Paul Volcker's Harsh Economic Medicine

Paul Volcker, former Chairman, U.S. Federal Reserve Bank


Paul Volcker speaks in a voice not quite up to the challenge of transiting his imposing frame. It is the voice of a man with nothing to prove: a leader chosen by acclamation when the Vandals have stood at the Gate.

Schooled at Princeton, Harvard and the London School of Economics in liberal arts, political economy and government, Mr. Volcker began his career as a summer research assistant at the Federal Reserve Bank of New York in 1949 and 1950. He returned twice, first as a research economist, then as President in 1975. By then he had already served two stints at Chase Manhattan (first as a research economist, later as vice president and director of forward planning), two stints at the US Treasury during the Kennedy and Nixon administrations, and a senior fellowship at the Woodrow Wilson School of Public and International Affairs at Princeton University.

President Carter, burdened by a deepening economic malaise with inflation running at 13.3%, appointed Volcker to a four-year term as Chairman of the US Federal Reserve Bank in August, 1979. Chairman Volcker immediately set about restricting the growth in the money supply, intent on getting inflation under control.

Ronald Reagan defeated Carter for the US Presidency in 1980, pledging to rebuild the military and restore confidence in the US economy. His economic plan rested on the postulate of USC economist Arthur Laffer that under special circumstances lowering the income tax rate might increase tax revenue by stimulating growth. Reagan's budget featured a massive tax cut concentrated in the upper income brackets. It also included a net increase in government spending, with defense spending increases overtaking the much publicized cuts in other budgets.

While Volcker was encouraged by members of the Reagan administration to continue to restrict monetary growth, he publicly worried in 1981 about the consequences of simultaneously pursuing restrictive monetary policy and expansionary fiscal policy:

I know that in concept a case can be made that restraint on money and credit alone, sustained long enough and strong enough, could control inflation and thus lay the ground for renewed growth. But is that a realistic, believable and tolerable course if other instruments of policy and opinion are running counter to our purposes? Will the sustainability of the policy be credible if the costs in growth and employment seem excessive? And the costs fall unfairly on the industry and elements of the population most dependent on credit?**

He had concisely laid bare the inherent contradiction in the policies of the Reagan team: supply side theory was to be crushed by a predictable monetarist outcome. When the excess demand for money set off by the unprecedented budget deficit was not accommodated by the Federal Reserve, interest rates spiked (spectacularly), inducing the recession of 1981-82.

Volcker seems to have set the terms for the harmonization of monetary and fiscal policy that ensued in 1982. Volcker began to loosen his grip on the money supply just as Reagan put through a major tax increase to check increases in the federal deficit, taking back 1/3 of the value of the 1981 tax cut. Reagan again raised taxes in 1983 and 1984, enacting a major increase in taxes to fund Social Security, increasing taxes on gasoline, and closing certain business tax loopholes.

Many remember Reagan's tough stands against the strike of the air traffic controllers in 1981 and his unrelenting escalation of the arms race that contributed to the virtual bankruptcy of the Soviet Union. Nonetheless, in large part the economic success achieved during Reagan's second term was due to his willingness to follow the advice of his equally resolute Fed chief. By forcing Treasury Secretary Don Regan to finance the arms race with higher taxes, Volcker burst the inflationary bubble and set the stage for two more decades of prosperity. When President Reagan reappointed Volcker in 1983 the rate of inflation was 3.2%.

Perhaps Obama is looking to the doctor of the 1980 economy to administer some bitter medicine early in his own first term.


*To view his Oct. 9, 2009 interview with Charlie Rose in its entirety and other clips featuring Paul Volcker, see the Charlie Rose website.

**Secrets of the Temple: How the Federal Reserve Runs the Country, by William Greider (Simon & Schuster, 1989), pp.358-359

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Responses from Readers: Auto Industry Bailout

Chevy Suburban

Last week we posed a simple question to readers of some of the new discussion boards on LinkedIn:

Do you think funds from TARP (Troubled Asset Relief Program) should be used to help the U.S. automotive industry? How about other troubled industries, like retail?

Readers from the Strategic Business and Competitive Intelligence board had the least sympathy for the industry. Eric Garland's first post favored the market-oriented approach:

If we really believe business is about innovation, then having businesses "too big to fail" is likely incompatible with future success. Plus, as a U.S. taxpayer, this is starting to get maddeningly expensive. Break them up, or let them fail.

Jorge Buhler-Vidal added a few populist licks:

I am generally not sympathetic to a bailout to an industry led by people that have consistently ignored trends towards better quality, higher fuel efficiency and safety, while collecting high bonuses and keeping their golden parachutes.

Some cited the high cost of U.S. health care and the generous U.S. auto industry benefits packages as factors that reduced American competitiveness.

The US does not have "socialized" health care, the costs are directly in the vehicles. For Europe and Japan, the health care costs are a bit removed and spread out in the form of higher taxes for their national health care. - Bryan Gavini

The cost structure of health in the U.S. is strangling the nation's ability to compete. Once we lose a few vital industries, corporate executives will be crying out for some form of social net that doesn't sit on their balance sheets. - Eric Garland

Until the Big 3 can at least shed the legacy costs saddling them from the UAW, I don't see why they should get relief from us. - Anders Bjork

Responses to the University of Michigan Alumni board tended to show greater concern for the welfare of workers and pay less heed to free market thinking.

I would support a bailout if the funds were used to lessen/deplete the legacy costs (retiree benefits) alone. We're going to pay to support the retirees if the companies go under anyway. We're also going to pay a ton to support the 3 million unemployed. If we could remove the legacy costs from the balance sheets, re-negotiate the UAW contracts and fix our trade agreements, maybe we could pull out of it. -Jennifer Ray

The financial bailout has done nothing to help credit markets as of now. No credit markets have been thawed and the banks are being admonished for not lending the money. This has led to the further spiral of the auto industry because customers with good credit are being turned away because they cannot qualify for a loan.
I am disturbed by anyone who invokes the "free market" as if we are a purely capitalistic society. We are not. There is no such thing as a pure capitalistic society because each and every system has some sort of government control to either prevent catastrophic success (i.e., a monopoly) or catastrophic failure (what is going on now). The US did not emerge from the Great Depression by letting the free market have its way. -Jon Liu

Guy Powell on the Executive Decision board wondered how best to manage our way out of the crisis.

If the auto industry goes bankrupt, then it takes money out of the banks. Will this then ripple over to the banking market again causing another higher bailout of the banks. It would seem that 'in for a penny, in for a pound.'

Respondents to our board, A Management Consultant @ Large, took a long-term view.

The longer term fix is to retool that work in Michigan to cars that fit a better vision of low energy usage and elimination of emissions. -Rudy Westervelt

Consolidation appears inevitable, given the ferocious international competition and sustained overcapacity in the industry -- so why not have two (or even all three) of the Big Three merge together as part of the bailout? -Ben Petree

What if GM & Ford could "draft" assets from Chrysler--would they take any? How about people? -Joe McKinney

The US auto industry (as distinct from the auto industry in the US) reminds me of the UK situation 40 years ago. Government bailouts failed. The lesson learned is that the best government involvement is that which greases the skids of change, and not that which just delays the change. Tax policy can be used as an incentive for value-added entrepreneur progress, and for humane retraining. -Robert Munro

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Credit Default Swaps: Recent Stories from NPR

National Public Radio

In a previous post I mentioned, without much explanation, that credit default swaps (CDS) were instrumental in creating the 2008 credit crisis. As it happens, Alex Blumberg has done some of the clearest reporting on CDS for a National Public Radio (NPR) program, "This American Life."

Credit default swaps, which have become featured players in the troubled asset drama, are over-the-counter contracts that have been widely used to hedge investors against the risk of mortgage-backed securities. Unlike insurance policies, however, they do not require that either party actually own the assets being protected. As one of their inventors, Gregg Berman, explains:

It is exactly like buying insurance for a house you don't own.

And that is the very definition of moral hazard. Speculators can enter the market to bet against houses they consider at risk, thereby creating a market for arson. And bet they did. Berman and Satyajit Das, a risk consultant, were interviewed for the story, How Credit Default Swaps Spread Financial Rot.

Das says that during his time in the industry, the amount of credit default swaps that were speculative grew to dwarf the amount that were used for insurance...There are $5 trillion worth of bonds issued in the world, but the total amount that people have bet on those bonds is $60 trillion.

Because they were traded over-the-counter, CDS have been unregulated and are nearly invisible to investors. We now know that many of the obligations to cover mortgage-backed securities are held by AIG, an insurance firm. On 16-Sept-08 the U.S. Treasury seized control of AIG and has now invested about $122 billion to prop it up.

This week I received a letter from AIG offering me an Essential Health insurance plan. The envelope exclaimed:

You Can help get greater control of your medical expenses. (And for less than you think.)

Imagine my excitement as I raced to read the fine print.

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Financial Crisis: Stepping Back from the Precipice

Tarpeian Rock, Rome

Economists, bloggers and amateur historians will read with interest the rich exchange of ideas on the Paulson bailout plan instigated by Christopher Carroll, the economist from Johns Hopkins University, on the Economists' Forum blog of the Financial Times, TARP and the Ruin of Pompeii: An Analogy.

Professor Carroll poses a simple model of a financial system in crisis that results when an under-capitalized bank holding mortgages of the citizens of Pompeii learns that its balance sheet has been compromised by an unforeseen event, the eruption of Mount Vesuvius. Writing during the critical days immediately following passage of the Emergency Economic Stabilization Act of 2008, Carroll and a cast of contributors try out a number of policy alternatives as they enrich the model, in the process making it ever more analogous to the present situation.

Mr. Carroll takes the question directly to Secretary Paulson, wondering rhetorically why the classical, free-market solution--let the banks fail--would not be more sensible than the approach initially suggested by Paulson, by which agents of the U.S. Treasury would inject capital into financial institutions by purchasing troubled assets at prices to be set by auction on exchanges to be named later. Carroll doubts that any auction can establish the real value of these securities and thus suggests that policy-makers consider direct investments in bank equity.

The contributors poke at Carroll's model and his history, variously:

• Defending TARP (Troubled Asset Relief Program) as a mechanism for creating liquidity in the short term
  
• Introducing complexity (e.g., suppose Pompeii's mortgage had been insured by entrepreneurs at Vandelsbank)
• Considering the fallout of market failure ("it will trigger a run on all the other banks in the Empire, putting millions of potential tourists to the new Pompeian ruins out of work and unable to afford the trip") and
  
• Noting that Titus and not the despised Nero was Emperor at the time of the Eruption

One commentator remarked:

How strange to call this plan “TARP” when the old Romans used to say “The Tarpeian Rock is not far from the Capitol.” (Editor: Following his link, one finds that the Tarpeian Rock is the precipice from which ancient Romans flung traitors, murderers, and those "cursed by the gods.")

Within days of Carroll's article the finance ministers of the G7, led by the UK, announced plans to battle the world liquidity crisis by directly injecting capital into their respective banks. Secretary Paulson, in what seemed a remarkable turnabout, shifted his policy focus from purchase of troubled assets to direct investment in financial institutions. Calling a meeting of the leaders of the nine largest U.S. banks, Paulson called on each of them to contract immediately with the US government for a direct infusion of federal cash in the form of escalating loans, along with warrants for preferred stock and limits on executive pay. In dramatic reporting for the The New York Times, Mark Landler and Eric Dash wrote:

In addition to the capital infusions, which will be made this week, the government said it would temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in noninterest-bearing accounts, mainly used by businesses.

All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks.

Carroll and his contributors have provided a masters class in political economy, open to the public. In it we read the thinking behind policy as it is crafted and revised in real time. More than that, we are witness to the development of economic theory. Hypotheses are set out. Models are postulated, tested and examined for implications. (One commentator, Professor Perry Mehrling of Columbia University, interprets the technical balance sheet entries of the U.S. Federal Reserve Bank on October 1, 2008 to conclude that the Fed had run out of ammunition to battle the crisis.) Consequences of policy provisions, with their inevitable compromises and disappointments, are weighed against the risks of doing nothing.

For the moment, the consensus view that banks should be forced to recapitalize despite concerns about damage to free market principles, seems to be carrying the day. And it should.

• Direct investment in bank reserves is considerably more efficient than purchase of troubled assets in producing liquidity because such action dramatically improves banks' reserve ratios.
  
• Under the latest plan banks remain responsible for their balance sheets.
  
• The government has agreed to charge a fair price for the required capital investment and has provided banks incentives for banks to buy back the the government's stake through privately financed equity. (The Treasury will purchase preferred stock paying 5% dividends initially, but rising to 9% on shares held beyond five years. Treasury will also get warrants to purchase common shares equivalent to 15% of its initial investment.)
• Compulsory action against the largest banks provides cover for others to volunteer for the program without suffering the financial taint of appearing weak. Without compulsion, which bank would have been first to appear at the government's lending window? Which executives would have volunteered to cap their own pay?

The crisis is not over and the full implications are not well known. Governments around the world will need to act responsibly and in coordination to bring the world economy to a soft landing.

Our thanks go out to bloggers like economists Christopher Carroll, Paul Krugman, Greg Mankiw and Peter Orszag for raising the level of discussion above that achieved by the mainstream media.

See also previous reports on the financial crisis, including A Review of the Economic Stabilization Act of 2008, The Bailout Explained by the CBO, The Case Against the Paulson Plan and Can the Banking System Hold Water?

A collection of posts about the US Economy is maintained here.

To learn more about our work in consulting, please see our Profile, download a brochure about our Practice, or check out our Case Studies.

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A Review of the Emergency Economic Stabilization Act of 2008

The Library of Congress


The U.S. House is expected to vote today on the Senate version of the bailout plan, HR1424, the Emergency Economic Stabilization Act of 2008. Following two weeks of intense scrutiny, debate, political wrangling and even some soul searching, Congress seems ready to pass a bill that offers hope of cutting the Gordian knot strangling credit markets. Action could not come too soon.

The bill, summarized here, has undergone some important changes over the past two weeks and its scope and intent have been clarified. Initially dubbed the "bailout plan" or the "Troubled Asset Rescue Plan," the bill's original intent was to grant sufficient authority to the U.S. Treasury to take steps that would avert panic in the credit markets. The most controversial portion of the plan, would create a:

Troubled Assets Relief Program (TARP), under which the Secretary of the Treasury would be authorized to purchase, insure, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages issued prior to March 14, 2008 - CBO Director Peter Orszag

As Joe Nocera reported Oct. 1 in the New York Times, large investors fearing imminent bank failures were cashing out even very liquid assets and moving them between institutions. Witnessing what appeared to be the first stages of a full-blown run on the banks, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke sounded the alarm, outlined emergency measures, and began to rally the political forces required. The name of the rescue plan was impolitic (why should the Public be troubled about bank assets?), details of the actions required were sketchy, estimates of the cost were imprecise, and oversight measures were missing entirely, but the critical first steps had been taken. The body politic was in motion.

On Monday, 29-Sept-08 the first bill sculpted from the plan, HR3997 (summarized here), failed to pass the House of Representatives, despite the incorporation into the bill of substantial improvements and clarifications to the plan, particularly in the area of oversight. Then, with unusual speed the Senate crafted the new bill, HR1424, adding two unrelated divisions designed to bring more Members of Congress on board. The new Division B, The Energy Improvement and Extension Act of 2008, and Division C, Tax Extensions and Alternative Minimum Tax Relief, would add approximately $112 billion to deficits over the next ten years. More importantly, they provide political cover to Members of Congress who will have to explain to constituents in this month before the election how they could enact an expensive and unpopular bailout plan.

It now seems clear that passage of the bill is necessary, but not sufficient to avoid a major recession. By insuring bank deposits and money market funds up to $250,000 per account, the measure substantially reduces the risk of runs on banks by depositors and will forestall a substantial amount of unproductive movement of deposits from bank to bank and account to account. This insurance provision will also calm investors in those banks.

TARP provides a mechanism for the Treasury to inject capital into financial institutions, transforming unproductive, illiquid assets at participating institutions into cash that can then support new loans.

Investors should watch closely the provisions of the bill relating to "mark-to-market" accounting requirements, which were instituted earlier this year to provide more transparency to financial reports. The bill would authorize the SEC to restate those requirements and require the Commission to reconsider them and report its findings back to Congress. The practical effect of these provisions will be to improve the balance sheets of financial institutions holding devalued assets, such as mortgage-backed securities, thereby allowing them to make more loans against those assets.

In combination, these provisions are designed to calm investors, create liquidity, and buy time for Treasury to help troubled institutions recapitalize.

The next Administration will have to preside over a period of further consolidation of financial institutions as it tries to keep mounting federal debt from further slowing the economy. It must also address the accounting rules that have confused investors and regulators alike about the underlying values of American assets and corporations.

A detailed analysis of the legal implications of the Act has been provided by the firm of Davis, Polk & Wardwell (available here).

See also previous reports on the bailout bill, including The Bailout Explained by the CBO, The Case Against the Paulson Plan and Can the Banking System Hold Water?

A collection of posts about the US Economy is maintained here.

To learn more about our work in consulting, please see our Profile, download a brochure about our Practice, or check out our Case Studies.

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The Bailout Explained by the CBO

Peter Orszag, Ph. D., Director of the CBO


The Director of the Congressional Budget Office (CBO), economist Peter Orszag, publishes a blog with detailed information about the issues shaping current legislation. In his role as the leader of the non-partisan research office of the U.S. Congress, Dr. Orszag is the ultimate insider--a primary source of impartial information to which Members of Congress often turn when seeking deeper insight.

Of course Dr. Orszag has posted a number of comments over the past few weeks on the current liquidity crisis. For example, the article posted 26-Sept-08, entitled Net Budget Cost of Treasury Proposal, begins:

A Wall Street Journal blog posting mischaracterizes CBO’s testimony earlier this week on the net budget impact of the Treasury proposal to buy troubled assets. The Wall Street Journal blog states that the plan “likely won’t have any effect on the 2009 budget deficit.” That is incorrect.

Orszag goes on to discuss how the plan would impact the 2009 budget deficit with the kind of specificity and understanding typically lacking in media coverage.

In his remarks of 25-Sept-08, Troubled Asset Relief Act and Insolvencies, Director Orszag focuses attention on the distinction between competing goals: increasing liquidity for the financial system as a whole and avoiding insolvency at particular financial institutions.

A company holding an overvalued asset would have to write down the value of that asset not only if it actually sold that asset to the government at a price beneath its current book value, but also if other companies sold comparable assets to the government at a price beneath that book value. This is the essence of mark-to-market accounting.

...Even if this process revealed more financial institutions to be insolvent, the result would not necessarily worsen the financial crisis. As I stated in my testimony yesterday before the House Budget Committee, the current crisis is fundamentally one of collapsing confidence in the financial markets and “providing more transparency about the lack of solvency at specific institutions may be necessary to restore trust in the financial system.”

...Financial markets face two distinct, but related, problems. One problem is that the markets for some types of assets and transactions have essentially stopped functioning. To address that problem, the government could conceivably intervene as a “market maker,” by offering to purchase assets through a competitive process and thereby provide a price signal to other market participants. That type of intervention, if designed carefully to keep the government from overpaying, might not involve any significant subsidy from the government to financial institutions. The second problem involves the potential insolvency of specific financial institutions. Restoring solvency to insolvent institutions requires additional capital injections, and one possible source of such capital is the federal government. Although the problems of illiquidity and insolvency are interrelated, they are at least conceptually distinct. Indeed, some policy proposals appear to be aimed primarily at the illiquidity of particular asset markets, and others appear to be aimed primarily at the potential insolvency of specific financial institutions. The Treasury proposal appears to be motivated primarily by concerns about illiquid markets. The more the government overpays for assets purchased under that act, however, the more the proposed program would instead provide a subsidy to specific financial institutions, in a manner that seems unlikely to be an efficient approach to addressing concerns about insolvency.

We expect to learn more about how well policymakers have actually performed when the revised proposal is published, which is expected to happen later today. It is difficult for this consultant to remember an economic episode that played out more dramatically or with greater consequences.

Update: Review of the Emergency Economic Stabilization Act of 2008, signed 3-Oct-08.

The Senate passed a modified version of the bill, now called HR1424, the night of 1-October-08. A letter of summary and analysis of that version was prepared by Director Orszag for Sen. Dodd. That bill is expected to be put up for a vote by the House 3-October-08. If passed without amendment, it will go to the President, who will then have 10 days to sign it into law.

A collection of our posts about the US Economy is maintained here. See also The Case Against the Paulson Plan and Can the Banking System Hold Water?

A permanent link to the CBO Director's Blog has been added to Reference Websites.

See Key Provisions of the Bailout Plan as summarized by Reuters 28-Sept-08. For the complete text of the 28-Sept-08 version of HR 3997 The Emergency Economic Stabilization Act of 2008, click here.

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The Case against the Paulson Plan

Professor Robert Shimer, University of Chicago


In a letter to Greg Mankiw, Professor of Economics at Harvard, Professor Robert Shimer of the University of Chicago shines a bright light on the $700 billion financial system bailout proposed by Henry Paulson. His prescription, that financial institutions be forced to raise capital in the market to increase their liquidity, would put the onus on the institutions themselves, and not the taxpayers, to solve their crisis. Participation would need to be coerced because no individual institution has the incentive to do so acting alone, fearing that such a unilateral move would signal desperation.

Greg Mankiw's Blog: The Case against the Paulson Plan

The letter makes clear that the Paulson plan may be neither necessary nor sufficient to solve the liquidity crisis.

A collection of our posts about the US Economy can be found here. See, for example, Review of the Economic Stabilization Act of 2008 (3-Oct-08)

See also Can the Banking System Hold Water?

To learn more about our work in consulting, read about our Practice or check out our Case Studies

The US Economy and the Bailout

See these posts from our blog, A Management Consultant @ Large, for our perspective on the Political Economy and the issues confronting economic policy makers in the U.S.

• Timeline of Financial Bailout of 2008 presents a list of key dates associated with the near collapse of the world economy
  
• An Explanation of the Health Care Bill examines Title 1 of the Affordable Health Care Choices Act (Senate H.E.L.P. Committee version)
  
• Health Care Reform Takes Shape describes key provisions of HR 3200, the version of the Health Care bill being considered by the U.S. House of Representatives
• Businesses Going Shopping advises corporations to realign their assets, obligations and capabilities to position themselves for growth as the economy recovers.
  
• General Motors Surrenders reports on the rejection of the General Motors restructuring plan by the Presidential Task Force on the Auto Industry
• Paul Volcker's Harsh Economic Medicine reviews Volcker's stand against inflation in the early 1980's as Chairman of the US Federal Reserve
  
• Credit Default Swaps: Recent Stories from NPR provides further explanation of the role of credit default swaps (CDS) in destabilizing the world economy. The post links to stories from National Public Radio about CDS.
  
• Financial Crisis: Stepping Back from the Precipice comments on the latest U,S. Treasury plan to directly invest in U.S. banks. The article reviews commentary by economists on the blog of the Financial Times.
  
• A Review of the Emergency Economic Stabilization Act of 2008 discusses the intent of the major provisions of the bailout plan.
  
• Can the Banking System Hold Water? examines the September, 2008 liquidity crisis and the bailout proposed by Treasury Secretary Henry Paulson.
• The Bailout Explained by the CBO highlights details of the Paulson plan as explained by the Director of the Congressional Budget Office.
  
• The Case Against the Paulson Plan introduces a well-reasoned and informative letter about the liquidity crisis authored by University of Chicago economist Robert Shimer.
  
• How Does the Elephant in the Room Like Your Lapel Pin takes a serious look at the importance of the National Debt and how it has been ignored during the 2008 political debates. Long-term imbalances need to be addressed before they destroy the U.S. economy in the coming decade.
  
• No Time for Panic, (misnamed, with apologies) was a reminder in the midst of the credit crunch that many good things were happening in the world economy that would keep the U.S. economy out of free fall.
  
• Getting it Right on the U.S. Economy offered early encouragement to the U.S. Federal Reserve as it successfully postponed a credit crunch in the run up to the Bear Stearns collapse
• The U.S. Export Opportunity encouraged U.S. businesses to take advantage of the historically low value of the U.S. dollar to export more goods and services and asks policy makers to do more to facilitate that process
• What is the Outlook for Business Investment in 2008? , first published in mid-November, 2007, forecast the weakness in the U.S. economy heading into the 2007 Christmas season and warned about the impending credit crunch. It also pointed to sectors that could be expected to thrive in world markets.

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Can The Banking System Hold Water?

John Kuhlman (left), economist, teacher and humanitarian


Struggling to understand the depth and breadth of the liquidity crisis enveloping us, I thought back to a quote projected onto a giant screen behind Professor John Kuhlman in the 900-seat auditorium at the University of Missouri many years ago.

The society which scorns excellence in plumbing because plumbing is a humble activity, and tolerates shoddiness in philosophy because philosophy is an exalted activity, will have neither good plumbing nor good philosophy. Neither its pipes nor its theories will hold water. - John William Gardner

Henry Paulson, U.S. Treasury Secretary, has put forth an emergency plan by which taxpayers would buy up some $700 billion of "troubled" mortgage-related credit instruments in order to inject liquidity into the financial system.

• Would it solve the problem?
  
• What would we be buying?
• From whom?
• Why us?
• Why now?

It is easiest to answer the questions in reverse order. Most immediately, the Treasury Secretary needed to coordinate an international effort to avert a liquidity crisis. It is not just that the money market funds were losing value; they were at risk of default. Nervous investors were redeeming money market funds for cash at such a rapid rate that some funds were on the verge of stopping or postponing payments, unable to sell assets fast enough to keep pace. Fearing a disastrous run on the entire financial system, Paulson's team reached for the most powerful defensive weapon in the arsenal, promising to put the full faith and credit of the U.S. Government behind those instruments. Only U.S. taxpayers could float that kind of cash, and it would take an Act of Congress to get them to do it.

Both presidential candidates, currently Members of that Congress, have rightly asked what they are expected to buy and under what terms. After all, $700 billion is the kind of money usually reserved for major programs like tax cuts, health care system overhauls, global wars, or all three combined. As it happens, the most troubling financial instruments at issue, credit default swaps (CDS), are mind-numbingly complex instruments by which investment bankers, mortgage lenders, and others have been able to transform risky portfolios of assets into profitable streams of cash, at least in the short run. In an article last week in Investors Business Daily, Ken Hoover states that "the worldwide CDS market has been estimated at $58 trillion at the end of 2007, a hundredfold increase from seven years ago." According to Wikipedia:

A credit default swap is a contract between two counterparties, whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default or "credit event" in respect of a third party or "reference entity"...A credit default swap resembles an insurance policy, as it can be used by a debt holder to insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes.

"In the long run," however, as economist John Maynard Keynes famously quipped, "we are all dead." Issuers of credit default swaps, like AIG, make money as long as the instruments they insure are safe. Holders of CDSs, like banks, are insured so long as the insurer stays solvent. However, when the underlying portfolios of insured assets began to fail, as did mortgage-backed securities, CDSs became unprofitable and more visible to investors. So many CDSs were becoming so unprofitable that the values of their issuers and some of their holders began to fall in spectacular fashion. Had AIG been allowed to fail, it might have taken hundreds of banks with it.

And so U.S. taxpayers are being told to cover the failed bets of financial institutions or suffer the consequences of an insolvent financial system that brings down speculators, investors and savers alike. The details of the plan are still being worked out and the price tag may change as well. As initially proposed the Government would buy mortgage-backed securities. Now Congress wants to include mortgages themselves.

The timing of the crisis does not bode well for devising a comprehensive solution, nor is it clear that Paulson has asked for one. The Federal Reserve and Treasury have already taken steps to provide liquidity to financial markets, extending federal loans to banks and equity to AIG, as well as supporting the transition of the two solvent investment banks, Morgan Stanley and Goldman Sacks, to more regulated bank holding company status with access to federal lending.

When Paulson asks for federal government help in cleaning up the balance sheets of private corporations, however, he raises profound issues about the role of government and the responsibility of private corporations to accept the consequences of the risk they freely take on. Demanding immediate and absolute authority to spend $700 billion to clean up private debt smacks of brinksmanship. A prudent Congress will take only the emergency measures required and leave the comprehensive solutions for its succeeding Congress in January.

Any comprehensive solution will require far greater measures of oversight, accountability and respect for federal debt than has been in evidence as of late. In a democratic republic such measures should be subject to careful deliberation and open debate.

There will be plenty of time in the coming weeks and years for the accountants and politicians to count the dead and bury the wounded. For thirty years politicians have found it useful to paint civil servants with the broad brush of "fraud, waste, and abuse" while promoting the virtues of Wall Street's "Masters of the Universe." Regulation and regulators, disparaged as unnecessary and incompetent, were ushered out of the financial markets with the passage of the Financial Services Modernization Act of 1999.

Had we paid more heed to John Gardner and John Kuhlman, would our financial plumbing flow more freely today?

Professor Kuhlman himself, now 85 and retired from a distinguished academic career, continues his career of service, teaching English to immigrants.

A collection of posts on the US Economy can be found here. See also Review of the Economic Stabilization Act of 2008 (3-Oct-2008)

See How AIG Fell Apart by Adam Davidson, in Slate.

See also Nearly Deaf Professor Teaches English Literacy, One Student at a Time, by Samuel G. Freedman, New York Times, May 21, 2008.

To learn more about our work in consulting, read about our Practice or check out our Case Studies

Blog vs. Flog: Promoting Professional Services

A review of SCOTUSBLOG


Providers of professional services, including lawyers, consultants, accountants and doctors, face a uniquely awkward sales challenge. Discouraged or prevented by law or practice from conspicuously flogging their services, most market their services through bone-dry websites. A few have begun to realize the potential of blogging to help them make more personal, but unobtrusive, contact with prospective clients. Among those leading the way is Akin Gump Strauss Hauer & Feld, a US law firm with 700 professionals and 12 offices.

Their traditional website at www.akingump.com, with a reported Google PageRank of 6, draws an estimated 5100 visitors per month. That site lists their service areas and offices, provides white papers, supports recruiting, and highlights company news.

However, the firm also publishes one of the better professional services blogs, www.scotusblog.com, which itself has a Google PageRank of 6, and draws about 19,000 visitors monthly, according to Quantcast.com. “SCOTUS” means “Supreme Court of the United States” and the blog is an authoritative source of information of interest to anyone following that court. Divided into sections called “commentary and opinion”, “new filings”, “orders and opinions”, “multimedia” and “term tracker”, the blog leaves little doubt that this firm knows the Supreme Court and practices before it frequently. The featured commentators are pictured in the right-hand margin, with accompanying links for emailing them. The tone of their posts is authoritative but not stodgy, sometimes speculative, always interesting. For example, in the post “Wild Opinion Speculation” from June 23, 2008 one of the authors surmises that Justice Scalia will be writing an important upcoming opinion:

It does look exceptionally likely that Justice Scalia is writing the principal opinion for the Court in Heller – the D.C. guns case. That is the only opinion remaining from the sitting and he is the only member of the Court not to have written a majority opinion from the sitting. There is no indication that he lost a majority from March. His only dissent from the sitting is for two Justices in Indiana v. Edwards. So, that’s a good sign for advocates of a strong individual rights conception of the Second Amendment and a bad sign for D.C.

A post with that kind of immediacy must surely be designed to attract the attention of the media, who will have no trouble finding experts at the firm to interview.

The blog directs readers back to white papers on www.akingump.com and also links to a new sister site, SCOTUSwiki.com, a reference site that "features pages maintained by many regular SCOTUSblog contributors, top law students, and leading experts in various legal fields."

What does this effort bring to the firm? The blog is a quick, interesting read that attracts both a general audience and potential clients, collaborators, recruits and reporters. It has a kind of personality and newsiness that keeps people coming back frequently for a few minutes at a time. It personalizes the experience of meeting the firm in a completely non-threatening way.

For potential clients, it is the written equivalent of speed-dating, except the prospect never has to tell the blog “No”.

To learn more about our work in consulting, read about our Practice or check out our Case Studies

McDonald's Strategy: Meat, Potatoes and Coffee

"50th Anniversary McDonald's"
in River North, Chicago, IL

 

In a story appearing in today's Chicago Tribune, McDonald's CEO Jim Skinner reports that his biggest pet peeve is when a worker fills a cup of coffee directly from the drip dispenser instead of waiting for the pot to be filled.

"You don't get the best cup of coffee that way," he said.

Having myself worked at a McDonald's restaurant in the St. Louis area when Skinner was getting his start with the organization as a manager trainee in Carpentersville, Illinois in 1971, I had to chuckle. Like Skinner, most of my managers had come out of the U.S. military and they had taught me to "shortstop" the coffee machine when a customer was waiting for a cup. They had also taught me an elaborate set of operating procedures, as specific and detailed as any I have seen since, e.g.:

• Get the milkshakes first because they will hold their temperature the longest and may need to thaw a bit before they are served. Then get soft drinks. Then milk and coffee.
  
• You can pour two cups of cola simultaneously if you tilt the cups to the side; Diet Coke foams more than regular.
• Throw away the burgers in the bin if they have been there more than thirty minutes; the fries don't last even half that long. Count and record the wrappers from the discarded food after the shift.
  

McDonald's has variously been characterized as a marketing company, a franchising company and property management company. It is certainly all of those things. However, under CEO Jim Skinner, McDonald's is once again, more than anything, a company focused on operations.

Skinner rose through the ranks of US restaurant operations until 1992, when he was tapped to lead restaurant development in the company's emerging markets of Central Europe, Middle East, Africa and India. At various times in subsequent years he had executive responsibility for every other part of the world and nearly every corporate function.

When Skinner ascended to the CEO position in 2004, McDonald's was preparing to celebrate its 50th anniversary. Planning had been underway to update the iconic "Rock and Roll McDonald's" in Chicago's River North entertainment district and prominent Chicago architects, including Helmut Jahn, Martin Wolf, and Dan Coffey were asked to submit designs. Foreshadowing its "back-to-basics" approach, and to the apparent chagrin of at least one architectural critic, Skinner's team instead decided to build the "really big" McDonald's depicted above.

His first priority was to renew focus on customer service, cleanliness and food quality at the more than 30,000 locations. Setting aside the restaurant diversification program begun in the late 1990's by Jack Greenberg, he sold McDonald's interests in Boston Market, Chipotle Mexican Grill, and Fazoli's Italian restaurants. At the same time, the products, menu and the store formats were updated, broadening the chain's appeal to more sophisticated consumers. Better salads and chicken sandwiches were introduced. Chicken nuggets and, most especially coffee, were upgraded. If critics of style have not always been impressed, investors have been delighted. The stock that traded in the mid-$20 range when Skinner took charge now sells for $64; same-store sales have risen consistently.

One of his more innovative predecessors, Charlie Bell, had participated in the assault on Starbucks as early as 1993 when the McCafe format was introduced in his native Australia. While that format, a pub-like version of a coffee shop with offerings similar to Starbucks, has been test-marketed in the U.S., it has not been widely adopted. Instead, a series of coffee drinks were perfected and suppliers worked with McDonald's to develop machines that could mass-produce them.

A strategist might have moved more dramatically; an innovator might have hired craftsmen to experiment with drinks as restaurants were rolled out. Skinner, the operations master, perfected the drinks, the equipment, the operating procedures and the marketing message before he unleashed the roll out.

See also Brand, Menu and Store Design and Chain Restaurant Development.

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You may contact JP Farrell & Associates here.

Remembering Michael Hammer: Father of Reengineering

The late Dr. Michael Hammer


The man at the front of the Reengineering movement passed away suddenly last week.

It is difficult to overstate the impact that he has had on the way the modern corporation operates or the way businesspeople think about their responsibilities. His central premise, that organizations should reconsider not only their business processes but also their fundamental architectures, resonated with leaders who found themselves trying to manage organizations that had evolved from 19th century models or, worse, had been cobbled together by merger and acquisition.

In a new world of more abundant capital, deregulated markets, freer trade and, most especially, inexpensive computing and communication, economies of scale and scope were being redefined. Hammer saw that yesterday's competitive yardsticks were no longer meaningful and that businesses needed to start managing themselves relative to their new potential, not just against their historical performance.

Many consultants have defined new terms, and "reengineering" may not have been either the most provocative nor the most descriptive of the kind of change he envisioned. However, those of us who had the privilege of working on some of the projects that he spawned recognize that his vision went well beyond that of the typical slogan-monger. Rather, his genius was that he could understand the problems in a general way while describing them with sufficient specificity to be credible. His prescriptions for change, neither simplistic nor simple, were accompanied by logical method, complete with milestones, metrics and other controls.

I am grateful for his life and work.

The following tribute was posted by Anand Raman, one of his publishers, The Harvard Business Review.
read more | digg story

See also the obituary from the New York Times, published Sept. 5, 2008. It is the source of the photo in this article.

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Kellogg: Digital ROI Surpasses That of TV

CHICAGO (AdAge.com) -- The digital divide is narrowing for Kellogg Co., which today said its return on online investment for the Special K brand has surpassed that of broadcast TV over the past 18 months.

read more | digg story

Articles and Citations for JP Farrell

James P. Farrell, management consultant and economist

A Management Consultant @ Large has become the primary publisher of commentary and analysis of James P. Farrell. Many of our articles have been featured on major online media, including Reuters and the Chicago Sun-Times.

Mr. Farrell's work has been published in the mainstream media and in the intellectual capital of firms that employed him as well. Recent articles include:

• Mastering Innovation Management: Collaborating for Speed and Profit is an AT Kearney white paper, written by Mr. Farrell, that expands on a discussion by a forum of experts he organized on the topic
• Keeping Track of Promotion Progress: How Marketing Will Become the Greatest Advocate of RFID, co-authored with Ralf Saykiewicz, appeared in Consumer Goods Technology
• Smart Freight Navigates the Trading Net is a TSC white paper that discusses breakthroughs in technologies and methods for improving supply chain visibility and control.
  

Mr. Farrell has previously been published in Food Logistics and Transport Topics. As an economist for the U.S. Transportation he authored studies on trucking deregulation and transit policy. One of those papers was referenced in the Preamble to the Motor Carrier Act of 1980, which deregulated the U.S. trucking industry.

He has been cited as an authority on the consumer products, retail and restaurant industries and consulted on issues related to supply chain management and electronic commerce by international, national and local print media in the U.S., the U.K., Mexico and Hong Kong. The Economist featured Mr. Farrell's comments in a feature article on McDonald's Corporation, Big Mac's Makeover.

To learn more about our work in consulting, please see our Profile or check out our Case Studies.

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