EXECUTIVES SHOULD NOT BE INDIFFERENT TO THIS TIME IS DIFFERENT

by: Issues: May / June 2010. Categories: Viewpoint.

Managing in a crisis, such as the one that now appears to be ebbing, will likely be more informed and even easier for those who read this highly-recommended book.

Carmen M. Reinhart and Kenneth S. Rogoff have written a book on the history of financial crises that is worth considerable executive time. This Time is Different (Princeton University Press, 2009) is a trip through eight centuries of financial crises covering five continents and 66 countries. You cannot read the book and not come away without a better sense of how to manage an enterprise, and especially its financial side, across the business cycle. The book will not hurt the management of your personal finances either. There are also insights that apply to management in general.

No book that goes back “expansively, systematically and quantitatively” to 12th century China and medieval Europe is written overnight. Happily for Reinhart and Rogoff, in a publishing world where timing can be everything, they hit the jackpot, arriving at bookstores in the early aftermath of the biggest financial breakdown since 1929. Foresight, based on their reading of events, undoubtedly played a role in their splendid timing; a bit of luck never hurts either.

In any event, we are all beneficiaries. We know more about what just happened to our financial system and why; we are better able to manage going forward, and we have perspective and context based on history and analysis, which is always more helpful than making it up as you go along.

Executives function in the here and now. Their job is to form a viewpoint on the emerging business environment, however murky it may be, and then make decisions on everything from the balance sheet to staffing levels to product mix. This book is terrific on the history of the aftermath of the kind of financial crisis we have just experienced. Executives are short-changing themselves if they form views on the future without incorporating the history of what happened previously under similar circumstances. Mark Twain agrees: “The past may not repeat itself, but it sure does rhyme.”

Reinhart and Rogoff are unambiguous on what the history of financial crisis tells them about causes and consequences: “We show that in the run-up to the subprime crisis, standard indicators for the United States, such as asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a country on the verge of a financial crisis – indeed, a severe one…What is certainly clear is that again and again, countries, banks, individuals and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits … Although private debt certainly plays a key role in many crises, government debt is far more often the unifying problem across the wide range of financial crises we examine … Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.”

Moving to the consequences of financial crises, the authors write, “The aftermath of systematic banking crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources… [In severe postwar crises] unemployment increases and housing price declines have extended for five and six years, respectively. Real government debt has increased by an average of 86 percent after three years… In the postwar crises it has taken almost four and a half years for output to reach its pre-crises level.”

Reinhart and Rogoff nicely connect the causes of financial crises to the consequences of the crises: “Most economies, even relatively poor ones, depend on the financial sector to channel money from savers (typically consumers) to investment projects around the economy. If a crisis paralyzes the banking system, it is very difficult for an economy to resume normal economic activity… This strong connection between financial markets and real economic activity, particularly when financial markets cease to function, is what has made so many of the crises we consider in this book such spectacular historic events”.

So executives, your future may look something like this: a slow, fits-and-starts return to normal economic activity, as the debt that caused the problems in the first place gets worked out; more often than not, disappointing growth; jobs, the lifeblood of an economy, will be tough to create and sustain; a big run-up in government debt; aftershocks in the economy, some quite large. Not fun.

A management lesson in all this: debt can be the same killer for an enterprise that it is for an economy. The balance sheet, liquidity and sound accounting matter.

This book is so detailed that it is easy to get distracted from the message that holds everything together. Reinhart and Rogoff: “We have been here before. The instruments of financial gain and loss have varied over the ages, as have the types of institutions that have expanded mightily only to fail massively. But financial crises follow a rhythm of boom and bust through the ages. Countries, institutions, and financial instruments may change across time, but human nature does not”.

Here there is also a nice management lesson. Enterprises have all kinds of issues: keeping ahead of the competition; employees who are not performing properly; managing product quality, pricing, promotion, distribution and service; adjusting to change; maintaining the confidence of the capital and lending markets; timing the finance and investment functions; identifying executives beyond their best before date, and being ready with a succession plan, controlling costs and more.

In the intensity of the moment, it is easy for executives to assume that the issues are all new ones. But on reflection, they have all been seen before. What caused them and will best deal with them is sitting right there in history just waiting to be tapped. When you are up to your ears in alligators, there is something quite soothing in focusing on “We have been here before”.

Learning about Reinhart and Rogoff’s title, This Time is Different, is itself fertile ground for executives. They explain it owes its origin to a meeting at the Federal Reserve involving market participants at the time of the Long-Term Capital Management fiasco. It seems that during the discussion one of the market participants explained, “More money has been lost because of four words than at the point of a gun. Those words are ‘This time is different’.”

Perhaps it is some giant psychological coping mechanism deeply rooted in our genetic code, but it seems that humans, when faced with obvious calamity, often go into denial, convincing themselves that averting action is not necessary on the grounds that “This time is different.” Denial is one of the most common yet one of the most dangerous responses to impending trouble. This time is different certainly explains the explosion in leverage and ultra high-risk financing and investment strategies that precipitated the financial crisis in September, 2008. It was obvious, ahead of September, 2008, that things were not going to go well; the only uncertainty was when and how badly.

“This time is different” rationalizes, at least for a moment, every issue an executive faces in running an enterprise. You cannot beat it for giving you a reason not to do anything. It legitimizes delay and inaction. Small wonder executives who deal decisively with problems are so valued. For more on the lethal side of denial, refer to a piece I did for Ivey Business Journal in November/December 2007 entitled, “Denial, Fear, Greed and Pride: The Four Horseman of the Executive Apocalypse.”

A close relative of “This time is different” and perhaps even more dangerous to enterprise health is, “We are different.” If ever you find yourself not dealing with an issue because “We are different” and somehow think you are immune to what causes everyone else to get into trouble, give your head a shake. No one is immune to the laws of running a good enterprise. “We are different” thinking, when it comes to justifying not dealing with issues, should be seen for what it often is: arrogant, short-sighted, lazy and just plain stupid.

An old one-liner about forecasting goes like this: “Give them a number or give them a date, but not both.” Reinhart and Rogoff explain why that is good advice: “What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fuelled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite. Such was certainly the case of the United States in the late 2000s”.

Timing financial accidents is difficult for the same reason as trying to time when a bad driver will have an accident is difficult: multiple factors are involved, including the behaviour of others. But, as they say, if the balloon is too full, the pin is always close at hand.

Managing an enterprise in an-accident-waiting-to-happen financial environment is no small trick. Prudence and discipline are the keys, but until the accident happens, prudence and discipline will be at cost to financial performance, relative to your more reckless and imprudent competitors. Enterprises that were careful in the run-up to the financial crisis had the last laugh; but they did not find it easy explaining their lower returns before the crisis.

At the day-to-day micro decision level, a group of enterprises can be one accident waiting to happen after another. For example, a weak balance sheet; waiting for the bank to call your loan; bad employee morale waiting for a strike; poor product quality waiting for a product recall; obsolete product waiting for the customers to leave en masse; poor financial control waiting for a fraud.

Small wonder the definition of a good executive includes being able to identify accidents waiting to happen and the courage to take corrective action. The trouble, of course, is that saving people from problems they do not know they have is rarely rewarded, as it should be. Regrettably, heading off a crisis before it happens is not recognized in the same way as arriving in the midst of a crisis with a solution.

This time is different is a very solid piece of work. It imparts knowledge that executives should have. It is context for decision-making that will help keep enterprises and government out of trouble. Had there been more appreciation of the points Rogoff and Reinhart make before the fact, the most recent financial crisis would surely not have been as deep.