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Taking the Medicine

The difficulties on Wall Street this week are a reminder that from time to time we have to take our medicine.  Many entrepreneurs felt this after the Internet bubble burst.  We all knew of the excesses of the Internet boom, but very few people were able to resist diving in and trying to capitalize.  When things burst, we had to radically change our approach and rationalize our investments.  Although incredibly painful, particularly for those who lost their jobs, this is an important part of capitalism.

This type of U-turn is important feedback to remind investors about irrational exuberance in the future.  Investors got religion on capital efficiency and more coherent business models.  Over time, they will get less disciplined as the sting wears off and, eventually, market strength returns.  But, corrections come which reminds people to stick to the fundamentals.

Homeowners who knew that they couldn't afford the loans that they were taking out and investment bankers who knew that they were overextending themselves with excessive leverage are both like crazy Internet entrepreneurs in the bubble.  They may have known that what they were trying to do didn't make sense, but the market was letting them do it.  It wasn't illegal or unethical (although I am sure that there were unethical dealings in some of each of these types of deals).  Maybe things would hold up long enough for them to take advantage of it.  But, when it doesn't, I don't have much sympathy.  They took a chance, and it didn't pay off.  Unless someone lied to them about the risks, they generally have to be responsible for their own actions.  That's taking the medicine, and it will make them think twice before they do it again.

I am generally not a big believer in government bailouts in these situations.  I guess that some of these situations are so big that the government has to guarantee some aspect of the deal to get it done.  But, I would be more in favor of cutting the price to the bone and having no guarantees.  If that means that the stocks of the investment banks are worth nothing or that someone loses the house that they couldn't really afford, so be it.  If the government helps anyone, it should try to make sure that unknowing customers are protected and that there isn't a run on financial institutions that is unjustified.  And, the government should insist on more transparency to limit the risk of this type of thing in the future.  I like transparency much more than regulation.  Regulators will inevitably get it wrong (see Sarbanes Oxley).  But, quantifying the risks of all of a banks holdings is a good thing.

Lessons for all: Don't live beyond your means.  Don't over leverage your business.  Don't take on much debt.  All of these things may feel good in the short term, but the medicine you will inevitably have to take won't taste very good in the end.

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