Prescient? Moi? On Not Predicting the Global Financial Crisis Again

The following essay began life in May 2007 and matured into a shorter, punchier one that I read out and was broadcast on August 2^nd 2007 on the Radio National Program “Perspective.” Certain rather significant events known as the GFC started to unfold not so long afterwards. There is the old adage that tells us that forecasts are very difficult to make, especially about the future. I obviously got some of the details wrong. But hey! Have things changed that much since? The recent Oscar wining film “An Inside Job” does not seem to think so and nor do I.  So what is it predicting today?

In is perhaps worth noting that I tried quite hard, back then, unsuccessfully, to get some version of the essay published in the Australian Financial Review.

Some years ago, a Professor of finance asserted to me that shareholder value is the only way to gauge the worth of a firm. I come from a marketing background where the sole purpose of a firm is creating value for consumers.  Obviously these two things are linked.  Do good for consumers, the firm prospers and so do shareholders through dividends out of profits.  All seems so simple.  But these days the world of business seems to have gone mad, with the brightest guys in the room producing Enron and HIH type catastrophes in the name of capitalism. Every country has its trail of financial fiascoes as major firms turn out to be hollow shells with inflated revenues, shriveled costs and ballooning egos and salaries. This is not just evidence of a few rogues getting their come uppance. There seems to me something more systematic and pernicious going on.

Each day we are told how such and such a firm lost or gained umpteen millions of its value, as revealed by some hourly, daily or weekly fluctuation in the price of its shares.  We are then offered deep and meaningful analysis and interpretation by the well opinionated financial and business analysts and commentators. They are so wise!  They are able to rationalize every blip and dip, even though the best minds in the world still struggle to find any discernable logic in the patterns of share price movements.  Research shows, in essence, that fluctuations in share prices and any indices derived from them are essentially random. Yes, they are not linked to real world business behaviour and performance.  They are produced from a gigantic casino called the financial market that operates in the real world but is not about the real world – it is about betting against each other and guessing and outguessing what others will do, not do and do do.

What is going on? When a firm seeks investment funds from the market it offers shares. When they earn profits they pay dividends to shareholders. But shares get bought and sold again and again.  Through this, firms can lose control to groups that buy up controlling shares of shares. In the 80s films like Wall Street depicted traders who looked for firms with real assets whose value exceeded the cost of buying a controlling share of shares.  They then buy the shares, gain control and sell off the real assets to presumably better uses.  This again seems okay, as it puts a lower bound on share prices that should reflect at least the real value of the firm’s assets.  But how assets are valued and how share prices vary are not linked to real value in use as they depend on accounting routines and speculation in share prices generally.

Who eventually picks up the pieces or suffers the losses if revenues don’t exceed costs?  Executives can bail out early, cash in stocks and move on.  The next lot of executives come in and tells us how bad the previous guys were and write down everything to more realistic values.  But then they repeat the cycle. Who loses?  In most cases and others it is the employees and shareholders left holding the eventually worthless shares and not able to claim their entitlements.  Bankruptcy acts as a clearing house. 

Shareholder value is okay if it is linked to the real value of the firm, in the form of dividends from real profits.  But, when second and third hand markets in shares dominate, the main money is made out of speculating on variations in the price of shares in these markets. Shareholder value seems to refer these days to the value of becoming a NON shareholder in a firm – that is selling your shares!  And most trading is not directly in shares at all, but in options and derivatives of the most obscure and rarefied kind. How bizarre is this! 

The existing economic system rewards this seemingly pathological behaviour and even celebrates it as the survival of the fittest. To be sure, the financial game is, currently, the game the winners (or a lot of them) play.  But is this the winning game? Are we creating a game, that will eventually collapse and damage us; like some of the civilizations described in Jared Diamond's wonderful book Collapse - cutting down the last tree (selling the last share) to have the last fire (sup the last café latte) before giving the whole thing over to the cockroaches?  Is it the modern day equivalent of Nero fiddling the books while Rome burns.

Addendum and Further Reading

It seems my concerns and consternation are not without company.  Since writing this piece and sharing it with others in business and academia around the world, I have discovered other kindred spirits.  Let me draw your attention to some of them, as they are a way for you to find out more about these issues.

First is Henry Mintzberg, one of the leading thinkers in management education who has long argued about the silliness of the way firms are valued in terms of shareholder value.  Visit his website (www.henrymintzberg.com) to find out more.  Then there is Michael Jensen, who, with Mecklin wrote some of the main articles on which financial theory is based. In a passionate address he gave at London Business School last year, which you can find on his website (www.people.hbs.edu/mjensen), he shows up the tyranny of measures of value and the way it encourages managers and financial types alike to cheat and lie to make the apparent reality look good (according to the numbers) and so to add “value” to their firms and their bonuses. Michael Jensen is an Emeritus Professor at Harvard – not a ninny to be scoffed at. According to a recent book by Daniel Yanklovich, Profit with Honour (Yale University Press 2006) Professor Jensen has become so personally disillusioned that he now refers to stock options as “managerial herion.”  Last, but by no means least, there is Nassim Taleb, who is a financial trader, and wrote the deep and deeply entertaining book Fooled by Randomness (2004, Random House second edition 2005).  He, of course, also has a website (www.fooledbyrandomness.com).  This book exposes all our human weakness and biases and draws on up to date research on the nature of man, mind and behaviour to show how we are fooled by the random ramblings of stock market prices and how we try to claim we understand it and are in charge of our destiny when we are not. 

Ian Wilkinson

Honorary Professor of Marketing, University of Sydney
Visiting Professor of Entrepreneurship and Relationship Management, University of Southern Denmark

April 2011