Economics · A Sideways View

A Sidways Look At The Carillion Debacle.

It’s world news now: the magisterial beast of the British construction industry, Carillion, is dead. Only it is no living thing, there is no successor in the way we used to say, “The king is dead, long live the king.” With this death, there are only more problems to uncover, not solutions.

Carillion worked primarily in the construction industry, and having run a business that was part of this charade, I know one or two things about it that few financiers would. As usual, these are the more obvious elements of the job – and it is always the more obvious things that are the easiest to overlook.

Financiers are largely unaware of how commodity markets work – whilst they can spout long lengths of prose about how one can exploit a commodity market, they still miss out on the obvious. That is to say, everybody is selling the same thing. This was as true of Carillion as it was our own family firm; fifteen years ago, I knew little of the realities of business. I could keep it afloat, but I could only do so by doing what everybody else did.

When everybody is selling the same thing, how can one choose between them? It’s not as if you trust these people – they aren’t carpenters who deliver consistently good work, are they? These are big businesses who sign contracts on paper. Which is where the problems begin: it’s on paper. The quality of work is assumed because of government – that is to say, legal – regulation. Not that this counts for a great deal in Britain on account of the paucity of regulation. Again, this is something too obvious for most people to see.

Suffice it to say that buildings in Britain don’t fall down; there are regulations that you can’t relax because a building would collapse – where a bank can do things without regulations that would lead the economy to implode in the way a multi-storey building falls in on itself if the structure is too weak or the foundations have not taken local conditions into account. If the lack of fiscal regulation in the UK doesn’t frighten you, nothing will. Even the American financiers, used to enjoying flexible regulations, were shocked at how little there was in London. Never mind that; the journalists shut up after a while because there was nothing to be done about it.

We had Carillion’s main business focussing on the construction industry; it was engaged in other areas, but the way they did this was largely the same. With Carillion being the size it was meant it could bid on contracts that were extremely large, which means government contracts. Governments, even in a de-regulated society like Britain, still hold the economic reins. That in itself should ring a few warning bells. In short, the government sloganizes about a free economy (1) and on the other, they control it.

The real problem here is more subtle, yet in a report by Zerohedge, it let the cat out of the bag. Not that anybody would notice because this is so normal that it’s, well, normal. Isn’t it? Who notices normality when it’s so normal that everybody must do it… but that is the point at which the British economy diverges from the European.

This is what Zerohedge said, yesterday:

“Outsourcing became a mantra of government efficiency. Carillion embraced the need. It ate itself on increasingly less lucrative contracts and increasing debt.”

Emphasis on the ‘less lucrative’ which is the key to any commodity market.

Baring Brother’s Bank, October 1890.

Well, it worked before, why shouldn’t it work again? Tom Baring thought this, and why not? Experience told him how the world turned and since it had turned, turn it would. He’d sailed his bank through storms before, why should he shorten his sails now? Only like Carillion, he didn’t know that his ship was holed. Everybody was looking to the future, new contracts and the possibility to pull themselves up by their own bootstraps. The British government was keen to keep Carillion afloat, ignoring the warning signs of Carillion’s warnings about profits and debt.

The government gave contracts knowing Carillion could deliver, and in delivering, dig themselves out of the hole they had dug for themselves. Read that again if you didn’t get it. Because in tendering in the way Carillion did – which is an industry wide standard method – Carillion were only making problems for themselves. They were trapped in the jaws of a commodity market: they needed the work, needed more profits and the only thing they could do was to offer their contract at less money.

The very thing that caused the problems in the first place!

Having worked in the building industry, I am also aware of another facet of the bidding process. Many businesses, including the subcontractors, sub-subcontractors and sub-sub-subcontractors all bid on the basis of underbidding on the price. Only unlike the trucker who can’t even make up the cost of his fuel that day, is so desperate to be out on the road that he takes the work. The subcontractors in the building industry are no less desperate – and I know how it feels to be caught in this trap! They can, however, make up their initial losses through the inevitable ‘extras’ that arise in any complex building operation. It is here, where the job is now under pressure of time to complete that the subcontractors (etc) who are already in place can demand extortionate amounts of money.

The result is a cost overrun. No wonder the government’s idea of outsourcing is proving to be an economic mirage. It is why the German government hasn’t outsourced in the same way – even with increasing EU (that is to say, Anglo-Saxon) pressure to do so. Even so, cost overruns in the new Berlin airport and the Suttgart 21 railway station are the new norm.

There can be no doubt that Carillion worked in this way. Everybody was at it, sucking at the money teat caused by deadlines. Maintaining the illusion of profitability in this situation is no easy game to play: but Carillion’s board were game enough. They raided their pensions pot – a form of borrowing that’s cheap in our day and age.

It’s not exactly legal, but who’s looking? The people who count, the shareholders, would get their dividend. And a handsome one it was. Eight hundred million doesn’t come from nowhere, but when the shareholders have taken their hands off the wheel and are checking their dividends on their smartphone. Nasty accidents can happen even when driving at a snail’s pace.

The people who don’t count – the staff, pensioners – have no say. Never have. They, like so many, are desperate to keep their jobs. Holland this is not! Their contracts can be terminated pretty well by the day, and they know it. It keeps them focussed on doing their work (incidentally, this is something Holland could do with a little of…) And now, having been part of the destructive process, they are reaping the benefits of having done their part in the destructive process. It has been mooted that the £580 million taken from the pensions pot will only replace current pensions to around 90% of their full value.

Naturally, this will come out of the government’s specially set up pensions pot and not out of the funds that Carillion no longer possesses.

Carillion’s Shell Structure.

Carillion as a business was effectively a ‘carry trade’ as the saying has it, an arbitrage. They, like a supermarket, could buy in bulk and having done so, pay at the standard three months. By the time they need to have paid this, the work has been done (or the goods sold in the case of a supermarket) and the bill already paid by the government. Add a modest profit to this and you have the interest on the money you haven’t yet paid out, there is a little more by way of profit.

What it does not add up to is a secure future in the way a small business can establish for itself. This post is not about fulfilling the three laws of business, it is about how one can make a profit whilst breaking all of them. The problem is that it’s not sustainable in any way, and the resulting corporations are creaky, overblown and underfed.

An apparent contradiction you might think; but in outsourcing all the risks to the subcontractors, sub-subcontractors and the rest, a corporation is there to make pure, risk free profit. It worked before, why shouldn’t it work next year? Only for Tom Baring to find that in the October of 1890 he had a hole in his accounts of some £5 million. No small amount; an amount that even the Bank of England could not help with. The British bullied the French who came up with enough gold to overcome the problems. The British interest rate shot up 50% overnight from 4% to 6%. Yes, interest rates were at a healthy level in those days; and as you can imagine, Tom Baring faced a surcharge on this figure! Take this as a warning, because interest rates have sharp teeth.

Carillion Collapses.

With the directors of Carillion charging into the future, the past was rapidly catching up with them. Oh, and as we’ve already seen, their future wasn’t exactly bright either, what with their competition and the government complicit in driving prices and profits down. But that was the way in which the government was saving money for the treasury: less outgoings! The problem here is the creatures this policy spawned: beasts the like of Carillion.

And now Carillion has sunk by the stern in what are relatively calm seas. Or at least were up until now.

I use the term ‘the like of’ because any major contractor in Britain, any major corporation, is going to have the same business methods. This, with the implosion of Carillion, should now be flashing warning signals across the country. At the same time they are going to be supported by a government that is more focussed on its slogans than the reality they avoid. The poor subcontractors (et al) can only believe what their government tells them, and so go and work for the new boys with their prices routinely hammered.

What message is that sending to SMEs? It’s saying to me: the government has done its due diligence and has confidence in Carillion.

Guardian.

I can sympathize with them: it’s nicer to believe the government than face the reality the government’s hiding from them. Illusion is an extremely dangerous phenomenon, and it is so because it is so much nicer than the reality it veils. Who wouldn’t choose the illusion over the reality? It’s nicer to drive down the motorway, even if it’s taking money out of the business’ own purse.

No wonder the ordinary worker in Britain needs an end of month loan from a shark. It doesn’t happen in Europe to the same degree, but this is Britain and the problems of Carillion are actually systemic; this isn’t limited to the corporate bubbles of the construction industry. It really is top to bottom.

Knock On Problems

The government in a much publicized comment has sought to support the subcontractors who now have deep trenches gouged in their bank accounts. Deep trenches that they could support given the size of Carillion and the bright (frothy?) words of the government. Until the crunch came, of course and Carillion’s bubble burst.

This is where the individual circumstance shows a tendency to become systemic. Medium sized companies that were subcontracting to Carillion now face a very real danger: they have no work (that is to say, no future) they have no money in their bank because they’ve not been paid and they still have staff to pay. Those staff are already being laid off in their hundreds, if not thousands.

That’s not to say that the work isn’t there, it does say that the payments for such work are not there.

And the government, who pay the big boys ever decreasing sums for the same work, only deal with the big boys. This is the kind of democracy that doesn’t have time for the minnows. The issue here is that when the minnows can’t buy their food at Lidl – who can afford the likes of Waitrose in our day and age? The Dutch can, and do; the British can if they have a managerial job in one of the thirteen tiers of management that Carillion had.

Nor is the government known for its alacrity; the small subcontractor will have to wait a good few weeks until new arrangements have been concluded – by which time the banks have bitten at the ankles of the subcontractor one too many times and the host has died. The allusion is an accurate one.

Oh, and the government covered the costs of the SMEs for … two days.

The Problem Of Debt.

Carillion became evermore indebted; that much is now clear. The markets knew this a long time ago and nobody took any notice of the menaces they were threatening Carillion with. In economics, like nature itself, it’s not the survival of the fittest, it’s the death of the weakest.

It looks the same, but the broader effect is dramatically different from the rosy tinted view of the Darwinist. Once a beast is ill or infirm, the hungry forces of nature will quickly catch up with it. Last year, Carillion was that infirm beast, and the markets had their daggers out. The markets are not the Darwinist’s nice guys.

Carillion’s share price was shorted – the markets made a stack – and in doing so, sent the world a message. Carillion, seeing the sunny skies and the calm sea, carried on as normal, oblivious to the sharks. The government acted in the same way, because Carillion was the sign that their policies were effective. What did I say about illusion?

The real problem with debt is that the government has nailed itself to its own cross here, in that the interest rates are extremely – unnaturally – low. Not that interest rates are natural, but they can be healthy. The problems with pensions are low interest rates in the so-called ‘secure’ investment hubs of government bonds; theBritish  stock market is too volatile in our day and age.

Deficits have swollen because companies have to calculate their future pension liabilities using safe assets, such as gilts (government bonds). About 62% of pension investments are now in bonds, compared with 34% a decade ago. With interest rates at record lows, these bonds are growing very slowly in value – leaving the schemes with yawning black holes.
Guardian.

What low interest rates meant for Carillion was the ability to borrow from the banks. And, you guessed it, just like Tom Baring 125 years ago, the banks are acting under the same set of illusions that Carillion did. Only when it was clear that it was too late did the banks get the jitters.

A Systemic Collapse.

Nine hundred million quid has been sliced out of the British economy; and at a time when it least needs it. It’s not a large sum of money for a corporation; their turnover was comfortably higher than that. The real problem was their ability to sustain their debts, which it was clear that for all their size, they could not.

With subcontractors, sub-subcontractors, sub-sub-subcontractors and the rest in the same leaky boat, how are they going to survive when a chunk is taken out of their balance sheet? How is the ordinary working man, often self employed and underpaid, going to manage to exist for six weeks whilst the new arrangements are put in place? They can’t go to Lidl and beg for money, and the alternative is the loan shark. Which only compounds the problem because they are then in the position of Carillion and are unable to service their debt. Even when the going was good, they, like Carillion itself, were only breaking even, bumping along the bottom.

The knock-on problems of indebtedness in the British economy may just be ready to strike.

I’m talking about the markets, that feral beast that is described in the media with such pretty words. But then, when the journalists are as blind to the reality of the markets as the market operators are themselves, can you blame them? They are only doing their job, and if today’s job is to short the pound, so be it. Be you journalist or financier. Illusions and markets work hand in hand.

The result is that interest rates are forced up by a government who is now panicking because Sterling has taken another hit. Jammed inside their comfort zone, they can do nothing else but raising interest rates, now the only thing that can keep the pound afloat. Usually the pound goes up because of something innocuous like Germany’s inability to form a government or a problem in Italy that has fuck all to do with Britain. But that is the market today: it knows fuck all about anything. It just eats and when there’s a feeding frenzy – as there was with Carillion’s share price – they just pile in. Wait until the pound comes under even a modest amount of pressure…

If interest rates are forced up, this will have a knock-on effect on corporations who, like Carillion, existed through their ability to pay the minuscule amount of interest on their ever increasing indebtedness – in the way the ordinary working man is at the end of the month. Carillion, in this respect, is but the tip of a very smelly iceberg.

Systemic indebtedness is a problem that is peculiarly British, and it has spawned a peculiarly British evil: rapacious markets. I will remind you that Germany’s stock market is roughly a quarter – if not a fifth – the size of London’s; and that for an economy that is substantially larger and with a stable government. The effect of the markets in Germany is very little. The effect of the markets in Britain is decidedly corrosive. Germany has its problems, but they are not British ones, so don’t fuck with the German economy in the way you can with the British ones and expect a result for your money.

And what of the government itself? The British government, like Carillion, is unable to pay its way. It has an ever growing debt and an increasing deficit, neither of which were in manageable territory a decade ago. Nobody talks about it in the financial press, and for good reason. It is out of control and there is nothing that can be done about it now, even if they wanted to. The British government, in outsourcing everything to the private sector has acted in precisely the way Carillion did.

The British government is Carillion. The truly worrying thing is that the British government find themselves in the same blind alley that Carillion did: too much debt and not enough money. Add the British government’s routine ability to play the clown and there really will be hell to pay.

Just look at the Brexit fiasco if you don’t believe me!

Notes:
(1) See my post on the AfD for more on the difference between the Anglo-Saxon style of sloganeering and the German way of contesting an election. Click HERE.

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There is no connection between the nature of the colour and the number it was given.
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A Sideways View · The Comfort Zone

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