Rediscovering Government

Can Tighter Financial Regulation and a Smaller Financial Sector Increase Economic Growth?

Jul 9, 2012Ugo Panizza

Economists are increasingly using statistics to debunk the age-old belief that economic growth goes hand in hand with a large financial sector. 

Economists are increasingly using statistics to debunk the age-old belief that economic growth goes hand in hand with a large financial sector. 

For a long time it was simply taken for granted that a large financial sector was beneficial to economic growth. This assumption supported the long period of financial deregulation and weak enforcement that began in the 1970s. Increasingly, economists are using statistical techniques to challenge this view. In the piece below, Ugo Panizza, the international economist who works for UNCTAD, summarizes the analysis he has done to show that a large financial sector is associated with slower economic growth. Links to the detailed papers he and colleagues have done are included at the end of this post. -Jeff Madrick, Director, Rediscovering Government Initiative

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The financial system acts like the central nervous system of modern market economies. Without a functioning banking and payment system, it would be impossible to manage the complex web of economic relationships that are necessary for a modern decentralized economy. Finance facilitates the exchange of goods and services, allows diversifying and managing risk, and improves capital allocation through the production of information about investment opportunities.

However, there is also a dark side of finance. Hyman Minsky and Charles Kindleberger emphasized the relationship between finance and macroeconomic volatility and wrote extensively about financial instability and financial manias. James Tobin suggested that large financial sector can lead to a misallocation of resources and that "we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity."

A large financial sector could also capture the political process and push for policies that may bring benefits to the sector but not to society at large. This process of political capture is partly driven by campaign contributions but also by the sector's ability to promote a worldview in which what is good for finance is also good for the country. In an influential article on the lobbying power of the U.S. financial industry, former IMF chief economist Simon Johnson suggested that:

The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

The objective of financial regulation is to strike the optimal balance between the risks and opportunities of financial deepening. After the collapse of Lehman Brothers, many observers and policymakers concluded that the process of financial deregulation that started in the 1980s went too far. It is in fact striking that, after 50 years of relative stability, deregulation was accompanied by a wave of banking, stock market, and financial crises. Calls for tighter financial regulation were eventually followed by the Dodd-Frank Wall Street Reform and Consumer Protection Act and by tighter capital standards in the Basel III international regulatory framework for banks.

Not surprisingly, the financial industry was not happy about this rather mild tightening in financial regulation. The Institute of International Finance argued that that tighter capital regulation will have a negative effect on bank profits and lead to a contraction of lending with negative consequences on future GDP growth. Along similar lines, the former chairman of the Federal Reserve, Alan Greenspan, wrote an op-ed in the Financial Times titled “Regulators must risk more, and intervene less,” stating that tighter regulation will lead to the accumulation of "idle resources that are not otherwise engaged in the production of goods and services" and are instead devoted "to fending off once-in-50 or 100-year crises," resulting in an "excess of buffers at the expense of our standards of living"

Greenspan's op-ed was followed by a debate on whether capital buffers are indeed idle resources or, as postulated by the Modigliani-Miller theorem, they have no effect on firms' valuation. To the best of my knowledge, there was no discussion on Greenspan's implicit assumption that larger financial sectors are always good for economic growth and that a reduction in total lending may have a negative effect on future standards of living.

In a new Working Paper titled “Too Much Finance?” and published by the International Monetary Fund, Jean Louis Arcand, Enrico Berkes, and I use various econometric techniques to test whether it is true that limiting the size of the financial sector has a negative effect on economic growth. We reproduce one standard result: at intermediate levels of financial depth, there is a positive relationship between the size of the financial system and economic growth. However, we also show that, at high levels of financial depth, a larger financial sector is associated with less growth. Our findings show that there can be "too much" finance. While Greenspan argued that less credit may hurt our future standard of living, our results indicate that, in countries with very large financial sectors, regulatory policies that reduce the size of the financial sector may have a positive effect on economic growth.

Countries with large financial sectors (the data are for the year 2006):

Source: Arcand, Berkes, and Panizza.

Ugo Panizza is a chief economist with UNCTAD, the United Nations agency dealing with trade, investment, and development, and is a visiting professor at the Geneva Institute.

 

References

Arcand, J.L., Berkes, E., and Panizza U. (2012) “Too Much Finance” IMF Working Paper WP/12/161 http://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf

Greenspan, A. (2011) "Regulators must risk more, and intervene less," Financial Times, July 26, 2011.

Johnson, S. (2009), "The quiet coup," The Atlantic (May 2009).

Kindleberger, C. P. (1978), Manias, Panics, and Crashes: A History of Financial Crises, Basic Books, New York.

Minsky, H. P., (1974), "The modeling of financial instability: An introduction," in Modelling and Simulation, Vol. 5, Proceedings of the Fifth Annual Pittsburgh Conference, Instruments Society of America, pp. 267—72.

Tobin, J. (1984), "On the efficiency of the financial system," Lloyds Bank Review 153, 1—15. 

This piece draws from a longer article titled “Finance and Economic Development” and published in International Development Policy (http://poldev.revues.org/?lang=en).

Wall Street image via Shutterstock.com.

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The Rebirth of Unions

Jul 2, 2012Hye Mi Ahn

Unions are a crucial aspect of the U.S. economy and should be adapted to be made more efficient rather than dismissed or eliminated. 

Unions are a crucial aspect of the U.S. economy and should be adapted to be made more efficient rather than dismissed or eliminated. 

In a letter to the president of the National Federation of Federal Employees in 1937, President Roosevelt wrote: "Organizations of government employees have a logical place in government affairs. The desire of government employees for fair and adequate pay, reasonable hours of work, safe and suitable working conditions, development of opportunities for advancement, facilities for fair and impartial consideration and review of grievances, and other objectives of a proper employee relations policy, is basically no different from that of employees in private industry." 

But the days of elected officials supporting organized labor may be behind us for good. Scott Walker, the Governor of Wisconsin who stripped government employees of collective bargaining rights, easily survived a recall election recently, inciting Republicans to declare that the backbone of the American labor union had been finally and truly broken. The discussion then turned to the implications for Democrats in the 2012 election, but the uncertain future for labor unions should not be dismissed so easily. 

Unions played a vital role in buoying the middle class throughout the 20th century, and they still remain a prominent fixture in countries around the world. During the 1950s—the height of unionization in the United States—membership rates hovered around 35p ercent and the public attitude toward unions was generally favorable. Progressives like President Roosevelt understood the importance of healthy unions to level the playing field between labor and management, and as a necessary check on the free market, so that employers would be beholden to their workers as well as shareholders and profits.

But in the following decades, several factors contributed to the steady decline of unions. As the United States began to move away from manufacturing, the middle class that supplied unskilled labor to the economy began to lose its collective power and political clout. Stonemasons, construction workers, and machine operators were laid off as the skills-focused service industry dominated the economy. Globalization led to the mass outsourcing of traditional middle class jobs. The relentless advent of technology required employees to have specific training or college degrees, when their positions weren’t replaced entirely by machines.

Unsurprisingly, income inequality grew larger as union membership rates fell during this time. And when union membership rates slow down, so do blue-collar wages. The middle class share of aggregate income has been in consistent decline since the 1960s, to an alarmingly low level today. 

In light of the Occupy Wall Street movement and the ongoing discussion of class warfare, it would be easy to presume that the "99%" would support labor unions that have been the historical equalizer between management and the working class. However, the fact that Scott Walker remains governor today is a sure sign that the existing model of unions, especially in the public sector, is unsustainable in an era of global economic turmoil. Eventually, budget deficits must be dealt with at every level of government, and austerity will spare few of the perks, like pensions and health benefits, that are associated with union membership.

But the election results should not be taken as the final word. Just as the motive for profit does not drive all employers to act ruthlessly, unions should not be assumed to exploit powers like collective bargaining to freeze out non-union members or hold employers hostage with strikes. Likewise, unions do not inherently cause inflation, unemployment, or state budget deficits, according to leading economists.

Here are some findings from a report by the Economic Policy Institute that show how unions benefit society as a whole:

  • “Unions raise wages of unionized workers by roughly 20% and raise compensation, including both wages and benefits, by about 28%.”
  • “Unions reduce wage inequality because they raise wages more for low and middle-wage workers than for higher-wage workers, more for blue-collar than for white-collar workers, and more for workers who do not have a college degree.”
  • “Strong unions set a pay standard that nonunion employers follow. For example, a high school graduate whose workplace is not unionized but whose industry is 25% unionized is paid 5% more than similar workers in less unionized industries.”
  • “Unionized workers receive better pension plans. Not only are they more likely to have a guaranteed benefit in retirement, their employers contribute 28% more toward pensions.”

There was a spurt of experimentation in the 1990s when companies and unions from AFL-CIO cooperated to form teamwork strategies that improved efficiency. Industry giants like Xerox Corp. found the initiatives to be so successful that they moved hundreds of jobs back to the United States and invested in their unionized workers for higher quality output and increased competitiveness. This is a norm in other industrialized nations; the history of modern European states shows a robust relationship, not fatal incompatibility, between organized labor and firms.

In the United States over the past few decades, unions have become saddled with an unsavory reputation of being ineffective, stubborn components of the economy that prioritize membership benefits at the expense of efficiency. The cozy, symbiotic financial relationship between public unions and elected Democrats hasn’t helped either. Instead of fanning the flames of the management-labor divide, as the unions tried to do with the recall effort in Wisconsin, unions should direct their energy to adapting and becoming cooperative elements in the free market by working with firms to generate productivity.

As the nation grapples with growing inequality, we should not categorically reject the place of unions in our economy. And as technology and changing business models reshape the global economy and feed the growing income gap as they have in the past, unions could prove to be critical at resuscitating the middle class now and protecting workers’ rights in the future. 

Hye Mi Ahn is a rising senior at Carleton College, and a Roosevelt Institute summer intern. 

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Government and Economic Growth: Correcting Common Mythology

Jul 2, 2012Jeff Madrick

The claim that the size of government is inversely related to growth is misguided and detrimental. 

The claim that the size of government is inversely related to growth is misguided and detrimental. 

A major purpose of the Rediscovering Government initiative is to counter unfounded and damaging claims about the effects of government on an economy’s growth. The Financial Times published a letter on June 27th, which asserted that all economists agree the size of government is inversely related to growth and that high levels of debt tamper growth. I wrote a brief letter challenging such all-too-common mythology, which was published on June 28th.

See the letter below, followed by links to first-rate scholars’ work that can be found on our web site. This in turn is followed by a link to a well-documented rebuttal to the widespread claim that debt of 90 percent affects growth negatively. Is there really a demarcation point beyond which debt as a percent of GDP slows growth? Many observers have simplistically adopted the Reinhardt-Rogoff analysis that debt of 90 percent of GDP is a threshold, but it is not considered valid by many economists because the analysis is so dependent on a few atypical post World War II years in the U.S. This criticism of Reinhardt-Rogoff can be found below. Finally, the UNCTAD economist, Ugo Panizza, wrote us and sent his own fine work on the subject. We link to that here as well.

On issues involving the uses and purposes of government, we at Rediscovering Government will respond to mythologies and deliberately misleading arguments as quickly and responsibly as possible. Our aim is to correct and nourish the public discourse.

 

FINANCIAL TIMES, June 29, 2012

“Bold statements – but few will agree”

From Mr Jeff Madrick.

Sir, Andrew Sussman (Letters, June 28) makes two bold assertions that require correction.

He says there is an inverse relationship between the size of government and growth. This is untrue. Serious economists agree there is no such statistical relationship. Many big government states have grown faster than the US.

Even more boldly, he states that “one thing all economists agree on” is that if debt reaches 90 per cent of gross domestic product, growth will slow markedly. This is based on a paper by Carmen Reinhardt and Kenneth Rogoff that has been widely criticised. Few economists agree with this simple conclusion.

Jeff Madrick, The Roosevelt Institute, New York, NY, US

 

1. Peter Lindert Bio

Full Presentation

Presentation Handout

2. Jon Bakija Bio

Full Presentation

Presentation Handout

3. Lane Kenworthy Bio

Full Presentation

Presentation Paper

4. A criticism of Reinhardt-Rogoff

5. Is High Public Debt Harmful for Economic Growth?  

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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The Start of Something Big: Obamacare May Renew Faith in Government

Jun 29, 2012Jeff Madrick

The Supreme Court ruling on the Affordable Care Act yesterday can be a pivotal point in the restoration of faith in government. 

With the affirmation of Obamacare, it is now up to the president to make clear to Americans how much help it will provide them. There are even bigger stakes than health care; this can be the pivot point around which faith in government can be restored. It is the main theme of our Rediscovering Government initiative.

The Supreme Court ruling on the Affordable Care Act yesterday can be a pivotal point in the restoration of faith in government. 

With the affirmation of Obamacare, it is now up to the president to make clear to Americans how much help it will provide them. There are even bigger stakes than health care; this can be the pivot point around which faith in government can be restored. It is the main theme of our Rediscovering Government initiative.

One can only hope the president won’t back off. Of course, the intense concern about the deficit can be hobbling, and it's a concern the president has too readily bought into. But it is now time to rejoice. Obamacare is full of what I’d call minimal decency, which is a big step up from the insensitive health care system the nation built—a cruel system because it left so many out. 

The law is complex but has so many good points, from closing the senior drug doughnut hole, to requiring insurance companies to take all comers regardless of pre-existing conditions, to ending lifetime caps on insurance payments, to providing understandable insurance plans for all managed by state exchanges, that it would take an hour or so if the president were to make a speech explaining them.

It also has faults, but not the ones the Republicans and extreme right are likely to point out, which will revolve around denying freedom in some way or other. Let's remind the anti-government right that healthy people are far freer than unhealthy ones.

Costs are an issue. Sadly, the Supreme Court majority voted to allow states to deny Medicaid coverage in the new bill. But perhaps this will be a rallying point for political activity in state capitals. Obamacare does have some mechanisms to reduce general costs, but we will need more effective ones to deal with rising health care costs in the 2020s. Let’s remember that an affordable public option—an alternative to private insurance—could eventually be added if the public starts to support Obamacare and elects congressional representatives willing to vote for such an option. This could do a lot to keep costs down.   

Here’s a link to a piece I did on Obamacare for the New York Review of Books that may be of some help. 

Again, however, Obama should use his health care victory as a message that government is necessary, can work, and will make America a far better place. The purpose of government is the issue of the age.

See the article from today’s New York Times, by Mark Landler, which repeats many of our own themes about government. Let’s try to make this a new beginning. As the economist Annette Bernhardt just said to me, “the president now has a second chance.”

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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The French Economic Experiment

Jun 27, 2012Jeff Madrick

Francois Hollande's novel economic policies in France should be monitored closely, to see if they are successful. 

The new president of France, Francois Hollande, has announced unusual new economic measures that everyone should pay attention to. They represent a decided turn away from the destructive policies of the eurozone so far, and even violate basic neoclassical economic principles. We all ought to watch closely to see if they succeed.

Francois Hollande's novel economic policies in France should be monitored closely, to see if they are successful. 

The new president of France, Francois Hollande, has announced unusual new economic measures that everyone should pay attention to. They represent a decided turn away from the destructive policies of the eurozone so far, and even violate basic neoclassical economic principles. We all ought to watch closely to see if they succeed.

While almost everyone in Europe is calling for lower wages, Hollande is raising his country’s minimum wage faster than inflation. He thus has favored a view of the economy called demand-led growth, which suggests higher wages will increase demand sufficiently to promote more growth. It is a version of Keynesianism, long since dropped by most American Keynesians. I discuss this at some length in a piece for New America Foundation, called "A Case for Wage-Led Growth."

He is also proposing a 75 percent income tax on those who make more than 1 million euros a year, and higher taxes on dividends. Many think raising taxes in a recession is anathema, but raising taxes on the rich will not hurt the nation. It will not affect their spending very much.

Thus, he stokes demand with higher wages for lower income people and satisfies the budget crisis with higher taxes on the wealthy. Not bad. There are hints he will also propose budget cuts, which would mistakenly play into the hands of the austerity advocates. We shall see.

The problem of course is that the wage increase is skimpy, to say the least. Another problem—and a bigger one—is that a higher-wage policy has to be taken broadly across Europe and led by the Germans. This is what I advocate in the New America piece. While German ministers have talked about higher wages there, they are not taking aggressive action.

Still, let’s keep an eye on the French experiment. It is a bit of fresh air in a compression chamber of stifling, self-centered economic policy-making.

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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Health Care Reform and the Supreme Court: Politics Over Constitutionality

Jun 26, 2012Richard Kirsch

The Obama administration's neglect did not cause this constitutional challenge to the individual mandate. Republican strategy did.

The Obama administration's neglect did not cause this constitutional challenge to the individual mandate. Republican strategy did.

On the eve of the Supreme Court's decision, after numerous lower court opinions and treacherous questioning by conservative justices, the overwhelming consensus in the legal community remains that the requirement in the Affordable Care Act to buy health insurance is unquestionably constitutional. As recently as mid-June, Bloomberg News asked law professors at the nation's top law schools whether they thought there was any question that the Affordable Care Act’s individual mandate requiring the purchase of health insurance was constitutional; 19 of the 21 who responded replied that it was. They were only confirming the opinions of two very conservative appeals court judges, who upheld the provision last year.

But the widespread view that the only reason we have a question before the Supreme Court is their receptivity to right-wing political manipulation of the law was not the story told by the New York Times on Sunday, under the headline, "Supporters Slow to Grasp Health Law's Legal Risks." The Times's Peter Baker faulted the Obama administration and Congressional Democrats for being unprepared for the legal challenge.

Some would view the fact that the Court is seriously debating a question that is so far out of the political mainstream, even among the most respected conservative jurists, as a testament to the groundbreaking work of a small set of conservative lawyers to change jurisprudence. They would compare their work to the careful strategy that led to decisions like the Warren Court's Brown v. Board of Education. I am not so generous. The legal arguments against the individual mandate remain flimsy and there is no comparable history of carefully plotted legal strategy. What has become more solid is the ground that the arguments are being made on, a Supreme Court majority whose magnet is not the Constitution or precedents, but the U.S. Chamber of Commerce.

In drafting what became The Patient Protection and Affordable Care Act, Democrats in Congress and the White House had myriad complex policy and political factors to juggle. The implication that they should have added in the minuscule chance that the mandate would be successfully challenged on its constitutionality is as silly as the opponents' legal arguments.

What might have given the law's drafters pause was the ruling on Citizens United, in which the Court majority dynamited a century of precedent to overturn the ban on corporate campaign contributions. But that decision was handed down in January of 2010, three days after Scott Brown won election to the Senate from Massachusetts, in a seeming repudiation of health care reform, which deprived Democrats of their filibuster-proof majority. At that point, there was neither the time nor the legislative maneuverability to consider changing the structure of the mandate, even if someone had raised their head and said that this Court is capable of doing anything it wants to further the corporate agenda.

In contrast with the Times article, Ezra Klein has a piece in The New Yorker titled "Unpopular Mandate: Why Do Politicians Reverse Their Positions?" Klein points out that the question of the mandate's constitutionality on the right changed when conservative politicians jettisoned their own idea, the mandate, after Obama accepted it. He describes how the Republican message machine legitimized the constitutional challenge once Republican politicians did an about-face.

Two days from now the Court will weigh in. Many of those same law professors surveyed by Bloomberg predict the Court majority will ignore precedent and overturn the mandate. The have reached the same conclusion as many Americans that the Court is driven by politics, not the Constitution. I'm hoping they will be proven wrong, and that the Court will put our founding document and two centuries of precedent before the partisan, corporate agenda. But whatever they decide, I won't blame the fact that the case has gotten this far on Democrats in the White House or Congress.

Richard Kirsch is a Senior Fellow at the Roosevelt Institute, a Senior Adviser to USAction, and the author of Fighting for Our Health. He was National Campaign Manager of Health Care for America Now during the legislative battle to pass reform.

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Debunking the Myths About Government

Jun 25, 2012

Rediscovering Government presented four mainstream, empirically based analyses of major government-related questions in the Myths About Government panel in Washington DC on June 21st. The panelists from the roundtable discussion addressed four common misconceptions about government and the economy. Read their summary responses below, and click through to view their bios and full presentations.

Rediscovering Government presented four mainstream, empirically based analyses of major government-related questions in the Myths About Government panel in Washington DC on June 21st. The panelists from the roundtable discussion addressed four common misconceptions about government and the economy. Read their summary responses below, and click through to view their bios and full presentations.

Does big government impede growth?

Government Social Programs and Economic Growth: Verdicts from History

Peter Lindert, University of California, Davis

Economic history does not find any net cost in GDP from democratic large-budget welfare states. The “free lunch puzzle” of welfare states is this: They avoided any net GDP cost while achieving many social goals: reducing poverty and inequality, extending life spans, and having cleaner government. In addition, their government budget deficits are no greater, and people are no less happy in these large-budget welfare states.

Peter Lindert Bio

Full Presentation

Presentation Handout

Do high taxes create disincentives?

Evidence on the Economic Effects of Taxes

Jon Bakija, Williams College

There have been many econometric studies of cross-country data that have attempted to estimate the effects of the overall level of taxes on economic growth, and many other econometric studies (using a variety of types of data) that have attempted to estimate the causal effect of changes in marginal income tax rates on peoples' efforts to earn income. This presentation displays the basic facts on these issues, discusses why neither approach has provided convincing evidence of a strong negative effect of taxes on long-run real economic activity, and explains why healthy skepticism of any claims to the contrary is in order.

Jon Bakija Bio

Full Presentation

Presentation Handout

Do markets distribute income fairly and equitably?

America’s Struggling Lower Half

Lane Kenworthy, University of Arizona

When the country prospers, everyone should prosper. In the period between World War II and the mid-to-late 1970s, economic growth was good for Americans in the middle and below. Since then, however, relatively little of our economy's growth has reached households in the lower half. Wages for this group have barely budged. Rising employment helped in the 1980s and 1990s, but that wasn't enough to ensure that incomes kept pace with economic growth, and employment stopped increasing after 2000. Government transfers are another key source of income for many households in the lower half, but they too have lagged behind growth of the economy. What are the prospects going forward? Will we see a return to rising wages or employment for Americans in the lower half, or are the trends of the past few decades likely to continue? What, if anything, could our government do to help?

Lane Kenworthy Bio

Full Presentation

Presentation Paper

Do Americans want smaller government?

Better, Not Smaller: What Americans Want from Federal Government

Ruy Teixeira, Century Foundation, Center for American Progress

Americans lack confidence in the federal government's ability to solve problems.  A wide range of other indicators show that people think the government wastes a lot of the money it spends, is inefficient, not accountable for its actions, unresponsive and more a hindrance than a help to getting ahead in life. Not a pretty picture.  However, that doesn't mean the public necessarily wants the government to be smaller.  They would prefer instead that it worked better and solved problems.  Therefore, reforming the way government works could potentially contribute to building public support for government programs both old and new.  This is particularly true among members of the Millennial generation.  The other important factor is better macroeconomic performance, which would go a long way toward making people more receptive to an active role for government, especially a government that seemed to be performing more efficiently and effectively.

Ruy Teixeira Bio

Full Presentation

 

Rediscovering Government is an initiative of the Roosevelt Institute dedicated to exploring the purpose and value of government. Led by Roosevelt Institute Senior Fellow Jeff Madrick, the program aims to reinvigorate conversation surrounding government and what it can and should be doing for its citizens, through the website, blog, roadshows, and conferences.

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Myths About Government

Jun 20, 2012Jeff Madrick

The Rediscovering Government roundtable discussion in DC tomorrow sets out to debunk misconceptions about government spending and the economy and reinvigorate a dialogue about the importance and positive potential of government. 

The Rediscovering Government roundtable discussion in DC tomorrow sets out to debunk misconceptions about government spending and the economy and reinvigorate a dialogue about the importance and positive potential of government. 

Perhaps it isn’t odd that the American people are so skeptical of the uses and purposes of government. As a nation built on a revolution against a monarchy, such skepticism is likely built into our national character.

But it doesn’t accord with our history, and that is why it remains surprising. Government was inseparable from American economic and social development. It did not reduce freedom, but protected it.

I am always disturbed when economists in particular talk about the “role of government.” It is like talking about the role of parents in their children’s lives, or the role of the basketball in a basketball game. There is no economy without government, even in America. The government does not merely correct market failures; its purpose is far more profound. It is about true freedom, true opportunity, and necessary change.

We have organized an important panel discussion on June 21st in Washington, D.C., to put to rest some of the prevailing myths about government. Peter Lindert of the University of California at Davis will tell us about his empirical work on whether large government impedes growth; his extensive research shows it has not. Jon Bakija of Williams College will similarly tell us about how little hard evidence there is that high taxes impede growth. Lane Kenworthy of the University of Arizona will show how much of the income of the lower half of the distribution depends on social policies. Nancy Altman of Social Security Works will put straight the true finances of Social Security. And finally Ruy Teixeira of the Center for American Progress will tell us how extensive the American antagonism towards government is despite these facts, and whether these views can be changed.  

Our goal is to present a counter-narrative to the prevailing anti-government ideology. We will not argue that government is all good, requires no radical reforms, or cannot be made to work better. After all, why should we expect politicians to act in the interests of others, rather than their own sometimes contradictory interests?  

But there is reason to expect this, because it has happened time and again in American history. Moreover, acting in the interests of others is often acting in one’s self interest. Thomas Jefferson championed regulations of land sales in early America to make sure many people got a chance at ownership. The result was a strengthened democracy of secure and satisfied citizens.

His party built the canals through public financing in the states, led by New York. Many, and probably most, prospered when New York City became the giant hub of trade and commerce with the opening of the Erie Canal. American government created free and mandatory schools, subsidized the railroads, started technical colleges, and sanitized the cities, which in turn became sources of growth. In the 1800s, these activities were typically led by the state and local governments.

Markets don’t work when monopolies gather power, and the federal government in the next century set out to limit that from happening. It protected workers in all kinds of ways. In the 1930s, it recognized that financial markets were different from others and required special regulations. It built highways, invested in medical and technical research, subsidized college, and established necessary product, safety, and environmental regulations.   

As Lane Kenworthy points out in his fine summary piece on our site, if big government were a problem, why did the U.S. economy keep growing fast even as government got bigger?  

And let me point out one other factor that is neglected. As I emphasized in my book, The Case for Big Government, government is the key agent of change. No one anticipated we’d need high schools and colleges when the Constitution was written, but government was the instrument to create these critical institutions. No one knew of germ theory, but government led the way in sanitizing water and making large cities habitable. Who knew about the computer chip?

Perhaps I am biased because I live in New York. The New York City government eventually took over and aggressively expanded the subways. It built the dramatic walls of Riverside Drive, so often neglected. Miracle of miracles, it collects the garbage in this densest of cities.

But consider the great water works of the west. This was the work of state and federal government. And the highways, of course.  And the university system of California, among others.

If one needs further historical examples, consider the first great European city, Rome. Its aqueducts and enormous road network were the work of the government. Its devotion to law is a model to this day. It was highly productive and conducive to commerce because of these advances.  

American attitudes towards government have always shifted; sometimes pro-government and public investment and social programs, sometimes against them. We were usually at our best when we favored government, but government was far from always efficient. America was not immune to substantial corruption. Government always needed a good wringing out. But when it was widely vilified and weakened, America often failed. Political instability, widespread sacrifice, and jeopardized democracy were results.  

As for contemporary times, the Great Depression was an important catalyst. It turned an already partly progressive nation (since Teddy Roosevelt and Woodrow Wilson) far more so. It gave us a minimum wage, unemployment insurance, Social Security, labor organizing protections, securities regulations, and great public works to create jobs. The New Deal was followed by Johnson’s remarkable Great Society in the 1960s -- Medicare, Medicaid, historic civil rights legislation, and on. The American social sphere was brought into modern time along with its economy, which required those social investments.

But these attitudes shifted strongly beginning in the 1970s. Attitudes towards government had already become somewhat more skeptical in the 1960s, with new poverty programs and racial demands. The Vietnam War was a further blow to confidence in government, as was the Watergate scandal.  

In my view, however, the economic devastation of the 1970s was the major blow. Inflation of 12 percent, unemployment soaring, mortgage rates at 18 percent. In 1972, Governor Ronald Reagan of California supported a referendum to demand a sharp and permanent cut in state income taxes. Californians voted against it; they said they would pay their state taxes. By 1978, only six years later, Proposition 13 passed overwhelmingly, sharply cutting property taxes and with it undermining the state’s great education system.  Nationally, the Kemp-Roth tax proposal to cut federal income taxes up to 30 percent was rapidly gaining support in Congress. Economic pain caused Americans to seek quick and sometimes vindictive solutions, even personally self-destructive ones.  

In my view, the lost faith in and mismanagement of government is the key cause of the crisis of the future the nation now faces. This lost faith resulted in deregulation, unaffordable tax cuts, and the failure of government to develop new programs and act as the agent of change it should be.  

We can argue about these issues philosophically. But Rediscovering Government will stay as close to the demonstrable facts as possible. We will present the evidence about government, the economy, and growth. Then we can discuss how to restore a true sense of our own history, rebalance our sense of the purpose of government, and move on constructively.  

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

 

Capitol image via Shutterstock.com.

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Reagan Redux: The Truth About Romney Economics

Jun 15, 2012Jeff Madrick

The oversimplification of Romney’s economic plan avoids calling it out for what it really is: an extension of failed Republican economic policies.

In the home of Sarah Jessica Parker and Matthew Broderick this week, The New York Times reported that President Obama described Romney’s campaign attacks, which claim all current problems are “the fault of the guy in the White House,” as “an elegant message. It happens to be wrong.”

The oversimplification of Romney’s economic plan avoids calling it out for what it really is: an extension of failed Republican economic policies.

In the home of Sarah Jessica Parker and Matthew Broderick this week, The New York Times reported that President Obama described Romney’s campaign attacks, which claim all current problems are “the fault of the guy in the White House,” as “an elegant message. It happens to be wrong.”

This is as clear an example as we have of Obama’s inability to make a powerful message in a few words. Sounding professorial, he uses the word “elegant” as if referring to a mathematical proof. Clean and simple, I suppose. But to many a listener and reader, elegant only has positive connotations. Why this loftiness when plain, honest, focused language will do the job?

The fact is that almost all of our current situation is a result of economic policies that were put into effect before Obama took office. Not only is Romney’s message not elegant, but his economic plan will boldly extend these failed policies. His central message is simplistic, ignorant, and, to use a lofty word, ahistorical. In actuality, the plan has been underway since the 1980s and even before, and look where it’s gotten us. It serves the interests of the wealthy very well, but has it served America at all? It’s not the collapse of the welfare state, but the ravages of a rising oligarchy, that are undoing America.

Which brings me to another New York Times piece, today’s David Brooks column. Brooks’s methodology as a “thinker” is to develop arguments that he knows will sound plausible to his readers and maybe to a significant swatch of centrists. He is good at these over-simplifications. Today’s column is as unaware or deliberately neglectful of history as ever. What Democrats don’t understand is that the system is broken, he says. Republicans understand this and want to return us to some early (if mythological) economic state. The welfare state is on the cusp of failing; he quotes a Weekly Standard piece on this idea that he thinks definitive. This welfare model, he goes on, “favors security over risk, comfort over effort, stability over innovation.”

This is breathtaking nonsense. The so-called welfare state—whose main features are benefits to the elderly, by the way—favors opportunity for those who have no access to it,  substantial government investment in education and research, which are the great sources of innovation, adequate transportation to enable business to operate efficiently, and fewer and more moderate recessions so that the nation does not lose investment, human capital, and many good businesses due to short-term fluctuations.

And, oh, yes, the welfare state does promote some compassion for the less fortunate—those thrown out of work through no fault of their own—and a sense that all of us owe something to each other. And, yes, it does require government.

What’s truly mind-numbing about the Brooks view, which clearly represents a Republican body of what is considered highly sensible thought, is that all the Romney proposals have been on the ascendancy since Ronald Reagan, and some of them before. These include lower progressive tax rates (Reagan and Bush); deregulation and weak regulatory implementation (Reagan, Bush I and II, Carter, and most important for financial regulations, Clinton); reduced social spending on many categories, notably welfare (Reagan and Clinton); few new programs even as social needs change; and inordinately tight monetary policy since Paul Volcker’s chairmanship at the Federal Reserve, to keep inflation and therefore wages in check. And what happened? Stagnating wages, modest capital investment, unequal public education, and collapsing infrastructure. These are the results of Romney economics.       

If there is theory at all in the Brooks view, it is of course the spurious generalization that individualism will win the day. Just make everyone take care of him or herself. Republicans love this notion. The other idea is that if business is just allowed to do its job, free of most regulation and taxes, everyone will do just fine.  The historical evidence clearly points to the opposite. Look at the levels of inequality in the good old regulation-free and low-tax days of post-Civil War America. Do you we need a better example?

Returning to Obama—he better fight this battle head on, not in professorial dignities, but on the sweaty mat where victory is won. He better understand that the Brooks's over-simplifications are appealing because they blame victims and relieve the rest of responsibility. Call these things what they are, Mr. President. Make America the responsible society once again. The Romney policies failed not just since George W. Bush, but since Ronald Reagan and even Jimmy Carter. 

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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How Does Private Equity Really Make Money?

Jun 12, 2012Eileen Appelbaum

Attempts at turnarounds of failing companies are only a very small portion of private equity investments. 

Attempts at turnarounds of failing companies are only a very small portion of private equity investments. 

The distinguishing feature of private equity (PE) buyouts is that they are changes in the ownership and control of operating companies in the later stages of a company's history. The transactions are led by a private equity firm, and the firm sponsors PE funds that purchase operating companies for their portfolios. The PE firm is the general partner (GP) and makes all the decisions; pension funds and other investors are limited partners (LPs). Acquisition of an operating company entails extensive debt financing, with the burden of the debt falling on the acquired company, which is responsible for repaying it. The focus in this post is on the sources of gains to private equity investors from these leveraged buyouts.

Maybe most important, we begin by noting that private equity is not mainly engaged in buying up failing companies and trying to turn them around. The disproportionate emphasis in the media and by PE firms on efforts to turn around failing companies paints a distorted picture of what private equity does. Bill Clinton unfortunately bought into this view when he tried to explain what’s good about private equity on PBS NewsHour: "I’ve got a friend who buys failing companies, and he tries to turn them around. And he’s turned a bunch of them around, but not all of them. So sometimes he tried and failed. The effort was honorable. That’s a good thing."

The reality is that distressed investing makes up only a thin sliver of private equity investments, typically 1 to 2 percent of annual PE investments. Indeed, a study of 3,200 firms and 150,000 establishments found that establishments acquired in private equity buyouts had faster employment growth prior to takeover than comparable establishments not targeted by private equity. Private equity mainly acquires successful companies.

The sweet spot for private equity is a company doing okay in an industry whose fortunes are about to improve dramatically. This can be a source of PE returns, but it is the result of successfully timing the market.  Management fees that PE firms charge limited partners account for about two-thirds of the earnings of PE firms, but this affects the distribution of gains between GPs and LPs, and not the amount.  Net returns to investors of these fees are unclear. Top quartile PE funds are able to beat the S&P 500 index, but results for funds below the 75th percentile are ambiguous. Returns to large pension funds rarely exceed the stock market by more than the premium for holding illiquid assets. Our focus is on the nature of the private equity business model and what this tells us about the sources of aggregate gains to the GP and LP investors.

Several characteristics of the PE business model directly impact the operations of their portfolio companies:

First, private equity investments are illiquid and more highly leveraged than investments in publicly traded companies–hence, more risky. They need to yield high returns to be worth undertaking.

Second, the high debt that portfolio companies must service means they must quickly achieve an increased and predictable cash flow. Cutting costs by squeezing labor is the surest way to accomplish this.

Third, the PE model is the opposite of "patient capital." While limited partners make a long-term commitment to the PE fund, portfolio companies have only a short time to show results.

Fourth, asset stripping is typical in retail. When PE buys a department store chain, it typically splits it into a property company (prop-co) that owns the real estate and facilities that house the stores and an operating company (op-co) that runs the business. The op-co now must pay rent and no longer has a buffer to help it survive in volatile markets. PE sells the prop-co, making a profit on its initial investment regardless of whether the stores prosper.

Finally, PE will not undertake long-term investments in its portfolio companies unless capital markets are efficient and reward such investments with a higher price when the company is sold.

In most cases, top executives in operating companies face perverse incentives. They are handed a debt structure, asked to put up some of their own wealth, and promised great riches if they meet the targets set by the PE firm. If they fail to deliver quickly, they can expect to be fired. One study found that 39 percent of CEOs were replaced in the first 100 days and 69 percent in a four-year period. Like the hangman’s noose, this tends to focus managers’ minds on aggressive cost cutting.

Operational "value add" – the development and implementation of a business strategy that takes an operating company to the next level, and/or improvements in operations (supply chain management, modernization, process improvements, worker engagement) – harnesses the PE owners’ access to superior management skills and capital markets to improve performance. Buyouts of family-owned businesses and acquisitions of hospitals that lack funding to stay abreast of the latest technology are examples, as is distressed investing that rescues companies from bankruptcy. In these instances, private equity creates economic value as well as gains for PE investors. The evidence of these operating gains is thin, however, and even sympathetic academic studies are not persuasive. Greater transparency by this notoriously private industry would help establish how widespread such economic wealth-creating practices are.

The creation of economic value is one source of private equity gains. It is not the only source, however, and is often not the main source.

A second source of gains is a transfer from workers to PE investors, as employees at healthy companies that are performing well are laid off and those that remain are subject to an intensification of work. Wages and benefits may be reduced to increase predictable cash flow. Work may be shifted from union to non-union facilities. While such actions may be necessary in the case of distressed firms in need of a turnaround, the practice is applied far more widely.

Transfers from portfolio companies to PE owners are a third source of private equity gains. The portfolio company’s private equity shareholders may require it to issue junk bonds or may dip into its cash flow in order to pay them a dividend – a so-called dividend recapitalization. PE takes funds that should be used to improve portfolio company operations and create economic value. Often, this creates financial distress for the portfolio company and may even drive it into bankruptcy.

The op-co/prop-co model in retail also transfers assets from the portfolio company to its PE owners. The PE investors enrich themselves at the expense of the portfolio company, which receives little or none of the proceeds of the sale of the real estate assets. As a result, the risk of bankruptcy of the operating company increases. It may get into financial trouble and have to shutter some stores or close down entirely. As a result, the pace of job destruction in PE-owned retail establishments is far greater than in comparable non-PE owned establishments; over a five-year period, the difference cumulates to 12 percent.                 

A fourth source of gains is a transfer from taxpayers to private equity – what a state economic development officer termed "taxpayer financed capitalism." The leverage used to acquire the portfolio company alters its debt structure, increases its debt, and, because of the favorable tax treatment of debt compared to equity, reduces the company’s tax liabilities. Lower taxes raise the bottom line and increase the value of the company by 4 to 40 percent , thus increasing the returns to private equity without increasing economic value. In addition, the PE firm is more likely to be able to use tax arbitrage to legally avoid taxes. Some acquisitions are made for this purpose rather than to create value.

The final two sources of PE gains were identified in the first wave of leveraged buyouts in the 1980s. Shleifer and Summers identified breach of trust as a possible source of increased returns following an LBO. Stable enterprises depend on implicit contracts between shareholders and other stakeholders. Private equity can get a quick boost to a portfolio company’s bottom line by reneging on implicit contracts. This, however, undermines the trust necessary to the long-term sustainability of the portfolio company. Ackerlof and Romer identified the possibility of bankruptcy for profit. This occurs when a PE firm takes a portfolio company into bankruptcy and then buys it out of bankruptcy. The PE firm is still the owner, but the debts of the company have been slashed and its pension liabilities have been transferred to a government agency, the Pension Benefit Guarantee Corporation. The PE firm comes out ahead, but lenders take a haircut and workers receive reduced pensions.

The goal of public policy is to reduce incentives for rent-seeking activities by PE firms. There are several key policy changes that could have this effect: 

First, we can limit the tax deductibility of interest to remove the incentive to overleverage the acquired company. This will reduce the amount of debt placed on companies acquired by private equity. Highly leveraged companies perform poorly in volatile markets and have high rates of bankruptcy during economic downturns.

Second, we can raise the tax rate on capital gains received by individuals. There is no economic rationale for treating interest payments differently than dividends.

Third, we can tax "carried interest" – the share of the gains claimed by PE general partners, among others – as ordinary income. It is a bonus or pay for good performance and should be taxed as such.

Finally, we can require firms to make severance payments based on years of service when laying off workers. This would make layoffs a last resort rather than the first. 

Eileen Appelbaum is a Senior Economist at the Center for Economic and Policy Research.

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