A Problem of Trust

May you live in interesting times is supposed to be an ancient Chinese curse.^[1] It's certainly been another interesting week in the financial markets.

Stock market drops are nothing new: the market valuation of stocks is often irrational and booms and busts happen with "unpredictable regularity". If the current financial crisis just affected the stock market politicians might be concerned about their pensions, but nobody would be really worried.

The difference this time is that the problem has become one of a lack of trust.

Can I trust my bank to repay the money I lend it? If not I would rather keep my money rather than leave it in the bank. If another bank doesn't trust my bank, it won't lend it any money either. If the bank doesn't have my cash, it can't lend as much money - the amount it can lend is decreased by many times the amount of decreased deposits. (At least that's my understanding of the fractional reserve system.)^[2]

Farewell Northern Rock (UK) and Washington Mutual (USA).

Trust is a remarkable quantity: often difficult to acquire, it can be remarkably easy to lose and almost impossible to regain.

Many companies assume that when a disaster occurs, they will simply be able to borrow the money they need to keep their business going until they have recovered. But this isn't a very safe assumption.

If a business looks like it is on the ropes with its building burned to ashes and its staff laid off, would you lend it money? If you wouldn't lend money in this situation, why should your banker?

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^[1] Even if it isn't, it most certainly should be.
^[2] For an interesting explanation of the fractional reserve system, see the Money as Debt (YouTube video) (DVD & website). I'm not convinced by the political and economic arguments which start about half way through this video, but the explanation at the beginning of the fractional reserve banking system (and what money is) are outstanding.

Putting all your eggs (and milk) in one basket

You should not put all your eggs in one basket, says the proverb.

Or, according to Mark Twain, put all your eggs in the one basket and — WATCH THAT BASKET.

I was reminded of both these aphorisms as news of the Chinese Milk Scandal broke. Somewhere in the milk chain somebody added melamine to boost the milk's apparent protein content (probably to counteract the effect of watering it down) and thus increase its value — with fatal effects.

Once upon a time, in the past I can almost convince myself I remember, people bought milk from the farmer or the local dairy. If the milk didn't taste right you bought it from a different farmer or dairy. A problem in the milk supply might affect a few hundred customers, and the biggest "risk" (following the introduction of pasteurization) was that the farmer had watered down the milk.

Scroll forward to the current day. Companies don't buy milk, they buy milk powder, modified milk ingredients, or some other milky product. A problem in the milk supply can literally affect millions of people. Milk is not bought for taste, it is bought for nutritional content from the
lowest bidder.

A lot of figurative eggs have been put into one basket, and the incentives for tampering with that basket are much higher.

The problems of the chinese milk industry (which, of course, have affected all sellers of milk or products with milk derived ingredients even if they were not at fault) are the result.

But the problem isn't really the milk industry. Remember tainted dog food? Maytag dishwashers? Listerine mouthwash? Painted toys? Contaminated toothpaste? (See Year of the Recall)

The problem is large baskets which (as Mark Twain pointed out) need to be watched very carefully.

What can we do to prevent or reduce this problem for ourselves and for our customers? We need to either:

• Make the baskets smaller. (i.e. differentiate products, differentiate batches, and use multiple suppliers - not just the cheapest). Would the recent Maple Leaf Foods recalls have been as big if "different" brands had in fact come from different production lines?
  
  
• Watch the baskets better. (i.e. inspect, test, and verify rather than blindly trust the supplier). Independent government (or other) certification is definitely an advantage here for any industry where the bad actions of one competitor can affect the trust in all industry members.

Or perhaps we need to do both.