In February 2009, the Queen asked a professor at London School of Economics about financial crises, which has now become the question of 2009, at the cost of a few trillion dollars and millions of job losses, “If these things were so large, how come everyone missed them?”

Why was the elephant in the room not visible to anyone? Here, though, we change the question somewhat and ask: even if the companies could have seen the elephant in their boardroom, what would they have done differently?

Consider the corporate response to the recession hitting the auto industry in the UK. The decisions taken include extending the 2008 Christmas shut down (Aston Martin, GM); layoffs (Aston Martin, Bentley, Jaguar Land Rover, Mini, Nissan, Toyota); temporary closure of plants (Honda, GM, Jaguar, Mini, Nissan, Toyota), reduced number of working days in a week (almost all companies); and salary cuts (Honda). These are tough business decisions.

Would the managements of these companies have taken these decisions two years ago if they knew the recession was going to be this bad?

If you asked a management expert the answer would be ‘yes’ the companies would have taken these decisions to stay afloat by becoming leaner and fitter. Tough times require tough decisions, will be the logic forwarded.

But do businesses really behave like that? Do they behave ‘rationally’ when downside risks, perceived or real, are recognised? The answer is ‘it depends’.

Depends - but on what?

First the management will consider how tough decisions will be responded to in the market?

Consider a situation where a board of directors of a company comes to a view that, as a result of certain developments beyond their control, there will be significant negative impact on sales two years down the line. Suppose the appropriate response by management is thought to be reducing costs by making some employees redundant. Will they do it?

They would weigh the impact of announcing such decisions on the share price of the company. If company is planning to raise funds in short term after such announcement they would worry about impact on credit ratings, and so on. They would weigh the possible trade union criticism and publicity liability it may generate.

Consider a chief executive retiring in next six months and due to realise benefits of stock options, will there be incentive to make decisions which may be good for the company in two years time but will push the share prices down now?

Therefore, although the board might successfully identify the risk, they may end up postponing the tough decision.

Second, there is research evidence that firms that have been successful for considerable length of time do not respond well to emerging threats. They suffer from ‘strategic persistence’ syndrome. Successful airline and trucking companies in the US continued with old methods even after radical changes to their environment, including the deregulation of airlines (1978) and trucking (1980). They experienced poor performance over the five years following deregulation.

So past success breeds the view that old tricks will continue to deliver better performance. Sadly, evidence is to the contrary. This ‘strategic persistence’ could thus stop the managements from doing the right thing even if they knew two years ago about the severity of current recession.

Third, some managers may just like the status quo and believe in the maxim if it ain’t broke don’t fixit.

Fourth, one may ask would the central banks have reduced interest rates and eased money supply two years ago, if they had seen the recession coming?

My answer is NO. The monetary policy as practised is reactionary in nature. It is used to reduce the supply of money when inflation is increasing (after an event which has already occurred) and to increase the supply of money to boost demand (in the recession, as now - again, after the event has occurred). This macroeconomics axiom of being reactionary rather than proactive would therefore have prevented the central bankers from acting during the ‘normal times’ of two years ago, even if they saw the recession coming.

Knowing the future results in one response - experiencing the present may result in another.

Find out more

The Paradox of Success: An Archival and a Laboratory Study of Strategic Persistence Following Radical Environmental Change by Pino G Audia, Edwin A Locke and Ken G Smith from The Academy of Management Journal, Vol 43 (5) October 2000 features the research on strategic persistence.

Discover more about the world of business and planning with the Open University Business School

About the author

Devendra Kodwani is Lecturer in Finance at the OU Business School. His research interests include the economic regulation of utilities and he has written several papers on privatisation and regulation.

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Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

Globalisation of trade has resulted in huge trade surpluses in many countries, particularly in Japan, China and other Asian nations. If you combine this with the build-up of foreign reserves in oil exporting countries, thanks to soaring prices, then you find some countries sitting on piles of US dollars, Euros and Sterling.

What do the governments of such countries do? They set up Sovereign Wealth Funds (SWFs) as vehicles for investing their foreign currency reserves. And looking for investing opportunities, they turn their attention to western European and the US financial markets (that provide a wide range of investment opportunities in financial and real assets). The main objective of most SWFs is to maximise returns on their investments.

In theory we can explain the phenomenon of state owned SWFs investing in foreign securities and assets in fairly simple terms. The financial markets exist to bring together the funds surplus units and the funds deficit units.

The recent crisis in banking industry illustrates this well. The consequences of sub-prime and credit crunch left many multinational and large banks needing fresh capital to bolster their capital base. In the UK, for example, HBOS and Royal Bank of Scotland tried to raise capital through rights issues. Both could not get enough subscription from their existing investors.

“their investments have helped stabilise the global financial markets”

SWFs have stepped in, and are injecting large amounts of money in multinational banks, including the British bank Barclays. Since the US sub-prime mortgage crisis their investments have helped stabilise the situation in global financial markets.  

A turbulent international financial system has an impact on the economic growth of the developed world. The developed world is the major market for manufactured goods (exported from China, Japan, South Korea) and oil (exported from the Middle-East, Russia and Nigeria). So an unstable global financial system can seriously threaten the economic progress in developing countries. And, of course, the investments that bring this stability are in the interests of source countries’ interest!

SWFs are not new, but they’ve attracted more attention in recent years. The Kuwait Investment Authority (KIA) was set up in 1953 and the Norwegian government set up their Global Pension Fund in 1990 to manage the surplus revenue from oil and gas exports to provide for future generations. So SWFs are not the preserve of fast growing countries such as China or South Korea. They’re been set up by Australia, Canada, Angola, Russia, some states of the USA, Ireland and even East Timor.

However, the western world is becoming concerned about the lack of transparency of SWFs, and the possibility of SWFs gaining control of domestic companies. Advised by the US, the International Monetary Fund is engaging with the major SWFs to agree on voluntary standards for transparency and governance mechanisms in order to allay these fears.

“governments are not known to be good managers of assets”

It seems worth bearing in mind that governments are not known to be good managers of assets, be it financial assets or public enterprises. And SWFs are essentially state owned financial institutions. Will sovereign wealth funds prove to be exceptional in the long-term? Data about these funds is scarce, so it won’t be easy to find reliable empirical evidence on their performance. Meanwhile, we can only watch and wait.

Weblinks

• Join the discussion
• Watch the Who's Buying up Britain trailer
• Calling companies to account
• Gold...always believe in?
• Sovereign Wealth Fund Institute
• International Working Group
• Equity finance  - OpenLearn unit
• The financial markets context - OpenLearn unit

Courses

• Issues in international finance and investment
• Financial strategy

About the author

Devendra Kodwani is Lecturer in Finance at the OU Business School. His research interests include the economic regulation of utilities and he has written several papers on privatisation and regulation.

Subscribe to Devendra Kodwani's posts

 

Blogging about

Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

Markets such as the airline industry, where there are a few large players, are known as oligopolies. In such markets, the limited number of players mean there’s an opportunity – and temptation – for firms to formally or informally agree to increase the prices of the services they provide, operating what is known as a cartel. Game theory can help us understand this behaviour, and the choices made.

The Prisoner’s Dilemma is a classic game devised in the late 1940s by John Nash (the subject of the movie A Beautiful Mind) to teach the conflict between group and individual rationality. Consider a crime drama where two partners are arrested. Both are being separately interrogated by a clever inspector who offers them this deal:

• If one implicates the other, he may get parole while the other will get 20 years in jail
• If neither implicates the other, both will get two years in jail
• If both implicate each other, both will get ten years in jail

Given the consequences of the different choices, and to minimise their individual punishment, both partners choose to implicate the other and end up getting ten years in jail.

Prisoner’s Dilemma is applicable to many walks of life. Consider sports. Imagine a contest with two players. Each player’s in a dilemma about whether to take a performance-enhancing drug. Rationally, each player may think like this:

• If I don’t take it and the other one takes it, this increases my chances of losing
• If I take it and the other one doesn’t take it, this increases my chances of winning
• If both of us take it, then at least I’m not disadvantaged

Thinking like this each player ends up taking the drug!

There's an incentive to any player in the game to blow the whistle

However, cartels aren’t a recent phenomenon. Adam Smith, the father of modern economics, warned of such possibilities over three hundred years ago in Wealth of Nations, when he wrote,

"people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices".

Fearing this, many countries have created regulators to curb anti-competitive behaviour. But would Smith have approved of regulatory interventions to prevent anti-competitive practices in a free market? The answer would appear to be no, as he went on to say,

"it is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice".

Now, let’s get back to the recent story about airlines. It is alleged that British Airways (BA) and Virgin conspired to increase the prices of passenger tickets, by making almost parallel increases in fuel surcharges over the last few years. Virgin reported this to the Office of Fair Trading (OFT), a government agency in charge of curbing anti-competitive practices.

Let’s look at this case from the perspective of game theory. The Enterprise Act 2000 provides that any party involved in cartels can become an informer to the OFT and cooperate with the investigating agency for possible ‘immunity from prosecution’. This provides an incentive to any player in the game to blow the whistle on another player.

Whether Virgin and BA cooperated and earned huge profits, or not, won’t be known until the full report of the ongoing enquiry is published. But, by becoming an informer before BA could do so, Virgin has increased its chances of going scot free by playing the game smartly. It appears it's one more smart move from Richard Branson and co!

Further reading

• Play the Prisoner's Dilemma with Open2 – an interactive version of the philosophical experiment
• Money Programme: The great plane robbery
• Calling companies to account – explore the tactics used to keep companies in line
• An Enquiry into the Nature and Causes of Wealth of Nations by Adam Smith
• Game Theory .net
• Setting the trap in the Economist
• Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life by Avinash Dixit and Barry Nalebuff
• The Cartel Offence from the OFT (PDF document)

About the author

Devendra Kodwani is Lecturer in Finance at the OU Business School. His research interests include the economic regulation of utilities and he has written several papers on privatisation and regulation.

Subscribe to Devendra Kodwani's posts