Readers of this blog will know that I am one of those deeply concerned by the consolidation afoot in our economy (e.g., “Beware the Land of the Giants…“), more particularly, in the financial sector (e.g., “Happy 9-15!“)

From Hypervocal, a powerful reminder of just how extreme the dynamic has become, “From 37 to 4: the Consolidation of Banks“…

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In 1990 there were 37 major banks in America. By 1999 there were 21. Just 14 in 2003. Now, present day, there are just four. Four major banks for consumers to choose from — Citigroup, Bank of America, Wells Fargo, and JP Morgan Chase — and we’d bet good money that number will be three soon…

As HV points out, the implosion began in the 90s with the erosion of the 1933 Glass-Steagall Act, legislation designed, after the bank failures of the Great Depression, to assure that there was no repeat of that debacle; it caught fire after the passage of the 1999 Gramm-Leach-Bliley Act, which finally and fully repealed Glass-Steagall– allowing financial institutions to operate as commercial banks, investment banks and insurance companies under one cross-collateralized roof, on the theory that the banks would be too big to fail.

Well, they’re big all right.  But as the events of 2008 demonstrated, they can fail… indeed, as we do our best to keep from disappearing into the sovereign debt sinkhole in Europe and try to find a road to recovery from the Great Recession, we have to hope that we haven’t created banks that are too big to save.

Tis the season…

November 27, 2009

As we metabolize our way through the annual tryptophan haze, two contributions on a theme that’s been raised here before (c.f., for example,  here, here, and most fundamentally, here), two video commentaries on the current state of economic play…

First, via the ever-insightful Calculated Risk, a piece from the Versus Holiday Songbook:

And (on a very different note, but to the same end), via MonkeyBusinessBlog, a “soliloquy” from Wallstreetpro2 (alert:  after you get past the first few seconds– which are devoted to a pitch for precious metals– this video is, by reason of sustained use of profanity, not even nearly “suitable for work”… but then, it’s a holiday; we’re not at work):

While it’s easy to quibble with a detail here or there, and to fault the not-so-veiled xenophobia in the latter, it’s hard to dismiss the through-line.   But that it’s a problem of a scale befitting both the cynical nostalgia and the epic anger?  Quod erat demonstrandum.

So, what to do?

Increasingly, wise and experienced observers are arguing that financial institutions central to the economic infrastructure– banks, some insurance companies, a few huge employers (like GM and Chrysler)… any institution that government(s) can’t permit to crash– must not be allowed to become (or, in our current situation, to remain) “too big to fail.” Former IMF Chief Economist and MIT Professor Simon Johnson, Nobel Laureate Joesph Stiglitz (see also Bloomberg video here), former Federal Reserve Chairman Paul Volcker– all warn against letting institutions grow so large that they cannot be allowed to die.

Why?  Far from reducing the appetite for the kind of risky behavior that drove us into our current trough, the effective guarantee of a government bailout removes all moral hazard; if the truly-huge get to keep their winnings, but have their losses covered, why not take more and more risk?  And since the bankers and the markets all know that the guarantee is in place, the gargantuan incumbents enjoy a cost advantage– they can (as the first video reminds us) raise money more cheaply than their competitors (after all, there’s no risk)– money that they have used not to restore the flow of credit, but to acquire even more scale through acquisitions, to fund extraordinarily profitable proprietary trading…  and of course, to pay those infamous bonuses (and here).  All, while these behemoths raise their fees to their customers (see here, here, and here, for instance).

For my part, I agree– I hope that efforts like those of Vermont Senator Bernie Sanders bear some fruit.

But I fear that they neither go far enough to address inherent risk and the attendant issues of fairness, nor get at what is, at the core of our troubles, an extraordinary opportunity for growth…  and after all, a crisis is a terrible thing to waste.  More on that shortly…

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It’s no secret that the economic “unpleasantness” we’re suffering is having a redefining effect on company after company and industry after industry.  Neither is it any surprise.  But it’s been, in my observation anyway, peculiarly hard for managers to think effectively about the most fundamental challenges that times like these present.

It’s widely appreciated that when the going gets tough, competition gets tougher.  We all instinctively get it that extra pressure will force all of our current competitors to fight harder.  And we get it that this pressure might drive new competitors– competitors from distant geographies, players from adjacent sectors, the owners of new technologies– into our market.  But there’s a deeper and more deadly threat that too often goes unconsidered.

There are two questions that, when I’ve had the opportunity over the last twenty years, I’ve encouraged managers to ask themselves:

What if the thing that you do for a living– the product that your company makes, the service you provide– simply evaporates?

What if the boundaries of your market or you profession change out of all recognition?

Sadly, these questions are more timely today than ever.

At first, the presenting reason to challenge folks in this way was the unfolding impact of technology.

Back in the earliest parts of the Twentieth Century, the owners of ice plants faced a tough investment decision:  should they bulk up their central facilities and invest in more ice wagons (maybe even those new-fangled gasoline-powered “trucks”) to carry their product to the growing number of customers at the expanding edges of the towns they served?  Or should they build more smaller plants across their territories?…  It was a tricky call– and of course, it was altogether beside the point.  While they worried over the centralization-decentralization dilemma, George Westinghouse introduced the fractional horsepower motor; the electric grid spread to the houses that the ice makers served; those homeowners increasingly bought the refrigerators that Westinghouse’s technology made possible… ice became a feature of (someone else’s) product, and the ice companies were frozen out of their own markets.

More recently, but in a painfully analogous way, newspaper owners have felt that same deep freeze, as the internet has almost casually made the distribution of news a “feature,” at the same time that the web has begun to revolutionize news gathering.  We’re on the verge of seeing the same thing happen in (what we used to think of as) telephony, as voice is increasingly just a feature in a bundle the “fat” parts of which are video and data.

In industry after industry, the same kinds of dynamics were at play, the same sorts of pressures building.  And so I challenged managers to think through the ways in which their products/services could become someone else’s feature.  At best, companies can develop effective defenses; at worst, they can minimize their exposure.  Either way, it’s more profitable– and less disorienting– than being blind-sided.

Technology remains a key driver, but it is only one enabler of this kind of transition.  Changes in regulation or the law, nationally or trans-nationally, can do it, as can material shifts in social values.  And so can big economic challenges.

Indeed, these big economic challenges are (as we’re experiencing) particularly potent: they are causes in their own right; and at the same time, they amplify and accelerate the other drivers.  From financial services to automotive, sector after sector is being wrenched into new configurations, with new economics, new rules.

- Technology was already eating at the newspaper franchise, as it had the recorded music oligopoly; but the implosion of advertising revenue that accompanied the downturn has accelerated the erosion.

- While there’s still hope that nationalist reactions to the downturn will stop short of Smoot-Hawley destructiveness, It’s clear that we’ve taken a step backward on the path to a Flat World, as global trade has gotten harder and more more expensive.

- Strapped consumers’ newly-found conversion to discounts, bargains, and “economic” answers to their needs is amplifying the attraction of bundles, and accelerating their adoption. If it saves money, “good enough” is good enough.

…and on and on and on.

As incumbent companies and their managers contemplate these threats, there are a number of defensive stratagems they can and should consider… steps that basically come to strengthening their foundations.  But while necessary, this defense doesn’t begin to be sufficient against the threat of re-definition.  The only really effective response is innovation– is preparing to change one’s offer– one’s business– to accommodate, indeed to take advantage of, the forces that are presenting the threat.

I’ve argued before (see, e.g.,  here and here) that the times we’re in look all too likely to lead to a period of consolidation, concentration, even lock-in.   That’s certainly challenging enough for managers determined to stay in business– and thus to be the “eaters,” not the “eaten.”  But that’s only part of the challenge.  In times like these, managers need to be watchful of the forces that could steal their companies’ markets from beneath them.  And even before it’s clear exactly how– indeed, if– that’s going to happen,  managers need to be innovating to succeed on the other side, in the the newly-organized, newly-bundled market(s) that might emerge.

Innovation like this can feel especially expensive when cash is as tight as it is today.  But it is, for all the world, like health insurance:  in the end, much more expensive do without.

“This is a transformational crisis, and the world will certainly be different afterward.”

- Klaus Schwab, founder of the World Economic Forum, on the eve of this week’s annual meeting in Davos

If every challenge is an opportunity, then the economic crisis facing the U.S. and the rest of the world is knocking like a jackhammer.  And if opportunities like these are too precious to waste, we might all do well to pay (even) more attention than we are…

Even as I write this, the Obama team is doing it’s best to convince Congress that the Administration’s pending Stimulus Package will get enough money to to the neediest corners of the economy quickly enough to make the crucial difference.  Most of the money is likely ultimately to flow to existing companies– both because they’re screaming loudest for it, and because…  well, there aren’t really any alternatives that’ll be ready soon enough to be useful.  All of us have a stake in the Stimulus Package working, and fast.  But as we saw when TARP funds meant to enable banks to resume lending were used instead to fund the acquisition of other banks, we have a huge stake in how it’s done.

It isn’t enough simply to stop the decline in the economy; we need to prepare the way for a return to growth, growth that’s fueled by innovation that addresses new priorities like energy and environment, growth that’s inclusive of more and more Americans.  And if we’re going to accomplish that, we’ll need to tread very carefully to avoid an all-too-plausible outcome of the kinds of stimulus measures being proposed– an economy congealed into oligopolies…

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Time and Again

Companies like to grow.  When they run out of the steam it takes to build from within, they grow, if they can, by swallowing other companies.  In good times we call it “expansion through acquisition”; in bad times, “consolidation.”  In either case,  the big get bigger by eating the small or the weak, and the result is concentration– more market share/market power in fewer corporate hands…  so (given that monopoly is, strictly speaking, mostly illegal in most developed countries) this natural tendency is toward oligopoly, the rule of the few… a market concentrated in a few (usually 3 or 4) well-coordinated corporate hands.

What’s not to love?  Competition in an oligopoly is “gentlemanly”; the pace of innovation/change slows to a manageable– and managed– pace; ditto, prices; and in all but the very worst economies, everyone makes money.

But what’s good for vendors isn’t always good for consumers…  nor, to the extent that the competitiveness of a nation is at stake,  for a country.  And so, for most of the Twentieth Century the U.S. has had (and for most of the post-World War II period, Europe has had) safeguards against this kind of concentration and the abuses that it can bring.

One or both of two things can restrain, even stop, the concentration that spawns oligopolies: 1)  regulation and the law (restricting collusive or otherwise unfair behavior, limiting percent market share of any one competitor, etc.) and 2) disruptive technology (which creates options for consumers faster than dominant companies can buy it in and control it).  Over the last 20, arguably 30, years in the U.S., anti-concentration laws and regulations have been, overall, steadily weakened.  (Enforcement, especially over the last eight years, has also been painfully lax).  But until relatively recently, the pace and character of technological innovation has kept the marketplace largely competitive.  Technology– and the new entrants and consumers it has empowered– have outrun the ability of big incumbent companies to contain it.  There’ve been “islands of oligopoly”– telephony, cable, et al.– but (at lest, until 6 or 7 years ago) competition was still largely the rule.

Oligopolies work to serve their members, so they make it very hard for new entrants.  It’s only during periods (like the last 25-30 years, in contrast to the 25-30 that preceded them) when technology is “outrunning” the oligopolies, and is reorganizing markets, that new entrants flourish.  The irony, of course, is that, as these new entrants succeed, they begin themselves to crave oligopolistic privilege.  Microsoft is an extreme example (craving, as it did, monopoly); more “normal” would be cell phone providers (now for all practical purposes four, probably soon three, competitors where there used to be a dozen).

So, for the last decade, up through 2007, the pace of consolidation and market concentration quickened.  Then the credit bubble burst…  I want to argue that it’s even more important in down times than up to be watchful of concentration– because it is even more likely to occur, and potentially even more dangerous.

Good Times

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In times of economic expansion– like most of the last 60 years– all of this consolidation is driven by two fundamental engines:  the desire for oligopolistic control and the desire for growth.  We’ve talked about the lure of concentration and control; as to growth: as a company grows, its increasing scale naturally tends to reduce it organic growth rate.  A $100,000 increase in sales from a base of $500,000, is a 20% jump; that same $100,000 on a base of $10,000,000, is a puny 1%.  With growth, every absolute increment of growth– every extra unit sold, every extra sales dollar gathered– “buys” the company less in the way of percentage growth.

So managers– especially those beholden to public markets– start to look for ways to keep those growth rates up.  In earlier posts, I’ve talked about two deviant techniques that have been used:  financial engineering and plain old fraud.  But the main event is merger and acquisition:  it buys growth that can move the needle, and it keeps the acquirer on the path to (or better positioned within) an oligopoly…

It’s a long-established and widely-known fact that, measured on the stated criteria given at the time of the transactions, most– between 50% and 85%– of all acquisitions fail (see, e.g., the preface this pdf download).

But the stated reasons for an acquisition (usually “syngergistic” arguments, articulated in operational terms like “cost savings”) are rarely the underlying– the real– motivation.  The real motivations are the manager’s categorical imperatives– growth and control… even if (as is too often the case), the deal destroys shareholder value.

(Ironic side-bar: If consolidation to often destroys value, break-ups often create it:  Most famously, the case of the Standard Oil Trust: John D. Rockefeller was a rich man before the government forced that break-up of Standard; but essentially immediately afterwards, his wealth tripled [and he bacame the first billionaire], as his holding in the resulting smaller companies soared.  More  recently, after the 1984 “divestiture” of ATT– its devolution into seven RBOCs and a long-distance company– total shareholder value rose sky-rocketed…  only to settle back toward earth over the next twenty years, as the RBOC and the LD company re-consolidated into two… )

Bad Times

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The urge to oligopoly has driven a tremendous number of transactions; the scale of mergers and acquisitions hit half a trillion dollars worldwide in 2007.  But it fell in 2008.  These are not expansionary economic times. Still, concentration is in the cards.

If mergers and acquisitions in good times are largely, shall we say, imperial, then in times like these, they are  mostly by default.  A kind of “circling the wagons” consolidation in which the stronger players in an industry pick up the other players who don’t outright die.  (Witness the game of musical chairs that played out among banks and investment houses at the outset of the TARP chapter of the on-going bailout…)

The assets-in-question are worth less in a depressed economy like today’s, so the value numbers are down from their bubble-inflated highs.  But on a percentage-of-market basis, it yields extraordinary concentration.  And this, at a time when the scarcity of credit and investment capital is slowing the pace of innovation (whether measured in corporate R&D spending or in the number of start-ups with any kind of meaningful financing).

So when we come out of this downturn– as someday, of course, we will– who will “we” be?  What will the topography of our economy be?  Will we find ourselves in a rich and varied landscape of the sort that, I suspect, most of us believe is the “natural” lay of the land?  Or in a flatland, punctuated by a few tall rocks?  It’s likely, alas, to be the latter– concentration is a natural consequence of times like these.

Next Time

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The real question, then, is whether that flatland will be a Monument Valley-like desert, in which not much is likely to grow in the several years thereafter; or rather, more like a Montana mountain valley after a forest fire– where the barren burn turns quickly into a fledgling forest.

We have a big stake in the answer being “forest”; our kids have an even bigger stake.  When oligopolies emerge, they do all they can to retard competition and innovation; it’s their self-interest.  But in a growing economy, their impact is measured in “decreases in the rate of growth,” “slowing rates of innovation.”  On balance, things are still trending up.  And to the extent that new entrants succeed, that innovation trumps defensiveness, the oligopolies fade.

But when oligopolies form by default in troubled times, their self-protection can salt the earth around them, can make it hard-to-impossible for ferment– for start-ups or disruptive innovation– to take root…  and it’s from those seeds that strong growth in a recovering economy can emerge.

We have a huge stake in making sure that the more concentrated economy with which we’ll emerge from this downturn is as “un-oligopolistic”– as free and open– as we can make it.

What we know about the new Administration’s stimulus package is that, while it is aimed at creating jobs, it isn’t focused on starting new businesses, nor even to any terrific extent on fostering innovation.  If our deforested economy is going to come back in the rich way that can restore its vitality– and America’s place as a world leader in innovation and growth– it’s going to take more than the stimulus package currently provides– more, and different.

Because while money could help; rules matter more…  rules and regulations…rules and regulations and a government commitment to enforcing them.   If we are to insure that the implosion of competition through this downturn doesn’t resolve into a tar-baby of oligopolies, we have to bank on the new Administration taking up again the long-ago-dropped mantle of oversight.

It will be an important start simply to enforce the pro-competitive laws and regulations that remain on the books.  Then perhaps some of those that were sliced away to make way for the Bubble should be reinstated, or better yet, reinvented– we certainly need, for example, to reform intellectual property laws, to remedy at least some of the most egregious excesses of the last decade or so, and clear the way for a next generation of innovation and growth.

But as important as these remedial steps may be, it’s more critical, I believe, to be sure that the legal and regulatory tracks that are laid for emerging new industries (broadband distribution, biotech, green tech, et al.) run straight and true– straight and true to the national interest, to citizens’ interests.  By way of one obvious example, network neutrality is crucial; but there are dozens of other formative issues of this sort facing the Obama Administration and the nation, as well.

They are– we are– facing those issues at a time when there is monstrous pressure– and some reason– to channel financial resources and to cut regulatory slack to support incumbent companies, even as they consolidate, in order to protect jobs (a la Detroit).  And even then, the Administration can largely only lead; Congress has to be on board as well…  Which is all simply to say that it’s going to be very hard to resist these centripedal forces, to keep markets open.

As I’ve written before, I’m enormously encouraged by appointments like Julius Genachowski (FCC)  and Steve Chu (Energy).  But they and their colleagues have rough rows to hoe.  They are going to need our support, both directly, and probably more importantly, with our Congresspeople.

Indeed, readers might consider Larry Lessig’s and Joe Trippi’s Change Congress movement as a resource.  Unless we wean our representatives from the steady flow of large-company contributions on which they’ve come to depend, it’s a sad-but-safe bet that– our new President’s best efforts notwithstanding– we’re headed for Monument Valley.

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