As the calendar closes on 2011 panic is spreading through the establishment. 2012 will be a make or break year and a lot of people are very nervous. Personally I believe we’re heading for trouble, probably a bond market crisis. More importantly 2012 will likely be the year that we finally abandon our faith-like allegiance to The Market. Economic stability and growth will not return until we realize that it is not markets that matter but assets, and, considering we’re in the white heat of an asset revolution we’ve all got some work to do. Fortunately it’s all been done before, at the industrial ‘asset’ revolution a little over a century ago. Here’s the story.
J. P. Morgan’s Industrial Asset Revolution
Every schoolboy and girl knows about the Industrial Revolution. It started in in the 19th century and was characterized by some extraordinary innovation: new technologies, mechanized factories, masses of urbanized workers and a new class of wealthy ‘industrialists’. Less well known is the Industrial ‘asset’ Revolution, which post-dated the original technological revolution by several decades. This revolution also involved considerable ‘innovation’, but this time it was not new widgets, but dull, banking, accounting and financial innovations. Although it has gone almost unnoticed by the general public, this revolution was far more important to our general prosperity.
John Pierpont Morgan was king of the industrial bankers. In his day the world literally came to his feet. He was an iconoclastic Victorian giant, complete with top hat, spats, silver tipped cane and giant cigar. It is a surprise to many to learn that Morgan the banker was also an industry insider, controlling (or owning outright) dozens of 19th century American railroads. Eventually Morgan expanded his banking network beyond railroads and either founded or merged the industrial giants of the 20th Century, participating in such famous businesses as US Steel, International Harvester, General Motors, and AT&T.
Morgan used his insider’s knowledge to build sustainable earnings in railroads and – indirectly – their industrial class assets; newer kinds of assets that the established banks found foreign and offensive. As hard as it is to imagine the great financial houses of the day, merchant bankers all, quietly ran for cover as the industrial era began. For merchant bankers like Barings and Rothschilds, industrial activity was strange and dangerous; railroads in particular were overloaded with fast talking (American) promoters, vicious competition and businesses that had a disturbing tendency to default on bonds and loans.
Morgan saw opportunity where the merchant banks didn’t, and grabbed it solidly. Morgan realized quickly that leaving the Railroad business to The Market was not a solution. Railroad entrepreneurs were dream merchants; not only were they out of control (irrational, hyper competitive) but they lacked business and financial disciplines which meant they were chronically under-performing as a group. The Wild West free market approach to Railroads led to misdirection of capital and waste, undermining profitability. This was the situation Morgan set out to repair, and repair it he did.
Morgan was one of the first to realize the importance of railroads. He saw that the many factories being built throughout the country needed railroads to get their goods to market. Railroads were the ‘de facto’ national distribution systems for industrially produced goods; so successful railroads were not only valuable in their own right, but the key to profitability of the entire industrial economy.
With the considerable resources of the London bond markets behind him Morgan acquired and merged railroads across the continent. He bullied everyone, including railroad owners until he finally consolidated the industry to the point where it was controlled, quasi-monopolistic and profitable. In doing so Morgan, almost single handedly, established sustainability in the railroads’ assets and, incidentally, in the ‘capital’ assets of a host of associated industries.
He was so successful that the United States government soon intervened with anti-trust legislation to break up the Morgan trusts. However they did so after the pattern had been set, and the asset model solidified so clearly that industry in the 20th century literally exploded on the back of new-fangled (capital) assets that today we take for granted: plant, industrial machinery and inventory.
The industrial ‘asset’ revolution that J. P. Morgan launched in the 19th century, and the new banking model it shaped, accelerated after his death in 1913, driven strongly by a new generation of commercial bankers.
Today the old industrial economy is expiring in the West. The so-called ‘developed’ economies are desperately hanging on to diminishing returns, hoping (praying) that the economy will return to business as usual. It won’t. According to a recent University of Maryland study intangible (asset) investment by U.S. businesses has now risen to $3 trillion per year (2010) dwarfing investment in capital assets. Meanwhile J.P. Morgan’s banking business model, based on collateralizing capital assets, is unraveled rapidly. How have commercial banks responded to these deep-seated changes in the economy? As the proportion of capital assets in the economy diminishes they’ve changed their businesses, abandoned corporate lending (to the commercial paper markets) and become essentially fee generating service organizations. The net effect of these changes in Western banking has been to direct corporate finance to away from ‘asset’ based commercial & industrial banking to a far risker Wall Street investment banking model.
Bankers today do not realize how rapidly intrinsic value is migrating and how dangerous this is to their profitability. In addition they have become complacent, over-focused on earnings (effects) while ignoring causes (solid, well managed assets). They cannot, or will not, do the hard work necessary to learn the intricacies of the new knowledge-based intangible assets. Like the merchant banks of old they will lose ground steadily as the revolution proceeds; before it’s all over many established banks will collapse in spectacular fashion.
The unpleasant reality is this: the western ‘industrial’ economy is sinking, while the assets of our lifeboat, our new ‘creative’ economy, are still too immature, too small to carry the societal load. The secret to making a successful transition, however, will be found in a formula that J. P. Morgan would recognize instantly.
Like the Morgan of old, successful commercial bankers in future will need to become pro-active. Modern banking needs innovators, specialists in the creative world of intellectual property and technology commercialization. The new banking order will be initiated by hard working insiders who having learnt the secrets of the new economy and who are prepared to work with businesses to bring order and sustainability to this new class of assets. It will be new, but once again rooted in assets, not simply (derivative) earnings. Success will breed success and a new much more productive economy will emerge that will lead to another Golden Age of Growth.
Age of Volatility 