Clever Geek Handbook
26 January 2026

12

Recommendation

The Gallup Organization has studied employment and management issues for decades. Rodd Wagner and James Harter distill its findings into 12 pivotal concepts that managers can use to develop and keep great employees. These range from creating strong teams to managing them so that they support corporate goals. BooksInShort lauds the way the authors illustrate their points with real-life examples. They show how and why managers implement each of the 12 factors, which are usefully broken down into business cases. The 12 principles are nicely interconnected. Each one explains a way to provide employees with direct management support. This means guaranteeing their loyalty to your firm by giving their jobs a context, providing a culture that supports their friendships, offering them clear career paths, and creating opportunities for them to grow and develop as people and employees. The authors explain why salary does matter, but also why it is not the most crucial aspect of employee management. They demonstrate how the worst managers view everything in financial terms, whereas the best managers give of themselves to support their people.

Take-Aways

  • To create a peak job experience, build a successful, committed team.
  • Supporting your employees begins with providing the tools and materials they need.
  • Sincere, frequent praise is a powerful, cost-effective employee development tool.
  • Help employees connect by explaining how their jobs support the firm’s goals.
  • Seek employees’ opinions and actively listen to them.
  • Employee satisfaction and achievement strongly correlate with having close friends at work.
  • Use goals to help employees excel and travel their own career paths.
  • Knowing your job also means learning how to handle extraordinary circumstances.
  • When pay becomes a point of conflict, you have failed to handle other management issues.
  • To be a great manager, support your employees instead of misusing them.

Summary

Prosper Through Your Employees

Yes, people come to work for a paycheck, but employees feel a big difference between putting in time going through the motions of the job, and being part of a high-performing team.

Now you can replicate the elements of a great work experience for your employees. After more than 10 million workplace interviews, Gallup found 12 concepts that great managers use to create quality employee experiences. These principles do not require rare talents or extreme performance. You simply have to apply them.

1. “Knowing What’s Expected”

Employees want to know what they are supposed to do to accomplish their assignments. A job description alone doesn’t ensure that an employee will perform well, and an employee can’t let the company down because his or her job description does not spell out necessary tasks. As a manager, coordinate with your staffers to make sure that you and they understand their jobs’ full implications, how their work connects to results and who to call when outside-the-norm events occur. Consistently doing a good job means performing well under varying, sometimes unpredictable conditions. Great managers enable their people to feel proud and empowered. Their leadership helps employees connect with their colleagues and their organization.

2. “Materials and Equipment”

Nothing is more frustrating than trying to perform a job without the right gear. Employees must be ready to work, but managers must facilitate that work by making sure that staff members have the equipment they need when they need it. Too many employers make the mistake of dictating work to their employees instead of listening to them and providing the resources they request. Front-line workers understand their jobs better than anyone else and can help the company improve by explaining what they’ve learned. When you implement employees’ suggestions, you reinforce positive behavior, garner good ideas and encourage their implementation. Conversely, if you pressure employees to work without timely access to needed materials or gear, you spur them to hoard and misapply resources. Such shortages increase stress and lower job satisfaction. Great employees love to be challenged, but they also want proper supplies, support and appreciation.

3. “The Opportunity to Do What I Do Best”

The intersection of what a person is good at doing and enjoys, and what his or her company really needs is the “sweet spot” of employment. A manager is responsible for aligning people with the jobs that are closest to their sweet spots, then helping their positions grow and develop into jobs they might not even realize they can do well. Helping a struggling employee is another pivotal management responsibility. Companies sometimes place good people in jobs that are wrong for them. Recognize this and redirect misplaced staffers so they can thrive. Act before they hurt the company or lose their confidence. Whether the person needs training or reassignment, handle such steps as opportunities, not as the results of failure.

4. “Recognition and Praise”

Showing appreciation for your employees is one of the most powerful tools at your disposal, so use it generously. Your employees will be delighted and you will get to know them more deeply, which enables you to manage them better – all at no cost. Wise managers know the power of frequent pats on the back and recognition. Caution: If you try to get by with insincere praise or a few shallow compliments, it will backfire. Sincere praise triggers a pleasure response in the brain, a feeling people want to repeat. If you evoke that response a few times, employees will act positively to gratify their hunger for more praise and that pleasure response. Being stingy with praise is a false economy. The rewards of positive feedback far outweigh the time and energy you invest.

5. “Someone at Work Cares About Me as a Person”

Great managers know that people are not machines. Although Henry Ford lamented that he had to hire a whole person to get the pair of hands he wanted, you know that getting the full benefit of each employee’s creativity and passion is much more valuable than hiring someone who merely fulfills a job’s required tasks. However, people need connections to other people. Job satisfaction and performance increase when employees know that their colleagues care about them and have a genuine interest in their lives. No matter how hard you push, you cannot force great work from people you debase or abuse. And your organization cannot compete if your employees provide only perfunctory performance. They must bring all of themselves to work. To nurture their involvement, create an environment that recognizes that real people have lives outside of work. When people feel that their employers respect their dignity, they work harder.

6. “Someone at Work Encourages My Development”

Human beings are not static. When managers give employees opportunities to grow and pursue individual career paths, employees are willing to stretch to accomplish big goals. If you provide them with mentors, their enthusiasm becomes job-performance rocket fuel. People learn by watching masters and imitating what they see. When a mentor shows an employee how to do a task and how the task connects to results and rewards, the employee develops confidence in the mentor, in himself or herself, and in the company’s ability to recognize great performance. Your self-confidence and your confidence in your company will inspire your employees.

7. “My Opinions Seem to Count”

You will undo all your progress if your employees get the message that their viewpoints do not matter. Do not wait for them to push into your field of vision. Ask for their opinions about their jobs, the company and your management. You don’t have to agree with them, but don’t disparage anything they say. Simply by acknowledging them, and demonstrating that you hear and understand what they are saying, you give them powerful affirmation. They will likely give you ideas and information you can use to improve your team’s performance. When that happens, praise the person and the team.

8. “A Connection With the Mission of the Company”

Don’t be satisfied teaching people solely how to perform their tasks. To make each staffer’s work more meaningful, demonstrate how it connects to the team’s goals and the company’s performance. People who realize that their tardiness or sloppiness could compromise another pivotal operation will perform their jobs even better. In fact, they will go out of their way to deal with anything that compromises their ability to do good work. They won’t wait passively until someone else fixes a problem; they will contact someone who can fix it. As a manager, you want this kind of personal investment.

9. “Coworkers [Are] Committed to Doing Quality Work”

When you ask people to describe their peak employment experiences, they usually cite working on a great team. This is because high-performing teams encapsulate the most important aspects of a meaningful job experience. Great teams know what they are doing. Team members support each other. They coordinate their tasks, bond and recognize each other’s contributions.

“Matching a person to the right job, or a job to the right person, is one of the most complicated responsibilities any manager will face.”

Your management approach can foster or impede your team’s success. No matter how well things are going, never stop managing. Continually take the pulse of the team and each team member. Be ready when team membership changes because of promotions, moves or departures. Have a possible list of replacements in mind, so you can minimize the sense of crisis or disruption such changes can cause.

“There is no such thing as an inherently meaningless job. There are conditions that make the seemingly most important roles trivial and...make ostensibly awful work rewarding.”

Keep your team committed by helping members stay focused on their success rather than on any disruptive events. Dealing with outside issues is your job.

10. “A Best Friend at Work”

Employees who have close friends at work have the lowest turnover and the most positive performance ratings. Polls with sentences that use the specific phrase “best friend” have the highest predictive power for employee performance. Having deep friendships with colleagues greatly enriches a person’s work life. Friends can communicate more freely, exhibit more trust and support each other.

“‘Knowing what’s expected’ [means having] a detailed understanding of how what one person is supposed to do fits in with what everyone is supposed to do.”

Arriving at work and entering a friendly atmosphere is much more inspiring than coming into a sterile, hostile interpersonal environment. Who wants to feel invisible or disliked? As a manager, foster friendships and support employees who are the least able to find friends for themselves.

11. “Talking About Progress”

Unless you are in a position to decide your company’s appraisal methods, you have to use the tools the firm gives you. However, you can choose how effectively you use them. Too often managers treat appraisals as trials to overcome. But done right, appraisals can be the culmination of employee development and career progress. Work closely with your employees so that nothing in the appraisal is surprising. Spend time together preparing goals for the next year that represent not only expected and stretch performance, but also a step forward on the individual’s career path. All employees should know where they are headed, and how their performance enables or hinders their progress.

12. “Opportunities to Learn and Grow”

Although a few people prefer learning one job and staying with it, most people regard such monotony with a special kind of horror. Nearly everyone wants to learn and grow. However, many employees will avoid taking risks if they perceive that the company will punish them for even the smallest failures. To reap the rewards that come from helping employees improve, even with some risk, create an environment that supports risk taking and the inevitable failures that accompany it. Back your staff members in learning needed skills and securing educational opportunities.

“Managers who fail to [use] positive feedback are not only handicapping their own managerial effectiveness, they also diminish the power of the salaries they are paying.”

Each person should become familiar with several jobs within the team’s scope so the group has coverage during absences or transitions. Your team members will trust and appreciate you more if they know you will help them advance and not hold them back for selfish reasons. Be ready for change due to the growth you encouraged rather than trying to stunt growth in order to prevent change – not that you can prevent it, anyway.

“The Problem of Pay”

For most employees, salary is fundamental. However, pay usually is not a job’s most important characteristic. If you have all 12 of the managerial elements in place, you rarely will lose a staffer over money unless your pay scale is very uncompetitive. Wages become the most contentious issue when the 12 elements are not managed well. Employees can’t change a toxic culture, but they can demand more money for enduring it. Yet, pay will not cure performance problems, and raises lose their motivational power quickly. Even bonuses can become an expected part of a pay package, so their absence can cause problems.

“Before a person can deliver what he should as a manager, he must first receive what he needs as an employee.”

Be aware that employees talk about their salaries. Trying to discourage them from doing so makes things worse by fostering rumors. Develop a rational pay plan that rewards great work without overpaying (easier said than done). To keep great people without breaking the bank, implement the 12 management concepts.

“The Heart of Great Managing”

All CEOs say employees are their companies’ greatest assets. This praise is usually meaningless, because these executives’ actions contradict their words. Gallup’s findings show that the managers who elicit the most out of their employees are those who give their employees the most – not necessarily in terms of wages, but in humanity, dignity, and support. The managers who derive the best financial performances from their employees are the ones who are the least motivated by money. If you work hard for your people, they will work hard for you; ultimately, everyone will benefit.

About the Authors

Rodd Wagner is a Gallup Organization principal and an expert on high-performance management and the interplay between employee commitment and company performance. James K. Harter, Ph.D., a chief scientist at Gallup, focuses on its international workplace-management program. He has written or co-authored more than 1,000 research studies.

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12

Book 12

The Elements of Great Managing

Gallup Press,
 


26 January 2026

How to Read a Financial Report

Recommendation

Taking the time to learn the basics of reading corporate financial statements can help you become more informed about your investments, your job and your business decisions. John A. Tracy provides a clearly written guide to core financial reports. He shows you how they fit together and why they matter. You will gain confidence as you work through the concepts he explains and begin to use what you learn to dig into the financials of familiar companies. In the hands of a lesser teacher than Tracy, these concepts could be confusing. In fact, the whole discussion could become a powerful soporific that descends on your mind like a fog. Instead, this book makes it interesting and clear. Everyone needs some financial awareness. BooksInShort believes that this valuable introduction is a good starting point for learning to read real business data. New managers may find that Tracy opens a door and invites you to come into a room that was previously locked.

Take-Aways

  • A company’s core financials reports are its balance sheet, and its income and cash flow statements.
  • These reports interconnect to provide a clear view of a company’s performance.
  • Accrual accounting matches revenues and expenses within the correct time period.
  • To see a company’s profitability, look at its income statement, not its cash flow.
  • The balance sheet is a snapshot of the company’s assets, liabilities and equity.
  • Footnotes illuminate the choices and assumptions of the reports’ preparer.
  • Ratios, such as price to earnings or earnings per share, can help you understand the financial figures better.
  • The law requires U.S. companies that publicly trade debt and stock to have full independent audits.
  • Companies can choose among accounting methods, but must stick with a consistent choice.
  • Get information from other sources to supplement your use of financial reports.

Summary

Core Financial Reports

Managers often have a feel for how their businesses are doing, but sometimes their impressions are off the mark. When you learn to decode well-prepared financial reports, you will be much better equipped to understand the realities of a business’s position, what it has been doing correctly and where it faces challenges. Reading financial reports with an understanding of how the accountant prepared them will give you an even clearer picture. When you compare reports from several companies in an industry, you will know their conditions and how they rank among their competitors.

“Financial statements are the primary and only direct source of information for the profit performance of a business, and for its financial condition.”

The statement of cash flows shows exact cash inflows and outflows to present a firm’s cash needs. The report shows the cash received from customers and other sources, and how it was used. Most managers focus on this report. However, you cannot use it to determine profitability or financial condition. Profitability is reported on the income statement, which begins with total revenue from sales and then steps through a series of deductions: cost of goods, operating expenses, depreciation, taxes and other business costs. This report also lists certain key numbers, such as gross margin, earnings before taxes and net income. Gross margin shows if the company can sell (and buy) products with sufficient margin to cover its business expenses and still remain profitable. Net income is the bottom line profit and tells shareholders what their investment is earning.

“The three basic financial statements fit together like tongue-in-groove woodwork. The income statement, balance sheet, and cash flows statement...interlock.”

The balance sheet lists the firm’s assets, balanced against its liabilities and the owner’s equity. They must balance to zero. This is easy, because the owner’s equity is simply the difference between assets and liabilities. It can be a positive (you hope) or negative number. The balance sheet does not show cash flows or profits. It presents a static snapshot of the business at a specific moment. To sum up the big three: the balance sheet shows assets and liabilities; the income statement shows profitability; and the cash flow statement lists how much cash a business is creating or consuming. The next step is to understand how these reports interconnect.

Sales, Accounts Receivable, Cost of Goods and Inventory

To see interconnections, trace the way processes described by the numbers on one report drive the numbers on another. For example, sales revenue on the income statement directly relates to accounts receivable on the balance sheet. Cash deals will show in the cash account, but selling on credit increases the accounts receivable. Accounts receivable shows an average collection period. If it rises without a matching growth in sales, that may reveal a collection problem. The costs of goods sold, shown on the income statement, drive the balance sheet’s inventory total since the goods you buy are inventory until you sell them. If the report shows rising inventory but dropping sales, you may need to cut purchasing. Check to see if this is a problem in spots or a general inventory issue.

“Financial condition is communicated in an accounting report called the balance sheet, and profit performance is presented in an accounting report called the income statement.”

Holding inventory ties up cash which is costly. If you borrow to buy inventory, you must pay interest. If you use cash, you’re spending money you could invest. Try to maintain the lowest level of inventory possible without losing sales or breaking delivery commitments. Determine the length of your average inventory holding period. If your annual cost of goods sold is $32 million and your inventory on hand is $8 million, you turn inventory over about four times a year, so you are holding it 13 weeks. Figure out the optimal period. Check competitors’ reports to see if your inventory management leads or lags.

Operating Expenses, Depreciation, Interest and Taxes

Most business expenses are recorded and paid within a single accounting period. However, some are paid later or in a series of payments. The goal in accrual accounting is to match and realize revenue and expenses. When you incur an expense, you create a liability. If you don’t pay expenses immediately, they become part of accounts payable. When you pay an expense in advance, say for insurance or taxes, create a holding account that you decrease each month as you “use” the insurance or taxes. Match the expense to the time period and revenue that aligns with its consumption. Companies accrue certain liabilities (product warranty costs, accumulated employee sick days) in expense payable accounts, but not in accounts payable. They also track and register interest expenses because of their tax implications.

“Sellers that extend credit set...prices slightly higher to compensate for the delay in receiving cash...a small but hidden interest charge is built into the cost paid by the purchaser.”

Use depreciation and amortization to show the costs of assets with extended useful lives, such as buildings or cars. The asset depreciation that the U.S. federal income tax schedules use for tax purposes may not match your experience with the useful life of equipment or property. Most companies also use these schedules for their financial statements. Some firms use accelerated depreciation schedules to front-load the expensing of these assets and to realize greater tax savings in the early years. Maintain a depreciation schedule for each relevant asset. Don’t lump them together. Most firms use a companion account for each asset to show its accumulated depreciation and decrease its net value on the books. Likewise, you can manage most business taxes, but you must account for them. A firm that earns no taxable income pays no corporate income tax. With planning, you can reduce and postpone taxable income. Use “earnings before taxes” to calculate how much tax you owe.

Net Income and Retained Earnings

Net income is your profit after expenses. If your firm retains the net income, add it to the owner’s equity, as shown in two accounts on your balance sheet: 1) invested capital and 2) earnings retained by the firm while it is operating. A going concern puts retained earnings on its balance sheet. Paying dividends reduces these earnings. To derive earnings per share (EPS), divide net income by the number of issued shares. A company with a million outstanding shares and a net income of $5 million has an EPS of $5. If the business closed, it would sell its assets, pay its debts and distribute any surplus to shareholders.

Cash Flows

Many people wonder why cash flow and profits are not the same. Imagine if you sold $1 bills for 90 cents each, you would have an immense cash flow as long as you supplied the dollar bills. But, you would lose 10 cents per dollar sold, so you would not earn any profit. The income statement and the statement of cash flows thus tell you different things. You must earn a profit and turn that profit into cash to realize its maximum value. If it sits in accounts receivable, it loses value daily because of the time value of money.

“Business managers have a double duty – first to earn profit, and second to convert the profit into cash as soon as possible.”

Profit is generated from internal cash flows. A firm may invest some cash or put it in an interest-bearing account until it needs money to fund the business. The earnings you make from interest and investments are accountable cash flows, but not profit. A rapidly growing business may have a negative cash flow, even if it is profitable, just as a shrinking firm that is unprofitable might show positive cash flow. People use the term “cash flow” loosely. Do not be deceived by managers who try to hide profitability issues by pointing to their high cash flow.

Using Footnotes

Footnotes are an important but overlooked part of every report. Almost always poorly written and hard to parse, they hold crucial data that can affect how you interpret the numbers in the financial statements. As an ordinary investor, you don’t need to be as concerned about the notes as a securities analyst must be. First, you are unlikely to unravel some fancy management misdeed. Second, the pros will read the report so closely you can usually ride their analytical coattails. Do read the footnotes and try to get them, but you don’t have to read all that small print over and over again.

Accounting

Certified Public Accountants (CPAs) prepare financial reports according to “generally accepted accounting principles” (GAAP) and Financial Accounting Standards Board (FASB) rules. Auditing firms have independent accountants who test reports against company data. Their statements that reports are prepared correctly and represent a firm accurately are important because investors cannot look at company books themselves.

“Profit is a vital source of cash inflow to every business. Profit is internal cash flow – money generated by the business itself without going...to external sources of capital.”

Auditing is costly and time-consuming, but it finds honest mistakes so the company can fix them. Auditors uncover deliberately misleading data or fraud. Publicly traded corporations must audit their financial reports. Purchasers usually audit private firms before buying them so they understand their value. Learning to read an auditor’s careful wording on these statements is subtle work, but worthwhile. CPAs aren’t there to ferret out fraud, but they do offer qualified statements when they find things amiss. Notice what they emphasize. After public firms and their accountants were involved in huge abuses, the U.S. passed the Sarbanes-Oxley Act to stem such fraud. Still, dishonest people will find new ways to deceive. Invest cautiously; if you are worried, take action.

“Most businesses follow the income tax methods in their financial statements.”

Two talented, well-trained, honest CPAs can come up with slightly different financial reports for the same firm;just as two cooks with the same recipe create dishes that taste a bit different. CPAs choose how to follow the rules while presenting a clear picture of a firm’s activities.

When firms can choose among accounting methods, they must pick one and stick with it. They can’t change methods seeking better results. The IRS and investors frown on such “flip-flops.” Follow a firm’s reports over time. If it over- or underreports a matter in one period, it will compensate later (unless there is fraud).

Issues with Cost of Goods and Depreciation

As you make sales, you remove items from inventory and add new ones that you buy. But did you sell the items you bought a while back or your most recent purchases? This affects profitability. Most firms use the LIFO method (“Last In First Out”), because it usually lowers gross margins, reported profitability and taxes.

“Creditors and investors frequently are stymied by poorly written footnotes. You really have only one option, and that’s to plow through the underbrush of troublesome footnotes, more than once if necessary.”

The other options are FIFO (“First In First Out” – as if all inventory has an expiration date) and the “weighted average cost” method. Select the one that matches how your company sets prices. Don’t seek short-lived gains based on accounting peculiarities. When you liquidate a product from your stock using LIFO, if prices have gone up, “old” items cost less than current items, increasing profits. This effect is called “LIFO liquidation gains.”

“Business managers, lenders and investors, quite rightly, focus on cash flows. Cash inflows and outflows are the heartbeat of every business.”

Depreciating a long-lasting asset is normal, but accounting theory says to add and depreciate certain costs, too. Yet, these costs are usually immediately expensed. Consider accelerated depreciation. Firms chose it reflexively, but over time it can fail to match costs with revenues.

Useful Ratios

Investors and lenders use financial reports to study your company’s performance. Some numbers interest them more than others. Often, they will compare one balance sheet item to another as a ratio to check receivable collections or short-term solvency. Investors want to know debt versus stockholder equity, or return on sales. To get the return on sales, they divide net income (if it’s a positive number) by sales revenue.

“Many investors and managers don’t seem...fully aware of the limitations of financial statements.”

Investors also want to know the stocks’ value and how many dollars they have to invest to get one dollar in earnings. Calculate this price to earnings (P/E) ratio by dividing the stock price by the EPS. A P/E of 20 means investors pay $20 for $1 in earnings. The list of useable ratios is endless.

Management Accounting

While financial accounting prepares reports for external use and tax accounting prepares statements for taxing agencies, management accounting provides data to internal customers. Its goal is to help decision makers make the right choices and help the company meet its goals. Management accounting is not regulated. While various consultants teach different approaches, you are free to develop the information standards and delivery methods you prefer. Focusing managers on strengthening the firm’s profit position makes sense. Help them understand their contributions to overall profit. Tie that lesson to goals for managers and their departments (easier said than done).

“Used intelligently, financial reports are the indispensable starting point for investment and lending decisions.”

Most financial reports are reliable and prepared with integrity. Track certain key numbers, such as sales and gross margin, for several years. If you see drastic changes, get alarmed. Never take financial reports at face value. Use them as tools, but seek other sources of information so you can put financial reports into perspective and deepen your understanding of the company.

About the Author

John A. Tracy is emeritus professor of accounting at the University of Colorado at Boulder. He has written several books on accounting issues.

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How to Read a Financial Report

Book How to Read a Financial Report

Wringing Vital Signs out of the Numbers

Wiley,
First Edition:1980
 


26 January 2026

The Trillion Dollar Meltdown

Recommendation

In this excellent, highly readable book, Charles R. Morris combines legal and financial experience with literary craft. No ideologue, no partisan and certainly no salesman, Morris traces the roots of the 2007-2008 mortgage securities crisis to its distant origins in the 1970s. He argues that policy missteps under the Nixon, Ford and Carter administrations, when Arthur Burns chaired the Federal Reserve, led to dollar debasement. He contends that the decline of America’s currency and its business sector at that time led in turn to the Reagan administration’s zeal for deregulation and Chicago-school economics. He details his belief that Alan Greenspan’s policies took America from a relatively healthy financial status to a position perhaps as dire as in the late 1970s. Morris also reveals the privileges enjoyed by an out-of-control financial services system. BooksInShort found this to be a trenchant and provocative read.

Take-Aways

  • The inflationary 1970s were a decade of fiscal misery for America.
  • Arthur Burns chaired the Federal Reserve for much of the 1970s, presiding over 37 months of negative interest rates.
  • Americans embraced deregulation and its early benefits with excessive zeal.
  • Deregulation contributed to agency risk: Financial firms could make risky bets and reap profits if the bets paid, but leave the losses to be socialized if the bets failed.
  • Excess reliance on questionable models has contributed to several financial crises since the 1980s.
  • The year 1994 offered an uncanny precedent for the 2007 mortgage crisis.
  • In the ’70s and early ’80s, Fed Chairman Volcker brought inflation under control by taking advantage of all instruments at his disposal.
  • His actions offer a model for steps the Fed should be taking now.
  • The U.S. financial sector shows no sign of admitting the full scope of the economy’s current problems and no zeal for Volcker-like resolve.
  • Failure to tackle these problems could result in a long, lingering financial malaise, like Japan’s.

Summary

Two Roads and a Choice

In June 2007, two Bear Stearns hedge funds ran into trouble after a downgrade. The firm had to pay billions to assume the hedge funds’ mortgage-backed securities holdings. Shortly, the contagion spread as banks worldwide took hefty write-offs. Central banks in North America and Europe opened the money spigot, to little avail. Even experts seemed to have no way of predicting how far the value of complex, mortgage-backed securities could fall – and how much damage their collapse would cause throughout the financial system. History marked out two roads and gave policy makers a choice. Then-Federal Reserve Chairman Paul Volcker took the first road in the late 1970s and early 1980s when he courageously, forthrightly grappled with the challenge of wringing inflation out of the U.S. economy. He restored confidence in America’s financial institutions. Japan took the second road after the collapse of its 1980s bubble. Japan did not admit its problems or deal with them straightforwardly. Instead, it concealed the problems, avoided responsibility and failed to take its medicine. As a result, Japan’s financial sickness lingered for a long time. Indeed, its financial system still has not quite recovered. In the present mortgage crisis, America seems to be following the Japanese course.

Liberalism: In Dollar Terms

From 1973 to 1982, the U.S. registered dismal economic growth, high inflation and a collapsing currency. Its industries were uncompetitive in domestic and international markets. Oil exporters drove up prices, but only in dollar terms. Calculated in gold, the price of oil was rather stable. Foreigners bought up America’s corporate crown jewels. This decade brought stagflation and the misery index, the sum of the inflation rate and the jobless rate. This happened for three reasons:

  1. Business failure – Major U.S. businesses embraced anti-competitive market sharing arrangements throughout the 20th century. Such arrangements in the steel industry, for example, provided no incentives for technological innovation. Labor participated in the system for a share of the spoils. Instead of focusing on core businesses and learning to create more value in them, corporations diversified willy-nilly. They became unwieldy conglomerates. Business schools taught students how to administer large organizations bureaucratically. Executives knew little of the shop floor. U.S. firms were sitting ducks when Japanese and German competitors entered the market in the 1970s.
  2. Demographics – The baby boomers were ready to go to work in the 1970s. They were young, unskilled, inexperienced and unproductive. With that kind of labor in abundance, wages fell. Cheap labor and expensive capital resulted in less investment.
  3. Bad economic management – Inflation soared in the early ’70s. Currency traders attacked the dollar. The standard defense would have been to increase interest rates, but that would have courted recession. Instead, President Richard Nixon reduced taxes, controlled wages and prices, and closed the gold window, effectively destroying the Bretton Woods system. Then-Federal Reserve Chair Arthur Burns increased the money supply. Growth surged; Nixon won re-election in 1972. But the long-term damage was severe. Floating the dollar while increasing the monetary supply led to a debasement of the currency. By the late ’70s, inflation hit double digits, the dollar was tanking and economic output was falling. Faith in the government’s ability to micromanage the economy faded. The time was ripe for a new ideology.

Wall Street Comes to Chicago

The new ideology, “Chicago-school” economics, which supported free markets, took America by storm. To some extent this was because pundits mistook correlation for causality. A 1978 reduction in the capital gains tax preceded a sharp increase in venture capital and investment, helping such startups as Apple, Compaq, FedEx and Sun Microsystems, among others. But did the tax cut lead to the investment boom? No. Most of the new capital came from tax-exempt pension funds, so the tax cut was irrelevant.

“The American financial sector today is far more powerful than it was in the 1970s. And to date, its response to the looming crisis has been, overwhelmingly, to downplay and to conceal.”

Another apparent but illusory confirmation of free-market ideology was the correlation between President Ronald Reagan’s decontrol of oil prices and the subsequent fall in the price of gasoline. Analysis after the fact suggests that the fall in energy prices had more to do with an increase in energy efficiency throughout the economy – indeed, worldwide. Energy efficiency meant less demand for oil, even as political and economic stresses were breaking the OPEC cartel.

Paul Volcker and the Fed

Paul Volcker took the helm of the Fed in 1979. He knew that his job was to slash inflation and put the financial system in order. Monetarism, a theory developed by Chicago school economist Milton Friedman, said it was possible to control inflation simply by controlling the money supply. Volcker made a public commitment to monetarism. Did it work? Not really. In fact, the members of the Federal Reserve Open Market Committee were not even sure what the money supply was. New financial inventions made it hard to keep track of what was – and what was not – money. Volcker’s announcement had strong PR value and he followed up by relentlessly, aggressively using every available lever to ratchet down inflation. Interest rates hit previously unimaginable heights. Recession was inevitable, but the U.S. accepted it as the price of recovery.

Mixed Policy Record

Presidents claim credit for good economic circumstances, but don’t deserve as much as they take. Reagan believed in lowering taxes and deregulating markets. His economic legacy includes the boom in leveraged buyouts (wherein acquiring holding companies purchased and dismantled major corporations, selling off their component parts), which early on did a good job of cleaning the deadwood out of America’s major corporations. After about 1985 though, LBO frenzy got out of hand and the market eventually collapsed. Reagan-era deregulation contributed to the savings and loan debacle, as entrepreneurs took advantage of deregulation to loot financial institutions and leave taxpayers on the hook. The era’s lesson is that letting market forces exercise creative destruction does have some benefits, but deregulation also bears associated risks.

“That is a path to turning a painful debacle into a decades-long tragedy.”

Similarly, President Bill Clinton and his treasury secretary Richard Rubin claimed credit for an economic boom in the 1990s. However, the boom had more to do with demographics. Productivity increased because the inexperienced baby boomers of the 1970s had become seasoned practitioners of their professions and trades. They learned from Japan and took advantage of new technology. With military spending declining and Social Security tax surpluses building, a boom was more or less inevitable. Then the Clinton era gave us the dot-com bubble.

Bubbles

Three 1980s and 1990s crises – involving portfolio insurance, collateralized mortgage obligations and the Long Term Capital Management hedge fund – prefigured the crisis of 2007.

“For connoisseurs of misery, the ten years from 1973 through 1982 are a feast of low points.”

In 1987, complex financial models led to a stock market crash. The models underpinned so-called portfolio insurance. For a brief time, major investors could use these models to sell stock index futures as a way to hedge against a possible fall in their stock portfolios’ value. But with most major institutional investors using the same models, the effect was not so much to protect as to magnify the impact of any market decline. In 1994, about a decade after the advent of complex mortgage-backed securities, their market crashed when the values the models had predicted proved unrealistic.

“The real problem was that America had debased the currency.”

Larry Fink and a team at First Boston invented the collateralized mortgage obligation (CMO) in 1983. They transformed ordinary mortgages into bond-like instruments with a menu of yields and risk alternatives. Wall Street ran with the innovation. Mathematicians designed extremely complicated variations. Some of the securities were high-quality, but they always left behind a residual, called “toxic waste.” Some hedge fund investors specialized in high-return, high-risk, toxic waste securities. In 1994, a highly leveraged toxic waste hedge fund ran into trouble after the Fed hiked interest rates. The hedge fund’s manager used models to calculate the prices for these illiquid securities, but the banks’ models set different prices. When the manager attempted to sell some of these securities, no buyers emerged. In other words, regardless of what the models said, the market answered that the instruments were nearly worthless. Bear Stearns aggressively moved to seize the fund’s assets, leading to a run that obliterated the fund and threw a wrench into the CMO market. The CMO market rout cost $55 billion and stalled the mortgage market for years.

“Volcker broke inflation simply by clamping down very hard and very persistently, using every weapon at his disposal – interest rates, money supply, jawboning.”

In the late 1990s, financial sophisticates at Long-Term Capital Management, a hedge fund established by the illustrious John Meriwether and his Nobel Laureate partners, Myron Scholes and Robert C. Merton, failed stupendously, putting the entire financial system at risk. The fund’s elaborate models did not allow for correlations that became evident during crises in Asian, Latin American and Russian debt markets. More worrying, the hedge fund’s investors included numerous major banks. Regulators had no idea how much risk LTCM’s failure would pose to the financial system. The fund’s partners had $100 billion in positions, but only $1 billion in equity.

“It is a canon of Chicago-school economics that government resource allocations always reduce productivity. As a blanket proposition, that’s evidently wrong.”

These three crises began in market niches that were not on regulators’ radar screens. They broke in an era when even America’s most important financial regulator – Fed Chair Alan Greenspan – was antiregulation. Agency risk was high, because deregulation made it easy for financial-industry entrepreneurs to reap profits for themselves while making the public pay the losses.

A Flood of Dollars

Habitually, Greenspan responded to crisis by expanding the money supply. Traders began to refer to this predictable response as the “Greenspan put.” He is largely to blame for the dire straits of America’s financial system. He ignored the inflation in asset prices, evident in the stock market bubble of the 1990s and the subsequent real-estate bubble, the biggest real-estate bubble in world financial history. This real estate boom was not without benefits. Home ownership expanded, and members of racial minorities hitherto excluded from home ownership finally had a chance to achieve it. However, predatory lenders flourished. Brokers exploited the ignorance and inexperience of the most vulnerable buyers, saddling them with complex new mortgages that exposed them to unconscionable risks.

“But the breadth of the current financial crash suggests that we’ve reached the point where it is market dogmatism that has become the problem.”

At the debut of the Bretton Woods system, America, then a creditor nation, held most of the world’s money. Now the U.S. is a debtor to peripheral countries, especially in Asia. These countries are beginning to shift their investments out of dollar-denominated securities. The dollar is losing its status as the world’s reserve currency. This will result in an increase in U.S. interest rates and probably a sell-off of America’s major corporations.

“The ‘wall of money’ that has kept American markets afloat also created a global dollar tsunami that has left a waterlogged world in its wake.”

It is possible to address these problems, but it would take the kind of decisive perseverance that Volcker exercised in the late 1970s and early 1980s. Regrettably, the U.S. financial sector shows no sign that anyone is willing to admit the full scope of the problems and take the kind of firm action necessary.

“It’s hard to imagine a worse outcome – the United States, the ‘hyperpower,’ a global leader in the efficiency of its markets and the productivity of its businesses and workers, hopelessly in hock to some of the world’s most unsavory regimes.”

Worship of the free market has cost America dearly. Financial entrepreneurs have despoiled workers. The rich are getting much richer and the poor are much poorer. The market system in health care has served Americans poorly. The U.S. has deregulated and privatized even those functions that government performs efficiently and cost-effectively. The U.S. created Sallie Mae to make education loans available, but then privatized it. Its CEO made a personal fortune, but students now struggle under a burden of debt. A much less costly government loan program exists and could expand tuition grants widely.

“That’s where a quarter-century of diligent sacrifice to the gods of the free market has brought us. It’s a disgrace.”

Irrational deregulatory zeal is also evident in proposals from President George Bush’s administration to privatize Social Security, a plan that would place pensioners at risk but would put more profits in the pockets of Wall Street firms.

The financial-services industry’s privileges and perquisites have led to exorbitant profits. These firms, uniquely, do not really face the risk of failure. Because their failure might endanger the financial system itself, these financial service firms’ losses are socialized. America must find a better way.

About the Author

Charles R. Morris, a lawyer and former banker, has published articles in numerous publications and has written 10 books.

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The Trillion Dollar Meltdown

Book The Trillion Dollar Meltdown

Easy Money, High Rollers, and the Great Credit Crash

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