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Plus ça change, the French say — the more things change, the more they stay the same. Or, as Yogi Berra put it, it’s that old déjà vu all over again.

The global financial crisis of 2007-9 has reminded us again of the vulnerability of world capital markets and of the persistent recurrence of financial crises throughout history. Moreover these crises are incredibly similar, in their broad outlines.

In 1907, in the so-called Bankers’ Panic, the following events occurred:

* The New York Stock Exchange fell by 50 percent, compared to its peak in the previous year, 1906. (World stock prices fell by exactly the same percentage from their peak, in 10 months, in 2008-9).

* The panic occurred after a ‘greed is good’ market manipulation – a failed attempt to corner the market in the shares of United Copper, not dissimilar to the shady sub-prime mortgage and credit default swap manipulations that led to the 2007-9 collapse.

* The 1907 panic created a liquidity crisis as banks stopped lending and borrowers lost faith in banks — just as in 2007-9.

* There were numerous bank failures in 1907, just as in 2007-9.

* The 1907 collapse was preceded by an inflationary bubble, just as in 1995-2007.

* The 1907 financial crisis was accompanied by a real crisis — a deep recession.

* There were emergency bailouts, involving brokerages as key players (similar to the collapse of Lehman Brothers on Sept. 16, 2008). A big brokerage firm borrowed heavily using its stock in Tennessee Coal & Iron as collateral; when those shares collapsed, a bailout was organized, with J.P. Morgan’s U.S. Steel Company taking over the failing TC&I — shades of 2008-9 and the bailout of AIG. Bear Stearns and GM. J.P. Morgan was the reigning hero. Were it not for his pledging huge sums of his own money in bailouts, and forcing his wealthy banker friends to do the same, the collapse would have been much worse. Ironically, in 2008, J.P. Morgan bailed out Bear Stearns!

* Here is a key difference between 1907 and 2007: while key CEO’s, chairmen and senior managers continued their ‘greed is good’, ‘you owe me obscene salaries’, policies, in 2007-9, tycoons like J.P. Morgan bet their wealth on helping markets recover their trust and sanity, in 1907.

* The crisis led to soul-searching and a total revamping of government regulation of credit markets, including the creation of the Federal Reserve System, America’s central bank.

Here, the jury is still out. Will the 2007-9 crisis lead to major reforms in how America regulates its banks and financial services sector, as it did in 1907? Or will the thinking be like the Silicon Valley bumper sticker: “Lord — please, give me another bubble”.

_________________
*This blog is based in part on Robert F. Bruner and Sean D. Carr, The Panic of 1907: Lessons Learned from the Market’s Perfect Storm (Wiley, New York, 2007). With perfect timing, the authors published their book about the perfect storm right at the onset of the 2007 financial crisis. The term “perfect storm” (meaning, a series of improbable events all occurred at the same time) has been used widely to describe 2007-9.

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Chris Anderson. “Free: The Future of a Radical Price” (Hyperion; $26.99);

(This blog is based in part on Malcolm Gladwell’s recent article in The New Yorker).

In the 1990’s a group of University of Illinois professors invented a web browser they called Mosaic, before anyone knew what web browsers were — then built a company called Netscape that gave it away for free. Millions downloaded Netscape. Netscape made its money by leveraging its widely-known brand name to sell server software. Its IPO in 1996 was a watershed — Wall St. noticed how Netscape’s share price soared by 10 times days after its launch, and decided this was the ideal way to make money. ( The result was the dot.com bubble that exploded in March 2000.)

Now the editor of WIRED magazine Chris Anderson has written a fine book that makes an exceedingly powerful yet simple point.

In the digital age, many products are bits and bytes. Digital products have zero marginal cost to reproduce. According to economic theory, in a competitive industry (and all digital industries are competitive), if marginal cost is zero, then the optimal price is zero too. Hence prices will gravitate quickly to zero — and they do.

Anderson’s previous 2006 book The Long Tail was equally insightful and spoke about how tiny niche markets can become huge businesses by leveraging the Internet.

Anderson writes: “In the digital realm you can try to keep Free at bay with laws and locks, but eventually the force of economic gravity will win.”

That law of gravity is the inexorable downward pressure on prices, driven by competition and zero marginal costs.
A great many industries have simply ignored this law and have reached the edge of bankruptcy, or even stepped beyond it. The music industry for one. Newspapers for another. 

In this blog we often observed how the global depression creates opportunities, through major shifts in business paradigms. The “free” paradigm is a good example. Is your product one that has low or zero marginal costs? If so, can you find ways to provide it for free, while still building a powerful organization with strong top-line and bottom-line performance?

* Can you offer some ‘lead’ products for free, while charging for others?
* Can you leverage what Anderson calls “Fre-mium” strategies: 90% of customers get the product or service for free, as a standard commodity, while 10% of customers whose needs are more special pay for ‘premium’, and generate all the revenue. 
* Can you introduce your product for free, then find a way to begin charging for it (realize, this is highly difficult, people hate to pay for what they once got for free)?
* Can you price “virtually” for free? (i.e. charge for maintenance contracts, etc., that generate the revenue)? Rolls Royce sells jet engines at low prices, but makes all its profit on high-margin service contracts.

Incidentally, there is a mathematical proof that a zero price is optimal.

Total Profit is Revenue (Price times Quantity) Minus Total Cost (TC).

Take the derivative of total profit with respect to quantity (Q), and equate to zero, in order to find the maximum. 
Result: d(PQ)/dQ – dTC/dQ = 0
Or: Price = Marginal Cost

Blog entries written by Prof. Shlomo Maital

Shlomo Maital
July 2009
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