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Evan Davis gets to the heart of the big finance stories at The Bottom Line.

In the late 1990s it was rumoured that an international investment based in London met with clients and competitors to make deals and set prices for a number of financial assets in one of the private rooms of a famous lap dancing club. Rumours also abound of trans-national corporations in certain sectors meeting once a year in possibly exotic locations to agree prices in their markets.

The boundary between co-operation and collusion among competitors can be a fluid one. Collusion between firms is illegal but the establishment of joint ventures can sometimes make the division between co-operation and collusion more permeable in some sectors and markets. It is the duty of regulators to attempt to define less porous boundaries.

A lap dance club in Rome [Image: Twm™ under CC-BY-NC-ND licence]

You might say what have lap dancing clubs got to do with the business relationships between competitors? Well apart from their metaphorical utility, they point up some of the paradoxes about regulation.

Lap dancing clubs are seen as part of the sex industry but had been regulated under the Public Entertainment Licence (PEL) which covers venues which sell alcohol.

At present there are proposals to regulate them under the sex licensing legislation, which is more restrictive. The moral and social issues about these type of establishments, notwithstanding, it does point to the problematic nature of business regulation.

Like difficult customers, businesses frequently complain about regulation, and point to apparently nonsensical examples. Yet one of the paradoxes is that not only does regulation often sustain the competitive environment, but also allows businesses to follow their own self-interest.

Adam Smith [Image: Thinkstock]

The notion of self-interest is most frequently associated with Adam Smith’s The Wealth of Nations, perhaps one of the most misinterpreted books in history. In his previous work The Theory of Moral Sentiments, he pointed out that if individuals do not have a ‘moral sentiment’ with counterparts in economic exchange then their self-interest will not be realised and just prices will not ensue. Regulation frequently substitutes for moral sentiment in market economies.

Regulatory arbitrage

By the same token, differences in regulation of time, place or market can present new opportunities. These come under the heading of regulatory arbitrage. Arbitrage is the process of taking advantage of differences in prices in two or more markets.

An example of the regulatory version is the establishment of the Euro-dollar market in London in the early 1960s. Regulation in the United States, at the time, limited foreign access to dollar deposits. To circumvent these regulations a new offshore (’Euro’) market developed to cater for this suppressed external demand.

There is an equivalent in our lap dancing example, by being licensed as a PEL rather than being regulated as sex establishment, these clubs had lower regulatory costs.

Systemic Risk and regulatory risk

The related issue is risk, of which two types are relevant here: systemic risk and regulatory risk. The former is that posed to the economy and financial system as a whole, whilst the former occurs when changes in laws and regulations impact on business activities.

The risk management strategies of minimising the impact of this regulatory type may perversely lever up systemic risk. This applies more strongly to firms with dominant or monopolistic market power. By exploiting their ability to extract economic rents from their commanding market heights, in order to limit regulatory risk, these firms may reduce economic welfare in the economy. This consists of lower output, income and employment - the consequence of which is to lever up systemic risk.

The thought of scantily-clad or naked businessmen (and aficionados of this type of establishment tend mainly, though not exclusively, to be men) gyrating around a regulatory pole and responding to bids to set prices from a closed audience is not a pretty one.

The bottom line is that if you regulate these collusive activities as the equivalent of PELs and not something more visceral, based on co-operative relationships, we all be will be dancing our way to some kind of oblivion.

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About the author

Leslie Budd is Reader in social enterprise at The Open University Business School. He is an economist and has written extensively on the relationship between regional and urban economics, and international financial markets.

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Blogging about

The Bottom Line

Evan Davis gets to the heart of the big finance stories at The Bottom Line.

The former lead guitarist of the American hard rock band Guns n Roses is known as Slash. Slash and burn could be seen as the slogan for this genre of music - but also for business and organisations when they face fundamental challenges in their markets and jurisdictions.

In the present economic environment the same could apply to governments as they deal with the fiscal consequences of the credit crunch and global recession. Indeed, the first album of Guns n Roses was titled Appetite for Destruction which appears to be apposite for current economic and business circumstances.

Should the strategy be to park the big guns on the lawn and blast parts of the business or economy whose expenditures seem unproductive? Or should the giving of roses signal a more gentle and colourful means of solving the same problems?

Slash - Saul Hudson, as was. [Image: Boboroshi under CC-BY licence]

The two approaches may appear to be diametrically opposed but they are linked by one factor: the market or the constituency they wish to serve. The tricky or, in the parlance of some academics, wicked problem is how to cut costs and keep your customers - even the ones that may present difficulties? The unintended consequences of the former may lead to the perverse outcome of losing the latter.

Let’s look at costs cutting. Reflex cost cutting seems central to businesses and governments when they face difficulties.

But just as there is a marked distinction between household debt and government debt, what is rational for the individual business may not be rational for the economy. However, there are feedback loops between them which make it irrational for the businesses to cut costs in the medium to longer term. It comes down to the aggregation problem.

The famous Swiss-born philosopher Jean-Jacques Rousseau wrote The Social Contract in 1762. It was a political treatise in which people give up their individuals rights in the state of nature for the general benefits of civil society. There is thus a constant tension between will of all and the general will in society.

The - again, celebrated - economist John Maynard Keynes espoused a similar idea in his book The General Theory of Employment, Interest and Money. What is economically rational for the individual household or firm is not rational for the economy. If households withdraw money from the economy through saving, or firms cut wages or cut back, then aggregate demand will fall - as will national income.

Thus, there will be lower income for firms and individuals, with the consequence that firms may go out of business because their individual act of cutting costs will ultimately reduce demand for their goods and services. The stocking problem illustrates this dilemma.

As part of reflex cost cutting advertising; research and development; and, training budgets are reduced. But these are part of the armoury of a business’s competitive advantage in their function as barriers to entry to new competitors.

Stocks are part of a firm’s investment portfolio and an asset that can be traded. In an economic downturn, not maintaining stocks can actually reduce the possibility of recovery and upturn, because of the combination of the accelerator principle and the concept of the multiplier: a combination first proposed by the Cambridge economist, Roy Harrod.

The accelerator relates the change in the rate in investment to the rate of change of output in the economy. The multiplier is the process where increases or decreases in investment; government expenditure; and, exports leads to a multiple increase or decrease in national income.

So, if the economy is near the bottom of the cycle, not renewing or maintaining stocks will accelerate the decline in the rate of output and the multiplier process will lead to a larger decrease in national income, thereby prolonging the downturn.

This also sends a signal to the markets not to engage in new investment; R&D and training for new opportunities that may arise.

There is clearly a paradox for businesses here, in that when and how much to cut when facing financial pressures may focus on more short-sighted considerations. There are two tricky problems; how can costs be identified and allocated? And, how to avoid confusing cash flows and budgets.

This is compounded by a frequent fixation on margins which as proportions must be maintained at all costs, irrespective whether the total sum of profits is driven lower.

This brings us to the denouement of our story; tricky customers. Customers are axiomatically demanding as they are the source of demand for the products and services that businesses and organisations supply. It may well be that in certain sectors, consumer-based services for example, customers have become tricky because the promise of service is upped during the up cycle of the economy, and they cannot deliver the promised nirvana.

For example, budget airlines can’t provide sturgeon roe and Chrystal champagne on their flights to Costa Binge Drinking, but equally if they cut certain routes or frequencies, then it becomes trickier to persuade customers to return. This appears to be the narrative of the stocking problem.

But the bottom line is if businesses don’t treat their customers like the most famous Guns n Roses song Sweet Child of Mine then, as they mature, their markets will go elsewhere and the only tricky problem will be how to cut down and dispose of their assets as they go into administration and bankruptcy. Now that is a wicked problem.

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For business skills as sharp as Slash’s axe playing, visit the Open University Business School

Evan Davis asks how easy it is to cut costs in a downturn

About the author

Leslie Budd is Reader in social enterprise at The Open University Business School. He is an economist and has written extensively on the relationship between regional and urban economics, and international financial markets.

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A century or so ago, the oppressive actions of the elite with respect to the poor or less powerful were justified with reference to Divine Law. A god had decreed that this was the way things should be, and eternal damnation would be the fate of those who dared question it.

Today, few Westerners (outside the more primitive parts of the USA) would subscribe to such a doctrine, but now a new, and even more fearsome, god can be invoked to support the powerful. That god is "the economy" and almost form of exploitation can be justified with reference to it.

The NHS, or care for the elderly, "costs the economy £x million per year" and should therefore be cut back. "The economy" cannot support reasonable pensions, higher education, reductions in polluting emissions or indeed almost any public benefit. The economy has to grow all the time, or the most awful fate will befall us all.

How do we know this? Well, like the old ones, this new god has its attendant priesthood, of economists, bankers and their "financial correspondent" acolytes, and they never cease to tell us what the economy needs.

Where the priests of old relied on Biblical quotations to support their claims, this new priesthood uses the unchallengeable force of economic statistics. Chief among these signs and portents is the supposed size of the economy.

If "the economy" has grown in a given quarter, then all is probably well. But if that growth is less than a percentage point, or - even worse - is zero or negative, then the priesthood has to demand sacrifices of the wider public to placate their god.

What is truly amazing is that in general, we all acquiesce in this situation. How many of us take the trouble to question this divine status of economic statistics? Yet the whole edifice is constructed on an arbitrary and partial set of indicators, compared to which the original Ten Commandments are almost a model of completeness and logical consistency.

An early conflict between God and money: Jesus throwing the money-lenders from the temple. [Image copyright Getty Images/Photos.com/Thinkstock]

What is the GDP?

The key indicator of the essential size of the economy is Gross Domestic Product (GDP), or its near relation, Gross National Product (GNP). This GDP is the number that has to grow all the time, or the great ogre Recession will appear to destroy us all. Yet what does GDP actually represent, and how is it measured?

The official definition of GDP is the sum of private consumption, total investment, government spending and net exports. Private consumption is defined as all the purchases made by households of things like food, televisions, cars and holidays. Total investment is the money spent by firms on new plant, machinery, land or factory premises, and also money spent by consumers buying houses.

Government spending is all those things that government buys on our behalf – spending on roads, hospital buildings, education and so on.

Net exports is the difference between the money gained by exporting goods and services and money paid for imports of these.

It all seems very clear and logical, but once we start to look in more detail, a lot of difficulties become apparent, and the awe in which these numbers are held begins to look much less explicable. Different sources appear to suggest different items are, or are not, included.

For the UK, there are officially three main ways in which GDP is measured:

• as the sum of all the Value Added by all activities which produce goods and services. Gross value added is the difference between output and intermediate consumption for any given sector/industry. That is the difference between the value of goods and services produced and the cost of raw materials and other inputs which are used up in production.
• as the total of incomes earned from the production of goods and services.
• as the total of all expenditures made either in consuming finished goods and services or adding to wealth, less the cost of imports

Source: statistics.gov.uk/about/glossary/economic_terms.asp

In theory, all three measures should add up to the same number, but they always differ somewhat, and close inspection of the published figures shows that the numbers quoted also change over time.

A figure announced to great fanfares in one week may subsequently (and much more quietly) be changed as more or better data are obtained.

Considering that so many economists trumpet GDP as a measure of national wellbeing, there are also some strange anomalies present. If there is a serious pollution incident then the expenditure on cleaning up the pollution counts towards GDP. Pollution incidents that require cleanup are, in GDP terms, positive, so one way for Governments to ensure growth in GDP is to encourage regular major incidents!

Other damage to our living environment that is not "cleaned up" may represent a real loss in human wellbeing, but does not have any economic component so conveniently does not get measured as a cost in the GDP calculations.

We also have problems in the way that components of GDP are interpreted. Although GDP is defined as including Government spending, it is currently fashionable to regard any spending that is not instigated by individual consumers as being almost inherently evil.

So while commentators may be bemoaning a drop, or even a less than expected rise, in published GDP, they will also be claiming that this means that Government spending should be cut "to allow real economic growth".

By-and-large, nobody argues with this bias any longer. It is also assumed that any expenditures on goods and services, or monies paid out as wages and salaries are proportionate.

Maybe they are, but my feeling is that £1million paid out to an investment banker has a lot less value to human wellbeing than £1million paid out in wages to a vastly larger number of hospital cleaners, nurses or teachers. This topic is the subject of an interesting recent report by the New Economics Foundation, Valuing What Matters.

The actual GDP, and the rate of change

Perhaps the biggest failing inherent in our fetishising of the economy comes from a basic human difficulty in distinguishing between the actual amounts of something and rates of change of these amounts. This means that commentators often confuse growth in GDP with GDP itself.

How often do we hear the statement that GDP (rather than the quarterly change in GDP) has risen to x% this quarter? This confusion leads to another fallacy that, in the long term, may be the most damaging aspect of the whole mess.

Take it to the limit

Growth in which there is any form of multiplication of the current value by a number greater than one means that whatever is growing will, in theory, ultimately reach a size that is astronomical. Any population of organisms where each organism gives rise over its lifespan to more than one surviving offspring would ultimately exceed the mass of the whole Earth.

In reality, of course, populations all living organisms either reach some stable level which can be supported by their surroundings without damaging them, or, quite often, their numbers crash spectacularly.

Our monetary GDP is not an organism, or even a physical entity, but the transactions that it supposedly measures have their origins in physical objects. So ultimately, GDP must reach a point where the physical manifestations of the measured transactions are limited by the available resources of the Earth. Yet this inherent limitation is conveniently ignored, and we are constantly told that "growth is good" (echoes of the 1980s Thatcherite cry that "Greed is good" and all the horrors that entailed).

So next time you are listening to a financial pundit talking about the economy, or politicians claiming how much better the economy would perform (i.e. how much more rapidly the official numbers would grow) under their party’s stewardship, pause for a moment.

Ask yourself what the numbers really mean. Ask whether the promises of everlasting happiness from everlasting economic growth are anything more than political sloganeering, or special pleading from sectors of the population who are creaming off more of the underlying monetary flows than is perhaps their due. I suspect the answers might not be as clear cut as economists and their apologists would have us believe.

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About the author

Dick Morris has been visiting senior research fellow in the Open University Technology Faculty since 2004. Prior to that, he was senior lecturer in systems, responsible for a range of Open University courses including the technology foundation course, food production systems and systems modelling, and for cross-faculty activities around the environment.

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