archive, economy, leadership

The Wrong Incentives – Lessons from the Economy

The current environment in the stock market and the economy can teach us some lessons that we can apply in the business world. Let’s recap our situation.

 

Timeframe

 

Issue

Government Action Bond Market Stock Market
2001-2007 Extended too much credit in the wrong places Pray it never ends, lower taxes (increase deficit) Weee! Weee!
2007-2008 Credit crisis, bank failures Win some (Bear), Lose some (Lehman); blame Republicans; bailouts/TARP Uh oh. Ouch!
2008-2010 Great recession Blame democrats; Fiscal stimulus, Fed monetary stimulus Weee! Blah
2011-2013 Economic growth = Blah Blame everyone, do nothing; Fed monetary stimulus on steroids Weee! (some more) Weee!
Future Unwinding the mess Who knows Can’t be good ???

So here we sit with a mess still on our hands – did you know that? Or have you been fooled into thinking everything is OK because you bought yourself that new Audi last year for Christmas and got a smokin’ interest rate. Or because you checked your portfolio for the 18th time during the month of February this year and calculated your annualized return as 75% – like you used to project your favorite player’s home run totals after the first day of baseball season.

Well it’s not OK. And the main reason is that we have not – through the entire timeline above – dealt with the structural issues in our economy and government finances. We have kicked the world’s largest can down a narrow, winding road full of potholes.

So the first lesson is – deal with problems when you first see them, since they don’t get easier to fix later (don’t kick the can down the road).

The second issue relates to perverse incentives. Notice that our stock market did great during a time of anemic growth over the last few years. The Dow Jones average is up 72% since January 2010. Why? Because the Federal Reserve has essentially fireman-carried our economy on its shoulders through the flames and falling beams. Its monetary stimulus program, through the use of its own balance sheet to buy bonds, is unprecedented in scope. And it has worked to mask underlying issues. Kind of like a drug that makes us feel less pain when we take it, though the underlying injury is still there.

The problem is, the fireman gets tired; or the drugs wear off, pick your allegory at this point.[1] At some point, it has to come to an end. As the Fed unwinds its bond positions, the bond market will suffer and interest rates will rise. So the stock market will suffer, as corporations have leveraged lower interest rates to survive the downturn and show record profits.

Normally, stocks do well when companies do well; but normally the reason companies do well is that the general economy is doing well. The Fed has said the unwind strategy will kick in as the economy gets better. So now the stock market (the drug addict) is in the position of actually hoping for a weak economy so it can stay on its drugs.

Lesson 2 could be re-stated as don’t put yourself in a position where you have to root against the thing you should be rooting for. Similar to my rule of never betting against the Denver Broncos, no matter how enticing the odds.

How does this relate to us in our corporate or business environment?

Lesson 1: Don’t kick cans. Deal with issues as they arise. Put mechanisms to spot trouble early and jump all over it to fix it – maybe it’s early indicators in employee or guest satisfaction scores; or a “small” fraud that you “assume” (hope?) is an isolated incident. Rationalization is your worst enemy here; sometimes you have to investigate small things just to make sure they aren’t big things.

Of course the best way to be in the position to deal with issues as they arise is to be prepared for them in advance. That means finding ways to increase institutional memory, and put in place policies and mechanisms to be prudent in financial matters, even when times are good. Ever notice how travel expense reports tend to get larger in good economies?

Lesson 2: Align interests and incentives. If you want to grow revenues, don’t constantly hammer your marketing folks about how much they are spending (you can try to influence HOW or WHERE they spend). Don’t tell your team that innovation is the number one focus, but then stifle creativity with volumes of policy and procedure over non-critical processes.

Finally, I hope, we can all learn a few lessons from the recent crisis, and not forget those lessons. I have consistently told folks that I believe the winners in the coming years will be those companies who remember best and longest what happened in 2008-2010. They will be the most prudent, most strategic, and sharpest operators.

[1] For an excellent discussion of the misalignment of the markets and the economy, and the coming “rehab,” see this blog post by Hightower Advisor’s Adam Thurgood: http://www.hightoweradvisors.com/who-we-are/hightower-advisors/las-vegas/blog/?p=338.

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