For any American who travels in Europe or Japan, one of the more striking contrasts comes with the train system. The trains are a clean, efficient and even enjoyable form of intercity transport. The nagging question for decades is why we don’t have the same level of train service in the US.
There are many reasons (cultural, geographic, and political) but the one I want to zero in on is featherbedding because some of the issues tie directly to today’s financial industry and has implications for us as investors.
Up until the 1940s, railroads (passenger and freight) were every bit as prevalent in the US as they were in Europe. However, in the 1950’s, the technology of transport started to change once again. On the railway front, new safety and management techniques were developed and implemented to improve the efficiency of the railroads for both passengers and freight. At the same time, the airline industry, the long haul trucking industry and the interstate system were also developing quickly to compete for business.
By and large, the railway industry responded to the outside pressure by imposing barriers, complex work rules and unnecessary procedures to stem the employment losses which resulted from the productivity enhancing new technologies. Whether those rules were imposed from a federal level (Interstate Commerce Commission) or by railway unions (featherbedding), the results were the same. Cabooses rode at the back of every freight train with a full crew well into the 1980s in both the US and Canada, decades after their usefulness had been replaced by simple technologies. In one famous business study of the Union Pacific Railroad, it was found that 14 layers of approval were required to ship a product on a freight car even though the stationmaster on site had all the information and tools necessary. Featherbedding not only involved creating make-work schemes for unionized staff, it also meant creating overly complex procedures and overpaying for management as well.
Mainstream economists are not particularly bothered by the practice of “featherbedding” or at least not the bits that arise from collective bargaining rather than government regulation. The comfort with the practice rests on the idea of “economic rents” (profit in excess of what one might expect theoretically) and how the “economic rents” are shared. Whether it goes to the CEO, shareholders or the staff, it is income and is generally treated the same in most models. That is fine for a short time when an industry is making large profits (or even super-normal profits, if you subscribe to that notion). The car companies formerly know at the Big Three were able to sustain multiple layers of featherbedding for decades while European, Japanese and now Korean car makers chipped away at the US market. On the government side, the politically protected and overmanned US Post Office, with offices in every zip code, was unable conceive of much less offer overnight delivery. A small company called Federal Express operating after hours from the airport in Memphis invented a whole new business service in that gap.
What does all this have to do with Finance?
Well, the same things that happened to the Railroad, Automobile and US Post Office are happening now to the large financial firms. Just as people from the 40’s couldn’t imagine a world without the big railways, people from the 60’s couldn’t picture a car industry not dominated by Detroit and people from the 70’s could not imagine anyone but the postman delivering a letter, we are now faced with the TBTF (Too Big To Fail) financial giants.
There was a time before debit cards and PayPal when we depended upon bank tellers to get cash and checkbooks to pay bills. The need for solid banks with vaults in every town was obvious. Financial information was difficult to gather and analyze, so there was a significant premium attached to those firms which had the scope to do the job. Size was all important. With size comes complexity but also efficiencies which, in a fully competitive market, are passed as savings to the consumer. But stocks are not socks and bank accounts are not household appliances (despite an early to mid-80s diversification attempt by Sears). The industry, always piously invoking concern for the security of the public’s money entrusted to these same institutions, erected legal, statutory, industry and procedural barriers to entry in order to maintain pricing power. The fact that much of the excess profits thus created ended up in bonus pools has in no small way shaped the career trajectory of most MBA graduates in the last two decades.
Prior to the improvements in technology and information availability, there was nothing much one could do about the situation. Indeed, financial services grew from 4% of the US economy in the 1970’s to 8.3% in 2006. From a pretax profit point of view, growth was even more dramatic, rising from 13% of pretax profits in 1980 to 27% in 2007. Demand for financial services increased and the industry responded by doubling as a proportion of the US economy. Some of that growth was necessary but as the accompanying graph to the Stern Report shows, the future trajectory is far from assured.
So, what will drive change? On the one hand, deleveraging should reduce the demand for financial services and products as the US consumer rediscovers savings and reduces risk appetite. On the other hand, the ability to access information and track investments on a personal computer is superior to what was available on the most high end dealing floors only a few years ago. The industry is already responding by offering financial products at significantly lower cost (low or no-load mutual funds, ETFs, low commission trading, online banking and other services). Although only time will tell, the initial indications are that the low cost products can be as good or better than the older, high cost products that they replace. We have already seen the exit of many hedge fund managers who were unable to deliver on the core promise to make money in all types of markets. Like the HELOC junkies in the residential market, it appears that most hedge funds grew primarily on the back of the loose money regime and benevolent markets that largely prevailed from the Asian and LTCM crises onwards.
How will this affect you?
Since long term investment returns can be severely impacted by costs (fees paid out are not available for compounding over multiple years of investing), the ability to find the right product at the right cost will be more important than ever. Mutual funds with 5% loads, insurance products with 8% fees baked in and 2/20 hedge funds will still exist. The question is whether they continue to offer value for money or whether the extra money you pay over a lower cost option is only going towards featherbedding someone else’s retirement.
The financial technology is changing and how you react as a consumer of financial products will have a large impact on the final result of your investment program. Companies and individuals who did not take advantage of the advances in long haul trucking, overnight delivery, air travel and efficient Japanese cars definitely missed out on opportunities. The same thing is happening today in the financial arena. Not all new products will be good ones and certainly some of the old ones deserve their reputations but a critical evaluation of those products will lead to better investment outcomes.
Many in the financial industry can’t or won’t see the shift. They are blinded by their own self interest which, when challenged, is recast as a greater societal interest. Over and over again, we have been told that America needs a strong steel industry, a strong auto manufacturing industry, a strong textile industry, a strong semiconductor industry, a strong pharmaceutical industry and so on. While these may be true statements, often the price for maintaining strength beyond what the market can bear comes in the form of protectionist barriers (in the manufacturing areas) , direct taxpayer subsidy (in the case of the TARP or the car companies) or indirect cost (in the case of the current quantitative easing program). The risk of massive financial failure means that we will never know what would have happened if a Resolution Trust regime had been imposed to wind down overextended bank balance sheets (certainly lending shrank anyway). The cash has been printed and doled out, the bonds have been issued and the debt will be on the books for us and future generations to pay as taxpayers.
But as consumers of investment services, we need not further subsidize the financial industry by continuing to buy overpriced product. With the information and technologies available today, the ability to pay for the investment value actually provided has increased dramatically. If you chose not to take advantage of these new capabilities, you certainly won’t hear any complaints from TBTF financial institutions. But don’t expect any “thank you” cards either. One critical element of “featherbedding” is the sense of institutional entitlement that drives the implementation and maintenance of such schemes well beyond their economic justification.