Why We Need Entrepreneurs

Let's take a break from our usual programme and not talk about Islamic finance. Please don't take this the wrong way. It's not as if there is nothing to write about. There is. The world needs to be made aware of more appropriate ways to finance growth rather than the growth-on- steroids-induced-by-ever-increasing-debt kind. However, for the more conventionally inclined readers I want to propose a more, well, conventional approach.

In a recent interview maverick entrepreneur Richard Branson, he of Virgin Records, Airline, Trains etc fame, mused that the world just needs more Richard Bransons. He says that "Fortunes are made out of recessions. A lot of entrepreneurs get going in the economic depths because the barriers to entry are lower. ... There are a lot of Richard Bransons that will come out of the next three or four years."

For now, let's ignore the fact that Branson's Virgin Blue (listed on the Sydney Stock Exchange) has the worst-performing share in the Asia Pacific airline sector in 2009. I am therefore prepared to concede that the man has a great point. Maybe the US government, or any other government for that matter, should accept that whilst the downside of Schumpeter's creative destruction is the unplanned obsolescence of companies like GM and AIG, the corresponding upside is that something new replaces the something that is no longer fit for the purpose.

Plenty of commentators, but especially politicians, and professional economists, who should really know better, tend to forget that a real recovery in the economy will be led by new production and not phoney consumption. Of course it's phoney consumption that has been the problem all along. The present policy, priming the pump, also known as goosing the money supply, only leads to artificial growth. The result is the creation of false demand and the appearance of economic activity. Surely any half-way intelligent observer can see that this is simply growth for growth's sake. Unfortunately, this is what gets politicians elected, or re-elected.

New products and services, combined with changes in consumer preferences over time drive sustainable and healthy economic growth. And this is precisely what entrepreneurs provide.
But let's look at the problem in more detail.

In his book "Time and Money The Macroeconomic of Capital Structure" (New York: Routledge, 2001), Roger W. Garrison points to the source of the problem we are now facing. He says that as long as risk is effectively, if even only partially, concealed from borrowers and lenders, or even transferred to third parties, risk-taking will be excessive. As a result of this initial phase of excessive risk-taking an economy will boom. However, over time, actual losses will begin to change the perceptions of borrowers and lenders and finally impact innocent bystanders. The boom will then give way to a bust. We can thus conclude that a market system with partially concealed risks as well as partially transferred risks will be biased in the direction of excessive risk-taking. And we all know that gravity will exert itself in the end and over time excessive risks are converted into excessive losses. I think this pretty accurately defines our present economic difficulties.

Under the above circumstances, the typical policy response of trying to rescue whatever there is to rescue runs into the obvious problem of identifying what it is exactly that you trying to bail out. I would claim that at the present moment there is a shortage of anyone who can estimate how much all of this will cost. We can point to two specific reasons for this. Firstly, the companies to be rescued, eg GM, Citibank, and RBS etc are opaque. What I mean by this is that transparency is no match for financial innovation. The financial community, and not only in Wall Street but also in other financial centres around the world, spent an enormous amount of its intellectual and political efforts on concealing the risks it was creating. The cynic in me says that this was not an accident. In order to produce attractive profits the resulting products needed to be priced inefficiently. Secondly, globalisation has resulted in an incredibly interconnected global economy. As a result, the health of large companies very much depends on the health of the same network that created them. Last time I checked the network is in the emergency room and it is touch and go as to whether or not it will survive. Thus, unless the network can be nursed to health, the assets of these companies will remain severely devalued. To state the obvious, when risk is allowed to remain hidden for so long, the system is in no position to manage that risk when it finally resurfaces.

To make the indisputable clear to everyone, policymakers as well as the man in the street, in this situation we cannot, under any circumstances focus on the short term. Any stimulus large enough can and will arrest the economic collapse, at least temporarily. How do we, however, ensure sustainable long-term, organic economic growth?

Policymakers in particular need to understand that the boom just passed was artificial, that is policy-induced and thus unsustainable. Specifically for the US but a similar argument can be made for many other countries around the world, this means that monetary policy kept interest rates low for too long. In addition, the US had a tax policy that favoured debt over equity, and a regulatory policy that allowed financial institutions to operate opaquely. Also, the government's social policy pushed home ownership regardless of affordability. On the back of non-existing savings, ie equity, all these policies combined to create artificial economic demand that could only be financed with debt.

In addition, as a result of sophisticated financial engineering even more debt was being created. This drove asset prices ever higher. The end is predictable. The value of these products became grossly inflated compared to any inherent economic worth they might have possessed. After the bubble burst, their value dropped rapidly and precipitously. As always in these situations, the face amount of the debt used to purchase these assets did not adjust downward at the same time. This leaves a serious dilemma for the owners of these assets and their creditors. The assets that were purchased at inflated prices are now worth a fraction of what they were purchased for.

The predictable response by the government is based on conventional economic thinking. Implement policies that are designed to reflate the value of these assets. Unfortunately this means creating trillions of dollars of additional debt to, artificially (this word again) create the demand required to purchase these assets. As indicated above, debt begetting more debt is an exceedingly poor prescription for sustainable long-term economic growth. I believe that by employing this policy the government can, at best, provide a very short-term boost to the economy. This contrasts with the need for a solid, natural foundation for growth.

The debt-financed economy has proven to be a disaster. How can we reasonably expect debt-financed government demand to be any different? This is a policy doomed to fail miserably in the long run. Anyone who tells you something to the contrary is lying. Looking at the balance sheet of the US government, or any government for that matter, the economy will have to, at some stage, generate sufficient revenue, ie tax income, to pay for this spending spree. Confirmation again that economic demand will have to become savings-driven. The alternative is another spectacular collapse.

So what is my solution to this problem you ask. I fully understand that economically speaking the optimum long-term solution of allowing the economy to hit bottom and then letting it rebuild itself naturally is politically unpalatable. This would likely mean an unemployment rate of 15 or more percent and would take a huge human toll. It would, however, give the economy a solid, natural base from which to rebuild. In this scenario, the government's role would be to provide the right kind of safety net of financial support for its people, as well as the right job and educational training to enable them to survive the crisis, and prosper during the resulting economic recovery.

I do not think that propping up bad banks through a "good bank/bad bank" model supports positive long-term economic growth. I believe this would simply direct funds to the support of past unhealthy economic activity. My solution would be to start a new Economic Reconstruction Bank (ERB) that would make loans available for new productive projects and direct funds into healthy long-term economic activity. This is where the role of the entrepreneur comes in. In the present environment it is nigh impossible for them to raise sufficient funds to get their exciting new projects off the ground and create badly needed new employment. The ERB would be the perfect vehicle to funnel the necessary funds into the economy as it is a new entity with no excess baggage. My preference would also be to have it run as a private enterprise rather than a new government department. I just do not think that governments are terribly good at identifying commercially viable projects. This conviction is based on the fact that nowhere in history was a market's efficiency ever improved by government interference. Equally, you will not find an example where government control of the capital markets led to prosperity. In this respect, the government's track record is unblemished by success.

Let's give Richard Branson the last word. "Creative thinking during an economic downturn will allow an entrepreneur to thrive while more-established companies founder. There are enormous opportunities when there is a crisis. In a situation like this, it's absolutely essential to conserve cash. But don't let it sit unproductively. Invest and expand."

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