvent is because the $1-4-6 (?) trillion of financial instrument wealth that has disappeared, like MBS value. FM above commented on buildings, houses (too many), factories and people — all real, all still there.
    But financial wealth is now much less.

    “Who eats the loss” is still what I’m looking for. Stock market values are one place. 401(k) values are another. And Tier 1 bank capital is likely to be another.

    Of course, the ‘insolvent’ Japanese banks were made into zombies instead, and so didn’t die. I fear that is the likely outcome of the Paulson Plan.

    Like

  11. Duncan Kinder permalink
    15 October 2008 6:10 pm

    Fabius Maximus replies: Let’s not go crazy. This is just a financial panic, followed by a recession (a normal cyclical event). America is still out there. It infrastructure, its industry, its people. Also, Australia — with many of the same problems as America — is likely also to be hit.

    Those interested in researching the insurance industry’s financial troubles, might begin with the NYT article Insurance Industry Joins Banking Giants on the Hot Seat:

    Months after the stocks of big Wall Street financial firms first came under attack, insurance companies are now being battered, suggesting that a similar round of consolidation and recapitalization may be in store for that industry.
    ….
    For now, analysts do not see insurers in precarious situations. But if the investment losses keep mounting, they will start eating away at insurers’ capital. Even insurers with conservative investment portfolios, like MetLife, are not immune.

    Like

  12. Andrey permalink
    16 October 2008 3:22 am

    Interesting article. How does one access the “bootleg” Sequoia slides?
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    Fabius Maximus replies: Follow the link; at the bottom of the page.

    Like

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