17

The Tide is Low and Still on Its Way Out

For several years when our unprecedented asset inflation was in full ascent ER warned that all the fictitious credit being created would inevitably be paid in full with interest and penalties. And we drew up a list of the scams we could recognize in the New Economy unbound from the shackles of bookkeeping.

Now we must confess that as long and seemingly interminable as was our list, we missed almost as many of these ingenious scams as we fingered. The Wall Street Journal (16/05, �Tough Equations - Blame the Profit Dive on a Marked Change in Companies� Costs� by Greg Ip) discloses a new source of capital deflation in Silicon Valley that is contributing to the vanishing of our credit-money supply.

�A year ago when Inktomi Corp. was flying high, Chief Executive David Peterschmidt marveled at the nature of the software business. His company had spent more than $10 million to develop its software for delivering and managing data over corporate networks. But once the costs were covered, each additional sale was almost pure profit.

�You have no cost of goods. We don�t even ship a physical diskette anymore,� he says. `Next to the federal government, this is the only business that�s allowed to print money.��

He didn�t get it quite right. There are the private financial institutions who having had most of the government�s money-printing franchise bestowed on them, financed such eery credit bubbles as the one that that has burst in Inktomi�s face.

�Now, the company is witnessing the dark side of that formula. In the past year, its development expenses doubled, as it invested the bounty from software sales in new applications. But sales have taken a nosedive, and the company reported a staggering $58 million loss for the first quarter of this year compared with a $1 million profit in the year earlier period.

�Inktomi�s reversal, seen at many other US companies this year, may reflect more than just the bursting of a technology bubble. In today�s economy, a product�s value is the intellectual property embedded in its design, its brand or its network of users. It takes enormous fixed costs in the form of research, technical equipment and marketing to develop such value. Moreover, intense competition and the rapid obsolescence of intellectual property mean that companies must make that heavy investment again each time the market demands new product - in effect, continually.

�In good times, customers keep buying new products, and healthy sales more than cover the fixed costs. But in bad times those enormous fixed costs will rapidly erode profits. The phenomenon has hit a wide range of companies: software makers like Inktomi and Microsoft Corp., Internet media companies like Yahoo Inc., and semiconductor manufacturers like Intel Corp.

�The growing prominence of companies with high fixed costs and low marginal costs could be changing the nature of the business cycle, subjecting companies to more dramatic reversals of fortune and leading to bigger swings in profits, stock prices, capital spending and hiring.�

Right here we must push the analysis a couple of steps beyond the point where the WSJ leaves it. Clearly part of the vulnerability is that the current method of accountancy was based on ignoring that the highly iffy future was cut up and packaged as a hard asset. The expenditures on patents and capital equipment in high tech should have been depreciated over a shorter period in consideration of the higher obsolescence in such companies. Moreover, the marketing component which includes �brands�, registered Internet names should be kept separate from technological patents and depreciated on a still quicker schedule. Basic to this rude awakening is what ER has repeatedly warned against - crediting accountancy with some of the black magic of the new technology.

Not to do so puts the more vulnerable members of society at risk. Richard Berner, Morgan Stanley & Co�s chief US economist, says this higher sensitivity of profits to sales growth is the Achilles� heel of today�s economy. It �makes a deep contraction in earnings unavoidable, even if the economy skirts recession.� Severe pressure on profit margins, in turn is �producing a capitalspending bust. And will likely force companies to lay workers off in greater numbers than have appeared to date.�

�from Economic Reform, June 2001

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