Defending Krugman: The Importance of Keynesian Economics

May 25, 2012Jeff Madrick

Keynes was right: increased government spending in the U.S. is necessary to decrease unemployment and raise demand in the near-term.

Paul Krugman hardly needs defending, but his views about the need for Keynesian stimulus in the U.S. right now are coming under considerable fire from centrist and left-of-center economists. I find this disturbing because Krugman’s view abides by basic Keynesian principles that seem to have been discarded by many who profess themselves Keynesians. Is there a wide misunderstanding of Keynes?

Keynes was right: increased government spending in the U.S. is necessary to decrease unemployment and raise demand in the near-term.

Paul Krugman hardly needs defending, but his views about the need for Keynesian stimulus in the U.S. right now are coming under considerable fire from centrist and left-of-center economists. I find this disturbing because Krugman’s view abides by basic Keynesian principles that seem to have been discarded by many who profess themselves Keynesians. Is there a wide misunderstanding of Keynes?

What seems to upset people is that Krugman argues the government must spend more money now, almost regardless of what it spends it on. The Keynesian thesis is that economies can settle at a high level of unemployment rather than re-adjust to the optimum unemployment level—or level of economic activity—on their own. This was a response to the classical, pre-Depression view that the beauty of free markets was a self-adjustment process based on falling prices in downturns. But ultimately the problem is a lack of demand, and Keynes advocated budget deficits to support an increase in demand.

The lack of demand in the economy now is palpable. Krugman’s contention is that in the near-term, we can solve this problem if we have the will to do so. The economy can reduce its rate of unemployment fairly rapidly with adequate Keynesian stimulus. It is clear that monetary stimulus at this point is not enough.

This view is not incompatible with longer-term concerns about the economy -- inadequate education for too many, infrastructure decay, old energy technologies, and so on. Many seem to criticize Krugman for not acknowledging “structural” changes in the economy, and they implicitly agree with classical conservative observers that the unemployment rate really can’t fall much below 7 percent. I can’t speak for Krugman, but he seems to be saying that we should not mix up longer-term structural issues with near-term demand inadequacy. It’s very likely the unemployment rate can fall much farther without igniting inflation.

I can’t see how he is wrong about this; indeed, he is urgently right about it. We are facing a year or two when the federal government will likely contract spending and will certainly not increase stimulus markedly. Of even greater concern is the refusal in Europe to recognize that austerity—the opposite of Keynesian advice right now—will lead to further recession, which in turn could spill over to the U.S., jeopardizing Obama’s candidacy.

When so many commentators criticize Krugman’s view, insisting that any new spending must be investment in infrastructure, must not go to the military, or that there should be no new spending at all, they are ignoring the Keynesian process. Krugman will not advocate against military spending cuts (and I certainly wouldn't myself). But priorities are important here. Let’s keep them clear.

In sum, let’s understand that more aggregate demand now will reduce the unemployment rate. There is a near-term solution, not to America’s long-term issues, but to an economy that is sputtering and may lead to a political environment in which those who plan to do more damage win office.  

One of the true advances in contemporary thinking is that both a power and a duty of government is to use fiscal and monetary policy to ameliorate downturns and create economic expansions. This is the legacy of Keynes, well supported by empirical research.  

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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New Deal Numerology: An Equitable Arrangement

May 25, 2012Tim Price

 

This week's numbers: $607 billion; 20%; 115; $12 million; 13

$607 billion... is a transactional number. That was the aggregate value of private equity’s buyout deals at their 2007 peak. If you could sum up that period in two words, they'd be "job creation." And if you had three more words, they'd be "there was no."

 

This week's numbers: $607 billion; 20%; 115; $12 million; 13

$607 billion... is a transactional number. That was the aggregate value of private equity’s buyout deals at their 2007 peak. If you could sum up that period in two words, they'd be "job creation." And if you had three more words, they'd be "there was no."

20%... is an encouraging number. That's how much of the private equity firms' value was due to tax breaks on debt during their rise in the 1980s. If debt were like beer, our tax code would be the frat boy telling them to chug until they pass out.

115... is an acquired number. That’s how many companies Bain Capital bought out while Mitt Romney worked there. One of them was Staples, which would later base its “Easy Button” ad campaign on the real life stories of the millionaires who owned it.

$12 million... is a rewarding number. That’s how much Bain made from its buyout of GST, a steel mill that went bankrupt two years after Romney left. It must have been tough to decide whether to send his old partners condolences or congratulations.

13... is a resigned number. That’s how many years it’s been since Romney worked at Bain. It’s odd that he’d rather not focus on any of his experience since then, but his base likes firing people a lot more than giving them health care.

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How Long Will Grads Be Stuck Working In Cafes, Restaurants, and Unpaid Internships?

May 25, 2012Elena Callahan

Without government action, a generation of college graduates will continue to flounder in unemployment or minimum wage jobs.

Without government action, a generation of college graduates will continue to flounder in unemployment or minimum wage jobs.

While reading Robert Reich’s post the other day about the horrible economy the Millennial generation is graduating into, I wondered what my life would have been like had I graduated in 2008. That year, almost three-quarters of graduates found a job within a year. I was supposed to graduate in 2008, but I ended up switching majors, taking time off, and graduating in 2010. And what a difference two years makes. Now, like so many of those who graduated with me, I’ve yet to land a full-time job and have been lucky enough to string together part-time work and internships. Too many graduates face un- or underemployment and will continue to languish unless the government acts.

My graduation date was delayed because I was a dance major my freshman year, but I realized I wanted to make a difference in the world and felt that switching to the social sciences and humanities would be the best way to do that. As it turns out, though, the arts and humanities are some of the worst areas to study in this economy. According to an A.P. report last month, those who graduated with degrees in zoology, anthropology, philosophy, art history, and the humanities were among those least likely to find jobs. Those who studied nursing, teaching, accounting, or computer science were better off. These things matter when 53.6 percent of college graduates under the age of 25 were jobless or underemployed last year.

These overeducated students are now occupying temp positions and taking jobs in the service and retail industries for a lack of better options. The Bureau of Labor Statistics reported in March that retail salespersons and cashiers were the occupations with the highest employment in 2011, and not far behind were general office clerks, food preparation, and serving workers like waiters, waitresses, and customer service representatives.

Those are some of the lowest paying jobs out there. Yet many students graduate with huge debt loads they need to pay off right away. According to the New York Times, the average load in 2011 was $23,300.

I don’t regret having chosen sociology as my major. It completely changed my perception of the world and broadened my understanding of why social problems exist. But it definitely didn’t employ me. Since I’ve graduated, I’ve applied to tons of jobs and internships, worked seven different part-time jobs, and volunteered and organized events when I’ve had the time. These jobs have included cafes, a bagel place, a bar, a restaurant, a boutique, and four different babysitting gigs. A lot of my friends have similarly worked at cafes, restaurants, and nanny jobs to pay the bills.

How will graduates succeed if they’re busy making lattes, mixing martinis, or helping customers try on clothes? Some, like myself, have decided that volunteering and interning is the next best thing. But not everyone can afford to take an internship, since most don’t pay and if they do it’s not very much. This ends up making the competition for finding a job even more skewed toward those who have the financial means to take the time away from other jobs. I may not come from a rich family, but I have the opportunity to take an internship where others don’t. As Tim Price recently pointed out, unpaid internships are not just bad for individuals but for the economy too.

So what’s the solution? According to another Pew Research Center study, the Millennial generation, more than any other, believes that government could do more to address our problems. Franklin Roosevelt implemented the Works Progress Administration during the Great Depression to employ individuals of all professions and education levels. We need an updated version of the WPA that can give everyone an equal opportunity to enter the workforce and live a dignified life. Over its duration from 1939-1943, it provided almost 8 million jobs. They mostly went to those who suffered long-term unemployment and 90 percent of the jobs went to those who were classified as needy. A program like the National Youth Administration, another result of the WPA, would also be effective in employing teenage and college aged kids with little education and opportunity. Employing those with and without a college degree is absolutely necessary for a healthy economy. 

I know a lot of inspired young Millennials who would be doing more if they had the opportunity, money, time, and resources. Getting everyone back to work, particularly the young, is a step in the right direction.

Elena Callahan is an intern at the Roosevelt Institute.

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Curing the Causes, Not the Symptoms, of the Job and Debt Crises Facing Today’s Graduates

May 24, 2012David B. Woolner

The country is doing little to make college an affordable and realistic goal for American families.

We have believed wholeheartedly in investing the money of all the people on the education of the people. That conviction, backed up by taxes and dollars, is no accident, for it is the logical application of our faith in democracy.

The country is doing little to make college an affordable and realistic goal for American families.

We have believed wholeheartedly in investing the money of all the people on the education of the people. That conviction, backed up by taxes and dollars, is no accident, for it is the logical application of our faith in democracy.

Man's present day control of the affairs of nature is the direct result of investment in education. And the democratization of education has made it possible for outstanding ability, which would otherwise be completely lost, to make its outstanding contribution to the commonweal. We cannot afford to overlook any source of human raw material. Genius flowers in most unexpected places; "it is the impetus of the undistinguished host that hurls forth a Diomed or a Hector." –Franklin D Roosevelt

As has been widely reported in the press of late, students graduating from college this spring are not just facing a jobs crisis; they are also facing a debt crisis. The New York Times recently reported, for example, that the average debt burden for graduating college seniors is now approaching $25,000, with ten percent of all graduates owing more than $50,000 and three percent owing more than $100,000. Taken together, total student loan debt in the United States now exceeds $1 trillion—more than all credit card debt in the country.

Equally daunting are the job prospects that current graduates face. It is estimated that more than half of all 2012 graduates will still be out of work a year from now, as was the case for the 2010 and 2011 graduating classes. What is more, even those graduates lucky enough to find a job will earn wages far below their counterparts who graduated in the years before the Great Recession, making it all the harder for them to keep up with—much less pay down—their student loans.

Facing high debt, bleak job prospects, and low wages, many students (and parents) are asking themselves if the high cost of education is really worth it. Current statistics suggest that pursuing a college degree is still a good investment. The unemployment rate among 21- to 24-year-olds with a college education is roughly half what it is for those with only a high school diploma, and the lifetime earnings of a college graduate still exceed the earnings of those without a four-year degree. But if—as some economists argue—our economic problems are more structural than cyclical and high unemployment and low wages will be with us for some time, then taking on a significant debt burden in the pursuit of higher education may in fact be a mistake.

In light of growing concerns about student debt, the Obama administration is pushing a proposal that would require schools to provide straightforward, standardized information on how much debt students should expect to incur over the course of their tenure in college. In addition, a bill has been put forward in the Senate that would require lenders and college financial aid officers to provide students with better information about their borrowing options, including the difference in cost between federal loans and private loans.

While these are welcome steps, they really boil down to treating the symptoms, not the disease. The real issue confronting students today is not the value of a higher education, but the cost. President Obama alluded to this in his 2012 State of the Union address, when he argued that our nation’s colleges and universities should do more to bring down the price of tuition. He also urged the states to make education a higher priority in their budgets. But the truth is that over the past ten years, state support for higher education has declined by about 25 percent, while the cost of tuition and fees at state schools has increased 72 percent.

Like the growing disparity in wealth and income that has emerged in this second Gilded Age, this combination of the decline in state support coupled with the rise in fees for both public and private colleges has rendered the dream of higher education less and less affordable for working families. And, as we have seen, those who do choose to pursue their educational ambitions do so at a huge cost, a cost that is becoming more suspect in a society where good jobs with decent wages are becoming a thing of the past.

In the middle of the 1930s, Franklin Roosevelt confronted a society that was equally burdened by the perils of structural inequality. But he was not content to merely provide relief to those suffering from the despair of unemployment or the scourge of poverty. Indeed, FDR often characterized the relief measures he initiated as temporary. What really concerned him was the far deeper question of structural reform: how to rid America of the one-third the nation that was “ill-clad, ill-housed, ill-nourished.”

It was this motivation that led to some of the most profound pieces of legislation that came out of the New Deal, including the Social Security Act, the National Labor Relations Act, the Fair Labor Standards Act, and the National Housing Act. It also gave us such critical financial reforms as the separation of commercial and investment banking and the creation of the Federal Deposit Insurance Corporation under Glass-Steagall, as well as the establishment of the Securities and Exchange Commission.

Roughly ten years later, as the Second World War was drawing to a close, FDR returned to this theme with his call for “a second bill of rights”—an “economic bill of rights”—that would include not only the right to “a useful and remunerative job” with an adequate income, but also the “right to a good education.”

To make good on the latter, the Roosevelt administration passed the “G.I Bill of Rights” later that year. The G.I. Bill represents one of the most significant government-led commitments to higher education and job training in our nation’s history. Under its terms, returning veterans received a host of benefits, including full tuition and book and living expense payments for those wishing to pursue a higher education. For those not wishing to go to college, the act also provided support for vocational training. The impact of the G.I Bill on postwar America was tremendous. In the next seven years, approximately 8 million veterans would take advantage of the education benefits. As a result, millions of Americans who might never have dreamed of going to college were able to do so, Millions more enhanced their earning power and job prospects through the vocational training and other educational benefits.

Of course, the G.I. Bill was not free; it required serious expenditures on the part of the federal government. But for FDR and his generation, this was an investment in America’s future well worth making. It was, as Roosevelt liked to say, an investment in our nation’s most precious resource, its “human capital.” To neglect America’s human capital, to cut back on our support for education, was simply not an option, for in FDR’s view if “we skimp on that capital, if we exhaust our natural resources and weaken the capacity of our human beings, then we shall go the way of all weak nations.”

If we are serious about the need to improve our economy, keep America competitive, and provide a hopeful and prosperous future for our children, then perhaps it is time we confronted the real issue that stands at the root of the student debt and jobs crisis: the woefully inadequate level of public support for higher education. No doubt the deficit soothsayers in Congress and elsewhere will tell us that we cannot afford such an investment. But the legacy of the 1930s and 40s suggests quite the opposite. Thanks to the G.I. Bill and the many other provisions of the New Deal, the better educated and better paid work force that emerged in the decades after World War II made the American economy—and the American worker—the envy of the world.

FDR warned us that “no country, however rich, can afford the waste of its human resources.” Yet the unfair burden we have placed on this generation of Americans—a generation that increasingly sees little reason to pursue post secondary education at such high costs and falling gains—suggests that we have chosen to abandon this lesson. In doing so, we have done much more than merely turn our backs on the millions of young people who dream of going to college. We have turned our backs on America.

David Woolner is a Senior Fellow and Hyde Park Resident Historian for the Roosevelt Institute. He is currently writing a book entitled Cordell Hull, Anthony Eden and the Search for Anglo-American Cooperation, 1933-1938.

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Till von Wachter: Prevent the Damage of Unemployment Before Workers Get Laid Off

May 24, 2012

In this week’s installment of the Next American Economy breakfast series, Roosevelt Institute Senior Fellow Bo Cutter hosted Columbia economics professor Till von Wachter for a discu

In this week’s installment of the Next American Economy breakfast series, Roosevelt Institute Senior Fellow Bo Cutter hosted Columbia economics professor Till von Wachter for a discussion of the serious damage unemployment can have on workers. Wachter points out that severe job losses during recessions harm not only short-term earnings but also lifetime career earnings, health, family, and even “short- and long-term mortality.” Those laid off during a recession can lose about 20 percent of their earnings over their lifetimes. And “it’s not just middle-aged men in durable goods manufacturing,” Wachter points out. Children of job losers and young people entering a depressed labor market also face grimmer futures. Watch here as Wachter outlines his findings:

All workers, even those who find new jobs relatively quickly, “suffer lasting and substantial adverse consequences from job destruction," he says. The key reason is the loss in human capital. “Workers had skills particular to that employer or that occupation,” so if they have to switch industries they will likely lose those skills and may get stuck in lower wage positions. New workers also face this problem, as their first jobs may be worse and they often become stuck in less attractive career tracks.

But what about “creative destruction"? Does job destruction during recessions have a cleansing effect on the overall economy, as it enables resources to be allocated to more productive enterprises? Wachter's answer: not really. He argues that human and physical resource reallocation occurs predominantly in stronger economic times, not during recessions. So the majority of job destruction is a cost without a benefit. “There’s not much cleansing fire” in recessions, he says.

So what can policy do about all of this? He suggests that given the severe and long-term consequences of lay offs in a recession, policies should focus more on preventing job losses, rather than just ameliorating the short-term effects of unemployment. The idea is to hang on to workers – which is better for them, their employers, and the economy overall.

For more, watch Wachter’s full presentation below:

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What Theory is Animating Rajan's FT Mortgage-Debt Reduction Policy Recommendation?

May 23, 2012

Ok, I'm genuinely confused. There's two interesting things about this from Raghuram Rajan's Financial Times editorial, Sensible Keynesians see no easy way out, that we should unpack (my bold and numbering):

Ok, I'm genuinely confused. There's two interesting things about this from Raghuram Rajan's Financial Times editorial, Sensible Keynesians see no easy way out, that we should unpack (my bold and numbering):

The key question then is whether more government spending can make a real difference to the most severe employment problems. Here the case for a general stimulus becomes less compelling. [1] In the US, demand is weakest in communities where a boom and bust in house prices has left an overhang of household debt. Lower local demand has hit employment in industries such as retail and restaurants. A general increase in government spending may be too blunt – greater demand in New York is not going to help families eat out in Las Vegas (and hence create more restaurant jobs there). [2] Targeted household debt write-offs in Las Vegas could be a better use of stimulus dollars....
 
Targeted government spending, or reduced austerity, along the lines suggested by sensible Keynesians, might be feasible in some countries and helpful in speeding recovery. But we should examine each policy based on a country’s circumstances. We should be particularly wary of populist Keynesians, who parrot “in the long run we are dead” to justify any short-sighted government action. They do the world a disservice by suggesting there are easy ways out.
So Rajan is a sensible Keynesian who would push us towards targeted, household mortgage-debt write-offs. Meanwhile others, including presumably Paul Krugman, are a dangerous, populist variety of Keynesian who want fiscal or monetary stimulus.
 
The first numbered argument is true - places where housing prices collapsed the most are hardest hit by unemployment. But unemployment is still a nation-wide phenomenon, hitting places that didn't even have a housing bubble.  Let's chart the ratio of unemployment for April 2012 versus the unemployment for December 2007 state-by-state (source, click for larger image):

The average increase is 1.65. In New York, which Rajan singles out as being ok, unemployment has gone from 4.7 percent to 8.5 percent, which gives us an above-the-average ratio of 1.8. This is not a localized crisis.

Now Rajan is almost certainly alluding to a graph like this, which we put together a year and a half ago (sigh), of unemployment against the percentage of homes that are deeply underwater, or more than 50% underwater:

There's a lot of ways to visulize this relationship between housing bust and unemployment - Jared Bernstein had one recently. But let's examine this relationship in light of Rajan's suggestion that "Targeted household debt write-offs" could be "a better use of stimulus dollars."

There's three stories explaining this this relationship between unemployment and underwater housing. The first is a structural story. Can't turn housing construction workers into nurses, underwater homeowners can't move, etc. The mobility story turns out to be incorrect, and the "skills" story has problems we've discussed elsewhere. But notice that writing down mortgage debt doesn't make a construction worker into a nurse. So writing down mortgage debt doesn't help with this story.

There's a second story about this graph that describes a "wealth effect." People where housing values collapsed feel poorer, so they spend less. The latest Economic Report of the President argued that the "severity of losses experienced during the recession that began in December of 2007 in both national output and in labor markets makes these [wealth-effect] estimates appear too small." Also households are the net seller, but also net buyer, of housing - it's not clear, outside demographics, that housing shifts should make the macroeconomy feel poorer. But either way, writing down mortgage debt would not help with the wealth effect: if all the housing was paid in cash we'd still have the same recession under this second story.

Now there's a third story, a "balance-sheet" story of the recession. Here consumers are overleveraged and are cutting back on consumption until their balance-sheet, or their amount of debt, is repaired. In this story, reducing household mortgage debt can be a really great use of stimulus dollars. We walked through this story in this interview with Amir Sufi, who has done the leading empirical work on this. And the key, recent, theorectical work on this story, the best model of how this happens, was done by.....Paul Krugman. Specifically Eggertsson/Krugman's "Debt, Deleveraging, and the Liquidity Trap."

If the problem is household's balance-sheets, you can either make people richer or reduce their debts. Rajan thinks that taking money and writing down debt is a good idea. You could also take that money, give it to people in exchange for building useful public stuff; they can pay down debts, and then everyone has some stuff that helps the productive capabilities of the economy. You could also just give people money by not collecting taxes and mailing out checks, and they can efficiently choose whether or not to reduce debts. But under the three most common stories for the relationship between housing and debt, Rajan's policy recommendation only makes sense in the context of deleveraging, or a serious demand story, or the theory that is animating the so-called "populist" Keynesian wing.

This debate is frustratingly not new. Christina Romer was telling media in early 2009 that balance-sheet problems become worse if you let unemployment soar, even if you reduce debts. Romer: "Actually, you know, a crucial thing–when [FDR] did the bank holiday, it took the next two years to actually clean up the banks, that we actually did not get the things really cleaned up until 1935. And that a big part of that cleanup was he managed to turn around the real economy. We saw employment growing again, GDP growing again, and that inherently helps your financial system." Nothing messes up balance-sheets like mass unemployment and falling median wages.

As we've seen, writing down mortgage debt is a viciously ugly, difficult, zero-sum battle. I think it makes good sense to consider, and will have some more formal writing on it, but the idea that it is the sensible ideal while everyone else pushing fiscal or monetary stimulus is behaving irresponsibly is wrong - they both are working from the same intellectual framework.

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The Case Against Tax Breaks for Private Equity

May 23, 2012Jeff Madrick

Private equity disproportionately rewards privatization companies while others are burdened with the risks. 

Private equity disproportionately rewards privatization companies while others are burdened with the risks. 

I wanted to wait a few days before commenting on Newark Mayor Cory Booker’s spontaneous criticism of Barack Obama for picking on Mitt Romney's experience at Bain Capital. Booker doesn’t know much of anything about private equity, but many financial services donors have his ear. He took in nearly half a million dollars in campaign donations from the industry over the last nine months, and he frankly sounded like its mouthpiece.

Booker backtracked, but it would be nice if he knew something about the private equity business before he spoke publicly about it. This expectation of knowledge should also apply to widely read columnists like David Brooks, who, as usual, reflexively defended the Wall Street practice without presenting evidence. He issued a piece of public relations diatribe that no doubt soothed the right but contributed nothing to our understanding. The contention is that these buyouts turned fat American companies into lean and productive ones since the 1970s. Other pundits less well known for their conservative reflex responses have also given partial defense of private equity.

So let’s begin with one point: there is a place for private equity. In a privatization or leveraged buyout, a company is bought by an investment partnership with moneys borrowed against the company itself. The new money can be used productively even when levels of debt against the company’s assets and profits soar. A smaller company that cannot raise adequate equity can raise money by being bought by a private equity partnership. A company that is doing poorly can benefit from added capital and new management. Sometimes trimming labor costs in the process makes sense, of course. 

But the record of leveraged buyouts and private equity reflects its excesses, and most importantly, the lopsided nature of the financial incentives for doing the deals in the first place. Companies like Romney’s Bain or Steve Schwartz’s Blackstone or Kohlberg Kravis Roberts, the early industry leader when privatizations were called leverage buyouts (LBO), take advantage of a major government-provided benefit. The interest on debt is tax-deductible, and high levels of debt are the source of profits in these transactions. It is just like buying a house with a small down payment; if you can sell as the value goes up, the return on the down payment is high and the interest was deductible all along. In the meantime, the house is collateral for the loan. Similarly, partners are rarely if ever on the line for the debt; the company being privatized is. The one difference is that if the collateral value of the house falls, as it has recently, the homeowner is on the line. This is usually not so with privatizers.  

Great deal? You bet. The owners of the privatizing firm put up very little capital; it is their limited partners who put up more.  Then they borrow like mad from banks, pension funds, hedge funds and so on. If the new company can be sold or brought to market again at a higher price, they make a bundle compared to their equity down payment. The CEOs of the company, or the new executives brought in, are given huge amounts of stock. They too make a bundle. Are these incentives conducive to good business decisions?

Most likely, the investment decision is based not on how much the company can be improved, but how much can be borrowed against its assets. The second concern is the interest rate on the debt. There is no evidence that privatizers mostly buy struggling companies to resuscitate them.

Moreover, companies with high levels of debt are subject to great risk of bankruptcy. Macy’s did one of the first leveraged buyouts of its size, the CEO made out wonderfully, and soon Macy’s was in bankruptcy. It reorganized and reemerged successfully due to its retailing skills, but these were not enhanced by the LBO partners.  

Data shows the newly bought firms create fewer new jobs—or result in more lost jobs—than firms that are not subject to private takeover. But what about the much-lauded productivity gains? On balance, these target firms mostly increase productivity by selling or closing low-productivity units. Arguably, they also make their employees work harder. The fear of lay-offs can enhance productivity. There is no evidence that these firms improve productivity mostly by investing in new technologies, new managerial methods, and so on, which is often their claim.

And of course what productivity gains they have had (overall they are small) did not reinvigorate the American economy. The two main sources of productivity gains in the U.S. were high-tech companies and the retailing behemoths led by WalMart. Many retailing targets of privatizations eventually went bankrupt.

The best recent paper on private equity was written by Eileen Appelbaum of the Center for Economic and Policy Research and Rosemary Batt of Cornell University. The David Brookses of the world will cry that these researchers are of a liberal bent. But read the paper to see how carefully it is done. The exegeses of much of the right in defense of private equity are essentially outright propaganda.   

However, the basic point comes back to government and regulation. A major tax advantage gives rise to these buyouts. The privatization partnerships are lightly regulated. After-fee returns to the limited partners seem to be below average. But as for their benefits to society, privatization rewards investors by cutting short-term costs. For a long time, the stock market pushed up the stock prices of companies that kept short-term earnings growing. The influence of such corporate governance has been to keep downward pressure on wages and stoke fear in employees for three decades.

Let’s be clear; some private equity investments were healthy and some of these partnerships do a good job. But all in all, it is clear most are simply exploitations of tax law, market fashions, and their power to borrow money. There is no reason America should reward these investors with a tax break on their huge loans.   

Privatizers didn’t rebuild America. They were rarely the people who planted the garden, watered it, or designed it.  They were by and large the ones who weeded it, sometimes recklessly, throwing out the gorgeous roses in the process. Gardens do need to be weeded, but should those who do the weeding, often heedlessly, make so much more money than those who do the planting? And with the added help of government tax breaks?

In the end, Romney’s Bain made money even though its takeover target, American Pad & Paper, went out of business. Consult Appelbaum and Batt on how some of these strategies work, involving mortgaging real estate holdings and transfer pricing to reduce taxes. Privatization was mostly, if not entirely, about working the system, not building capitalism.  On balance, evidence suggests it hurt more than helped. Any way you read the evidence, it is clear the rewards for private equity firms clearly exceeded the risks. That’s not good for free markets.  

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 to Avoid the Long-Term Damage of Unemployment: A Discussion with Till von Wachter

May 23, 2012Bo Cutter

Recessions have long-lasting consequences for the unemployed, but the U.S. policy response only offers short-term solutions.

Yesterday morning the Next American Economy breakfast seminar hosted guest Till von Wachter, who led a fascinating but disturbing discussion of the long-term effects of unemployment. Till, a professor of economics at Columbia, has become known more and more broadly for his research in this area. You can watch my interview with him below:

Recessions have long-lasting consequences for the unemployed, but the U.S. policy response only offers short-term solutions.

Yesterday morning the Next American Economy breakfast seminar hosted guest Till von Wachter, who led a fascinating but disturbing discussion of the long-term effects of unemployment. Till, a professor of economics at Columbia, has become known more and more broadly for his research in this area. You can watch my interview with him below:

When a worker loses a job during a recession and goes through a period of long-term unemployment, both the short- and long-run effects are devastating. We usually think of the short-run reduction of income and the family crises that reduction can cause, but according to Professor von Wachter, the longer-run effects are even greater. Lifetime earnings are reduced by as much as 20 percent, health worsens, mortality rises, divorces increase, children's school performance declines, and the lifetime earnings of the next generation are lower.

It's important to underline that Till's work focuses on the effects of recessions, not unemployment in all periods. Our economy is constantly churning, far more than most recognize, and men and women are constantly changing jobs -- mostly voluntarily, but also involuntarily. In periods of growth, these job changes don't seem to have the same effects.

There are several explanations for the long-term effects of unemployment in a recession. Sometimes workers who have privileged positions because of factors such as long tenure or union membership lose those positions. Once unemployed, workers may lose skills that they have developed while working. Recessions also tend to "reset" all wages for new workers, including those who are rehired. (This also affects graduates who enter the job market during a recession, as their earnings are also lower over a long period of time.)

We have really not developed policy tools to deal with these pervasive effects of unemployment and recessions. Our policy remedies focus almost entirely on short-term income replacement and not much -- or not very effectively -- on the long-run effects.

Another part of Professor von Wachter's work is currently focused on a broader issue in recessions: does "creative destruction" occur? It is sometimes argued that recessions sort of boil away excess and therefore are regrettable but necessary aspects of our system. Till's work here is beginning to suggest that this just isn't so. It's not just marginal workers who lose their jobs, and recessions do not lead to particularly high levels of sectoral change. So it's hard to find positive arguments for recessions that offset the negative effects on workers. (I know that sounds like an obvious point, but economists do have to ask.)

So what? Where does this take us?

It takes me first to Ben Friedman's book The Moral Consequences of Economic Growth. Friedman argues that the consequences of sensible growth are so pervasive and positive that we should focus much more on it. I've long argued that this should be the mantra of the radical center, and even of progressives.

Till's work suggests a corollary: we should focus not simply on growth but on increasing the long-run probability of stable growth by reducing risk, thereby reducing the occurrence of recessions and their severity when they do occur. (Yes, I have in mind our financial system with four major banks all clearly too big too fail providing a huge share of all credit in the U.S.) Good businesses routinely look at – forgive the jargon – risk-adjusted rates of return; macroeconomic policy should, too. A risk-adjusted view of the economy in 2007 might have made a lot of people much more sober about likely future scenarios.

But the punch bowl is always kept out too long at the party, and recessions will occur. What more can we do that might be effective in reducing the long-term effects of unemployment?

I distill three lessons from Till's work. First, short-term income replacement and government work programs are not the answer. Second, the real problem is a loss of job skills and human capital. Third, most job training programs seem to have had at best mediocre success because they are hard to design, hard to manage, aren't routinely evaluated, and can't focus on the truly critical skills that are developed and maintained on the job.

America needs to develop formal mechanisms that keep more workers in their jobs – mechanisms that allow their hours or even wages to adjust rather than have the only real adjustment be the on-off switch of full job loss. We might, for example, look at Germany, which, in the recent Great Recession, avoided the severe rise in unemployment we had here in the U.S. The German experience is complicated, but Germany does have formal approaches to job-sharing and a highly developed program of work-time accounts. These had a substantial and positive effect in Germany, yet we don't have them.

We're in the middle of a big debate about the nature of capitalism. A lot of truly stupid things are going to be said on both sides about capitalism and each other. I've been a proud but fairly minor league capitalist for a long time, and I know its workings can be made better. Long-term unemployment and its effects do not have to be a partisan issue. There are some actual concrete steps we could take that would do real good and make the Next American Economy a better place.

Roosevelt Institute Senior Fellow Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama’s Office of Management and Budget (OMB) transition team. He has also served in senior roles in the White Houses of two Democratic presidents.

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Can Private Equity Firms Like Bain Do Whatever They Want With the Companies They Buy?

May 22, 2012Mike Konczal

Three critiques of the notion that private equity's actions are above public concern.

The question of Romney's tenure at private equity firm Bain Capital will stay in the headlines as the Obama team releases ads on the subject and Romney continues to run on that record. But what can we take away from this debate?

Three critiques of the notion that private equity's actions are above public concern.

The question of Romney's tenure at private equity firm Bain Capital will stay in the headlines as the Obama team releases ads on the subject and Romney continues to run on that record. But what can we take away from this debate?

Ezra Klein argues that running a leveraged buyout company ought to give one some sense of solidarity with those left behind. As LBO/private equity creates winners and losers, winners should be in favor of an expanded social safety net that helps those who lose in the layoffs get back on their feet with minimial disruptions. Since LBO overall creates more wealth, part of that wealth should be taxed for the benefit of those who need help adjusting to their new economic reality afterwards - such as providing continuous health care coverage, job training, etc.

One thing I'm noticing in these debates is an almost tautological idea that since shareholders own the firm, anything shareholders do with their firm is legitimate and outside the boundaries of public concern or critique. It was in the background of what Karl Smith was discussing on Sunday's "Up With Chris Hayes," and Josh Barro made it more explicit this morning on twitter.

A Stick

Let's imagine that I buy a stick. Under a idea of general, everyday libertarianism, since I own the stick I can do anything I want with it. I can break it in half, burn it in a fireplace, carve it into something else, turn it into woodchips, attach a kite to it, exclude people from using it, etc. I can't hit people with it, or use it to set their stuff on fire, or attach duct tape to it in order to steal their stuff - but that's a function of general prohibitions against force and fraud. Short of that, it would be weird to say that I shouldn't do whatever I want to my stick of wood - that something I do with it could be illegitimate - as long as I enjoy it.

But does a private equity firm own its portfolio businesses in the same exact way that I own my stick? Is it weird to even think, outside general prohibitions against force and fraud (which I'll treat as unproblematic as it relates to the question at hand), that their actions could be illegitimate? There are many references to increasing profits, or making firms more dynamic, or "creative destruction," but those are side effects of shareholders doing whatever they want with its portfolio. The core issue is that there could be nothing illegitimate in terms of how a private equity firm runs those businesses in the sense there's nothing illegitimate I could do with a stick I own.

Three Critiques

Starting from this baseline, the critiques as far as I read them (which will draw on two previous posts) break down along three lines:

1. Tax/regulatory loopholes. I did an interview with Josh Kosman, author of The Buyout of America, where he argued that the whole point of the enterprise is to game tax law loopholes. Private equity "saw that you could buy a company through a leveraged buyout and radically reduce its tax rate. The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same."

A recent paper from the University of Chicago looking at private equity found that “a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of firm value,” which is value that comes from taxpayers to private equity as a result of the tax code.

That's one thing in an industry with large and predictable cash flows. But after those low-hanging fruits were picked, as Kosman explained, "firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years — they are way over-levered."

This critique has power as far as it goes. But let's combine it with another issue.

2. Risk-shifting among parts of the firm. Traditional "creative destruction" is about putting rivals out of business with better products and techniques. Leveraged buyouts and private equity are about something different, something that exists within a single firm. This is often described as putting new techniques into place, firing people and divisions that are not performing, and generally making the firm more efficient.

The critique here is that, instead of making the firm more efficient, it often simply shifts the risks into different places. As Peter Róna, head of the IBJ Schroder Bank & Trust in New York, described it in 1989:

The very foundation of the LBO is the current actual distribution of hypothetical future cash flows. If the hypothesis (including the author’s net present value discounted at the relevant cost of capital) tums out to be wrong, the shareholders have the cash and everyone else is left with a carcass. “Creating shareholder value” and “unlocking billions” consists of shifting the risk of future uncertainty to others, namely, the corporation and its current creditors, customers, and employees…
 
The notion that underleveraging a corporation can cause problems is neither new nor unfounded. What is new is the assertion that shareholders shouid set the proper leverage because, motivated by maximizing the return on their investment, they will ensure efficiency of all factors of production. This hypothesis requires much more rigorous proof than Jensen’s episodic arguments… although Jensen denies it, the maximization of shareholder returns must take place, at least in part, at someone else’s expense.
Shareholders gain, but at the expense of other stakeholders in the firm. This isn't the normal winner/loser dynamic, where some suffer in the short-term to do what's best for the long-term. Here the long-term suffers to create short-term winners. Once again, this issue becomes problematic when combined with another critique.
 
3. Dividend looting. The theory behind private equity, as Róna caught above, is that it requires shareholders to be the proper and most efficient group to set the leverage ratio. But what if, instead of setting leverage for the long term to make the firm more efficient, shareholders simply use additional debt to pay themselves, regardless of the health of the firm? As Josh Kosman put it:
If you look at the dividends stuff that private equity firms do, and Bain is one of the worst offenders, if you increase the short-term earnings of a company you then use those new earnings to borrow more money. That money goes right back to the private equity firm in dividends, making it quite a quick profit. More importantly, most companies can’t handle that debt load twice. Just as they are in a position to reduce debt, they are getting hit with maximum leverage again. It’s very hard for companies to take that hit twice...
 
The initial private equity model was that you would make money by reselling your company or taking it public, not by levering it a second time...Right after this goes on for a few years, you’ve starved your firm of human and operating capital. Five years later, when the private equity leaves, the company will collapse — you can’t starve a company for that long. This is what the history of private equity shows.

This runup in dividend payouts is feature of the post 1980 financial markets more broadly, one that LBO had a hand in creating:

The blue line is profits, the solid red line is payouts. As Josh Mason noted (my bold), "In the pre-neoliberal era, up until 1980 or so, nonfinancial businesses paid out about 40 percent of their profits to shareholders. But in most of the years since 1980, they’ve paid out more than all of them...It was a common trope in accounts of the housing bubble that greedy or shortsighted homeowners were extracting equity from their houses with second mortgages or cash-out refinancings to pay for extra consumption. What nobody mentioned was that the rentier class had been doing this longer, and on a much larger scale, to the country’s productive enterprises."

Versions of these three arguments form the core of the private equity critique. Instead of simply carving a figurine or starting a BBQ, private equity uses its stick to game tax law while cashing out short-term value, leaving others in the firm worse off and the firm itself more prone to collapse and less able to produce long-term value. Do you find this critique convincing? What else is missing?

Mike Konczal is a Fellow at the Roosevelt Institute.

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Cyclicalists/Structuralist Divide, Redux

May 18, 2012Mike Konczal

Karl Smith has had some great posts lately, both about Noah Smith and the cyclicalists/structuralist divide and about Rajan's Foreign Affairs article (I, II). I'm going to add my own thoughts on each topic here.

Karl Smith has had some great posts lately, both about Noah Smith and the cyclicalists/structuralist divide and about Rajan's Foreign Affairs article (I, II). I'm going to add my own thoughts on each topic here.

Noah Smith has a blog post arguing that cyclicalists should start talking about structural issues too. Using David Brooks' recent terms, he says "I do not mean that cyclicalists should stop recommending things like quantitative easing. I mean that they should start also throwing out ideas about how to improve our economic performance in the long run."

There's two issues here worth bringing up. The first is that Obama is in a ton of trouble, because all he's done in the past two years is talk about long-term problems (remember Winning the Future?) while dancing around the short-term unemployment crisis. His big achievement, health-care reform, wasn't about how in a rich, modern society like ours everyone has a right to health care. Instead it was explained as a way of "bending the cost curve." Bending the long-term cost curve is about as much of a "structuralist" way of pitching expanding health care as possible.

The second is that blurring these two items as an economic matter has been a major problem for both the Obama economics team and for a certain variety of centrist, deficit-hawks in their view of our economic situation. This is the "two deficits" problem. In this argument our short-term deficit isn't large enough, but our long-term deficit is too large. Fine as far as it goes. But in this theory, in order to fix the first you have to make progress on the second at the same time.

Maybe there are political reasons why this is the case, but the economic ones don't jump out. There are good short-term ideas and good long-term ideas. If they are each good ideas, why not do each on their own? Why do they have to move together? The explanation most give, as a Treasury official told Noam Scheiber, is that the government needs to show “some signal to US bondholders that it takes the deficit seriously” and that “spending more money now [on stimulus] could actually raise long-term [government] rates, thereby offsetting its stimulative effect.” I think this is dead wrong, and if Obama loses this argument will be one of the major reasons why. It is what kept him trying to kick Lucy's football negoitate with Republicans in 2011. If both need to move, they throwing a roadblock in front of one stops the other - and given that Republicans won't budge on tax increases, it takes away the case for more stimulus in the short-term. Meanwhile interest rates continue to stay at record lows.

As for the Rajan piece in Foreign Affairs, I think there are two big problems with it beyond what Karl mentions ("the piece had little to do with the recession and nothing to do with borrowing and spending for recovery"). The first is the crux of his argument, which is that 2007 featured "artificially inflated GDP numbers." It is no doubt impressive to people who haven't thought about it hard to state that we had a GDP bubble in 2007 alongside a housing bubble. But what does that even mean? What else would be true about the world if US GDP was unsustainably high in 2007?

Jim Bullard made this argument recently and even then the justification for the argument switched completely within days, once it came under the critical scrunity of the econoblogosphere. In one version the case was about how the collapse of the housing bubble represents a technology loss. In the second argument it was pure wealth effect: we feel poorer, and the only solution is to beg policymakers to “please reinflate the bubble."

The second issue is that the manitude of numbers are completely off. Subprime mortgages were about refinancing, not about new home construction. As Karl Smith noted, to the extent subprime encouraged single-family home construction, it came at the expense of multi-family home construction. Residential building construction is off about 400,000 workers - even if those jobs are gone completely, we have 5 million more workers unemployed right now than we did in 2007 (12.5m versus 7.5m). I'd be happy to say that the NAIRU is up 400,000 people if we can end these so-called structural arguments here.

[Also: Rajan's GSE argument has been debunked in several places. It is hard to argue that Congress is pro-consumer-debt and pro-debtor/easy credit policies in the past 30 years when it passed the 2005 bankruptcy reform act. It is not controversial to argue that the 2005 bill was significantly harder on debtors looking to file bankruptcy. Instead of Congress, the major thing that changed the consumer debt markets came from the Supreme Court. In 1978's Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp, the Supreme Court interpreted the word “located” in the National Bank Act of 1863 as meaning the location of the business and not the location of the customer, which completely changed how credit cards would work in the following decades.

Also, the conservatives' publically-stated calculus is off. There is a sense in which there are short-term things we can do, or long-term things we can do, and we have limited time and energy, so better to focus on the long-term things. But there's reason to believe that conservatives are purposely ignoring the short-term things, because weak economies are the perfect time to be able to achieve their preferred long-term agenda ideas.

We know from the explanations for dissenting votes on the Federal Reserve that those dissenting from more demand now believe that this higher demand through monetary policy gets in the way of making "hard choices" on entitlements and tax reform. The Wall Street Journal has Federal Reserve Bank of Dallas President Richard Fisher saying “The more we offer accommodative monetary policy, the less incentive they have to pull their socks up and do what’s right for the American people.” (This is also currently going on in Europe.)

If you view the Great Society, the New Deal, and the whole regulatory/Keynesian/welfare state as a form of tyranny, well, destroying most forms of tryanny requires bloodshed. If a conservative revolution happens in the next Congress, and the only cost was 4 years of mass unemployment, wouldn't it be worth it to experience liberty in our lives? I fear this explanation drives more conservative commentary on economics than we realize.]

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