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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What Lies Behind Clinton's Remarks on Private Equity

Jun 7, 2012Jeff Madrick

Bill Clinton's remarks about Romney's record and the Bush tax cuts demonstrate his fealty to the financial sector.

Bill Clinton's remarks about Romney's record and the Bush tax cuts demonstrate his fealty to the financial sector.

We can attribute Bill Clinton making trouble for President Obama to his unquenchable need for the limelight. He first praised Mitt Romney’s business record and private equity practices in general. He then said the Bush tax cuts should be extended, without indicating that he agreed with Obama that the tax increases on the wealthy should be retained.

Clinton’s concern about raising taxes in the weak economy while cutting federal spending is right on. America is now practicing austerity, if a milder version than Europe’s. If not reversed, we could well have a recession again in 2013. And then what happens to the still-strained financial sector?

But Clinton’s remarks are disturbing for what they suggest about his tolerance for the financial class, for lack of a better term. Was it an accident that he left out any mention of raising taxes on the wealthy? The financial class dominates that group, if we include business execs who make a great deal of money from their stock options.

The real giveaway about Clinton is how he supports the financial industry’s assertions about the good done by private equity. We’ve addressed some of that in this space before. Clinton says flat-out that they do a good job. Does he have any evidence to demonstrate that? Has he looked at the evidence that undermines those assertions? Does he really think private equity was all about saving companies rather than exploiting the ability to borrow against their assets, cut them down, and then sell the company? Was it all about making America more productive and innovative? Come on.

This is of course the Bill Clinton who wholeheartedly gave us financial deregulation—no regulation of derivatives, no restraints on bank expansion as Glass-Steagall was undone, little concern by his SEC about over-speculation and analytical lying in investment firms, allowing CEOs to get enormous stock options, and so on.

He has apparently bought the assertion that the financial engineering of the past 20 years was mostly good. Of course, Wall Street is where the campaign money is.

In his most recent book, Clinton argued for stronger government, a welcome call. But he was the one who gave us less government.

Next week, we will post a thorough piece by economist Eileen Appelbaum on the good and bad of privatization. In the meantime, keep in mind that the heyday of privatizations, then known as Leveraged Buyouts, was the 1980s, when productivity growth for America remained historically slow. It did not rise again until the mid-1990s, with the advent of the Internet. The large, large share of productivity gains was in high technology and companies like Wal-Mart, not in the buyouts of companies by Bain and others.

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

 

Bill Clinton image via Shutterstock.

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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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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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Demand, Deficit, and Denial: A Simplified Case Against Austerity

May 17, 2012Robert Leighninger

President Roosevelt's legacy of public works programs offers insight into the importance of increased government spending to create jobs and restore the economy.

President Roosevelt's legacy of public works programs offers insight into the importance of increased government spending to create jobs and restore the economy.

It’s good to hear more economists talking about the foolishness of austerity in Europe and the United States. Some, including Joe Stiglitz and Paul Krugman, have been saying it for a long time, but the chorus has gotten louder recently. Still, I have yet to hear anyone put the argument in terms simple enough for the average citizen (including the average Republican not too tied in ideological knots) to understand. I’d therefore like to take a shot.

To reignite the economy, we need more people to buy things. For that to happen, we need to keep people in their present jobs, re-employ people who have lost jobs, and employ those just entering the job market. Once people are buying things, those who make the goods and services being bought will have reason to invest, hiring new workers and buying new machines that make things. They have no reason to invest now; there is no likely return on their investment.

Republicans have things backwards. They assume that investors will invest if we give them more money. But they already have lots of money. Why assume that giving them more will change their behavior? They’re not stupid (at least most of them aren’t). What they need is a prospect of profit.

Tax breaks aren’t any incentive. What good are lower taxes on income that you don’t have? What’s the point of hiring another worker if he or she will have nothing to do? Fewer regulations are equally irrelevant. This is why “uncertainty” and “confidence” (the claim that investors won't invest because they are uncertain what their taxes might be in the future or what new regulations they may face) are smokescreens.

What do you suppose investors would do if there were customers pouring through their doors? If goods and services were in demand and inventory was disappearing? They would not say, “No, I don’t think I’ll take advantage of this. I’ll forgo making a profit now because I don’t know what my taxes and regulations will be next year.”  More likely, the response would be, “Wow, we can sell more widgets now; let’s crank up production!”  

In the language of economists, this is a demand-side problem, not a supply-side problem. Republicans have been looking at the world through supply-side lenses for over 30 years and can’t see the total economy. They are blind to common sense.

So how do we get people to buy things? We can save good middle class jobs by aiding states so they can stop laying off teachers, police officers, firefighters, and other public workers. We can create new jobs with large infrastructure projects. There are so many things on the landscape in need of repair or replacement that it shouldn’t be hard to employ or re-employ millions of people. In 1933, the Civil Works Administration (CWA) put 4 million people to work in two months. 

But good heavens, this will cost money! Yes, it will drive the deficit to new heights, and deficits are worth worrying about. But a stagnant economy will not reduce deficits. Putting people out of work through an austerity campaign only decreases revenues and cripples our ability to deal with deficits. A robust economy will handle the problem much more quickly. Restarting the economy will be expensive, but we need to spend the money. If your house is on fire, you don’t tell the fire department, “Don’t use too much water, I want enough for my morning shower.”

If Obama’s $800 billion stimulus package hadn’t been weighed down with so many useless tax cuts, we might not be having this conversation. The experience of the New Deal is relevant here. At its beginning, 25 percent of workers were out of work; when World War II started, it was down to 10 or 12 percent. That is significant progress. And there would have been even greater progress had President Roosevelt not twice stalled the recovery he had created. In March of 1934, after it was only four and a half months old and employing 4 million people, he pulled the plug on the CWA in spite of the fact that even the Wall Street Journal noticed its effect on the economy. He just didn’t want to believe that it was going to cost so much money to end the Depression. 

Once he had replaced the CWA with the Works Progress Administration (WPA), and after his other giant public works programs—the Public Works Administration and the Civilian Conservation Corps—were fueling the recovery, Roosevelt again cut back. Despite the crisis, he still believed in a balanced budget. This return to orthodoxy produced a recession that by early 1938 was looking like 1929. His advisors finally persuaded him to restore the works programs, and thus he ended the recession. Had it not been for these two crises of confidence, the employment rate at the start of the war may have been lower than 10 percent, and we wouldn’t be hearing these claims that it was the war that ended the Depression.

Once demand is stimulated through public jobs, private investment will return and private jobs will increase. A healthy economy can then deal with deficits. It will be costly to regain that economy, but if we don’t, we will have both stagnation and deficits. 

Robert Leighninger is faculty associate in the School of Social Work at Arizona State University, and author of Long Range Public Investment: The Forgotten Legacy of the New Deal.

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JP Morgan Proves That Size Does Matter

May 15, 2012Mike Konczal

Breaking up the big banks might not be the whole solution, but it could make resolution authority more credible.

Breaking up the big banks might not be the whole solution, but it could make resolution authority more credible.

Before we start talking about the advantages and disadvantages of introducing size caps and restricting business lines through a new Glass-Steagall, it is important to understand how very big the five biggest banks are. If you need a sense of how big JP Morgan is and why it is hard for it to "hedge" without moving the market, the graph below gives you a sense. This is a graph I put together during Dodd-Frank based on data that was floating around at the time:

When bills restricting size of a large financial institution have been introduced they usually put size in the context of deposit liabilities (what we provide a backstop for and what reflects consumer savings, expressed as a percent of all deposits) and non-deposit liabilities (what reflects a blunt measure of size and potential for shadow banking runs, expressed as a percentage of GDP). The SAFE Banking Act, which has been reintroduced, mostly impacts the six firms listed above. The original SAFE Banking Act had a cap of 3 percent of GDP for non-deposit liabilities for financial firms (2 percent for actual banks) -- a space that ignores over 8,000 banks to just focus on the biggest six.

Yesterday Elizabeth Warren sent out an email with PCCC calling for a new Glass-Steagall. Let's back up: what kind of regulation do we have in the financial sector? First, there's the background regulation that structures and forms the financial markets. How are derivatives treated in bankruptcy? How is capital income and debt taxed? How are contracts and corporations set up and enforced? And so on.

The second level of regulation is "prudential" regulation. Prudential regulation of financial institutions is the various ways regulators regulate banks. Capital requirements are one example. So is prompt corrective action, restricting dividends for troubled firms, etc. One reason to do this for regular banks is to act as a coordinator for dispersed depositors who are unable or unwilling to perform these functions. Another is that financial firms have serious macroeconomic effects on the economy. And another is to intervene in issues of asymmetric information. The everyday libertarian case against regulating a restaurant is "who would want to poison their customers?" As we saw in the last 20 years, Wall Street is comfortable not only selling their customers poison at a high margin, but taking out life insurance on them through the credit swaps market.

The third level is blunter, and that's strict prohibitions, either on businesses or on size. What are the advantages and disadvantages of adding prohibitions? One factor is simplicity compared to other forms of prudential regulations, but what else is there?

Resolution

Adding prohibitions can help ensure the end of Too Big To Fail. In this sense it works to amplify, rather than replace, Dodd-Frank's resolution authority.

A common response is that the problem with Too Big To Fail isn't that the firms are too big or too complex, but too interconnected. Matt Yglesias notes that in the context of resolution, prohibitions aren't that important: "we can't put investment banks through the bankruptcy process because it's too systemically chaotic. In that case, Glass-Steagall is irrelevant and what we really need is a new legislative mechanism for the resolution of investment banking enterprises. That's what Dodd-Frank is supposed to do. This all just backs in to the point that even though the phrase 'too big to fail' has caught the public imagination, it's never been clear that size is relevant."

But here's Martin J. Gruenberg, Acting Chairman of the FDIC, in a big speech last Thursday:

While there are numerous differences between a typical bank resolution and what the FDIC would face in resolving a SIFI, I want to focus on a few key differences...

In addition, the resolution of a large U.S. financial firm involves a more complex corporate structure than the resolution of a single insured bank. Large financial companies conduct business through multiple subsidiary legal entities with many interconnections owned by a parent holding company. A resolution of the individual subsidiaries of the financial company would increase the likelihood of disruption and loss of franchise value by disrupting the interrelationships among the subsidiary companies. A much more promising approach from the FDIC's point of view is to place into receivership only the parent holding company while maintaining the subsidiary interconnections.
 
Another difference arises from sheer size alone. In the typical bank failure, there are a number of banks capable of quickly handling the financial, managerial, and operational requirements of an acquisition. This is unlikely to be the case when a large financial firm fails. Even if it were the case, it may not be desirable to pursue a resolution that would result in an even larger, more complex institution. This suggests both the need to create a bridge financial institution and the means of returning control and ownership to private hands.
Resolution authority is an untested solution for a financial firm, particularly one as large and complex as JP Morgan. Size and complexity make a difference. If financial firms were smaller and more siloed, there is an argument that resolution authority, which is one of the core mechanisms of Dodd-Frank, would work more smoothly and be more credible.
 
Market Power and Competition
 
As Barry Ritholtz noted on the JP Morgan loss, "Simply stated, once you are the market, you are no longer a hedge." Size makes a difference in these markets, and by breaking up the largest firms you'd see reduced market power. In terms of size, Andrew Haldane argues that economics of scale in banking top out at around $100 billion, or signficantly less than a 3 percent GDP liabilities cap. Beyond market power, the largest banks represent a large amount of political power as well.
 
And in terms of business lines, Kevin J. Stiroh and Adrienne Rumble, in "The dark side of diversification," look at financial holding companies as they absorb different business lines in the late 1990s and 2000s. "The key finding that diversification gains are more than offset by the costs of increased exposure to volatile activities represents the dark side of the search for diversification benefits and has implications for supervisors, managers, investors, and borrowers." New business lines introduce new profits but also introduce new volatility. The more volatile a firm is, the harder it is for it to fail without bringing down the financial system.
 
Mike Konczal is a Fellow at the Roosevelt Institute.
 
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The Dimon Fiasco: A Stark Lesson on Why Finance Needs Government Regulation

May 11, 2012Jeff Madrick

J.P. Morgan Chase's trading losses are a perfect example of why we need increased government regulation of banks.

Many people see the $2 billion in trading losses announced by J.P. Morgan Chase as the quintessential example of why strong regulation is needed. There is a lot of irony in this story. It is a true story about the importance of government.

J.P. Morgan Chase's trading losses are a perfect example of why we need increased government regulation of banks.

Many people see the $2 billion in trading losses announced by J.P. Morgan Chase as the quintessential example of why strong regulation is needed. There is a lot of irony in this story. It is a true story about the importance of government.

When Sandy Weill, the rough and tough entrepreneur, ultimately built a financial conglomerate from many pieces—including Salomon, Smith Barney, and Travelers Insurance—into Citigroup, Jamie Dimon, someday to be the outspoken CEO of J.P. Morgan Chase, had always been at his side. A bright and dutiful young man, Dimon stayed with him when Weill was consigned to a number two role at American Express after selling his firm, Shearson Loeb Rhoades, to the credit card giant in the early 1980s. He was with him in San Francisco, when Weill was charged with slimming down American Express’s subsidiary, Fireman’s Fund. Weill’s expertise was making companies lean and mean, which often entailed ruthless lay-offs. Dimon ran the numbers for Weill and participated in the implementation of the lean and mean philosophy.

When Weill finally left American Express, Dimon again went with him. Finally, they found the consumer finance company Commercial Credit Corp, which made high interest loans to low-income consumers, including early subprime mortgages, much like the old Money Store. According to biographers, Dimon liked the industry because it was unregulated. He and Weill took over the company, fired lots of people, issued a stock offering quickly, and used it to rebuild the Weill dynasty, which would soon include Smith Barney, Shearson again, and, the giant Travelers Insurance in 1993.

But Weill still had no serious investment banking presence, so he turned his attention to Salomon Brothers, king of risky bond and currency trading, the birthplace of what later became Long-Term Capital Management, and maker of much money and several major trading losses. How risky was this trading firm?

Dimon was skeptical. But here is the irony. Weill sent Dimon to study how Salomon made its money, and the originally hesitant Dimon said he now believed the risks could be controlled. Immediately after the acquisition in 1997, however, Weill was clobbered by Salomon losses due to the East Asian financial crisis and many more to come. Weill quickly limited trading exposure at Salomon. Dimon must have learned that losses are inherent in such businesses.

Dimon was finally at Weill’s side when Travelers merged with Citicorp to form Citigroup, becoming a massive financial giant. He left soon after in a personal dispute as Citigroup took on more and more risk, more and more debt, and adopted unethical practices that were later unearthed by Eliot Spitzer, which resulted in more fines than for any other company.

Dimon wound up running J.P. Morgan Chase, where he emerged as a hero after limiting mortgage market risks before the crisis that felled so many. He became the most respected of Wall Street’s leaders, and he was arguably the best of them. But Wall Street trading profits are too tempting, and individual Wall Street traders too hard to control. Even with tight oversight, they often go their own way. And they often lose hundreds of millions and sometimes billions of dollars in the process.

Dimon may have known precisely what his London trader, the “Whale,” was doing. I doubt it. But it’s likely the so-called “London Whale” had been making big bucks for the firm for a long while. Giving him more line would only be natural.  

Herb Allison, former president of Merrill Lynch, is a strong skeptic of commercial and investment banks’ trading operations. He even thinks over time they may all lose money. What happens is that they make plenty along the way, then lose it in a big bust.  As author Michael Lewis divulged, a Morgan Stanley trader, Howie Hubler, lost $9 billion in 2007 and 2008. Nevertheless, Hubler left Morgan with millions of dollars, and later returned to work on the Street.

Dimon, among the most cautious of executives, couldn’t control this trading animal with a life of its own, either. That’s the important conclusion. A Volcker rule to limit speculative trading for banks is necessary. They are using federally insured money to finance much of their banking operations, enabling them to leverage other facets of the company. They are using shareholder money, not their own, to take risks, yet they take enormous bonuses when all goes right. And they are implicitly using taxpayer money, because if they lose too much, they will be bailed out by the federal government. They remain too big to fail.

Serious capital requirements must be implemented against such trading, and banks must also change banker compensation procedures further. For traders, it’s a heads I win, tails you lose proposition. And so it is with the bank CEO as the firm’s overall earnings rise and are socked with a blow only every once in a while. These compensation plans have changed under pressure from the federal government to some degree. But probably not enough. The firms’ partners and employees have to be on the line for losses over time.

All this is a case study in why finance needs more government rules and regulations than most other industries. The omnipresent claim that such rules undermine liquidity in markets is almost laughable. In truth, we have a lot of liquidity when we don’t need it and little when we do—such as after the Lehman Brothers catastrophe in the fall of 2008. As regulations were eliminated and weakened after the 1970s, finance became more unstable, crises more frequent, and trillions of dollars were invested down the rat holes of speculation and fantasy, while Wall Street employees made countless millions. Yes, finance is important to economic growth, but only if government controls it properly. Otherwise it can be and has been damaging.       

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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Assessing Yet Another Round of the Structural Unemployment Arguments

May 8, 2012Mike Konczal

No matter how much elites insist that our unemployment problem is structural, they don't have the data on their side.

David Brooks has the 2012 version of the structural unemployment argument in his editorial today, "The Structural Revolution." Here's rooting for this one, as the previous arguments haven't held up all that well.

No matter how much elites insist that our unemployment problem is structural, they don't have the data on their side.

David Brooks has the 2012 version of the structural unemployment argument in his editorial today, "The Structural Revolution." Here's rooting for this one, as the previous arguments haven't held up all that well.

The 2010 version of the argument had to do with an increase in JOLTS "job opening" data, data that turned out to be incorrectly estimated by the BLS (as we learned in 2011). The 2011 version focused either on the idea that the unemployed had bifuricated into a normal unemployment market and a long-term, zero-marginal productivity market (it hadn't) or that the "regulatory uncertainty" of the Obama administration was holding back the economy (which, as Larry Mishel found, wasn't backed by the data).

There's been a ton of situations where these structural unemployment arguments came charging down the runway only to hit a cement wall of data. One "oops" moment was Raghuram Rajan citing Erik Hurst in claiming that unemployment would be three points lower if it wasn't for "structural" reasons, and Hurst having to publicly point out his preliminary research said nothing of the sort. Another was Rajan arguing, in June of 2011, against monetary policy. Why? Because "one view is that corporate investment is held back by labor-market rigidities (wages are stubbornly too high)....There is, however, scant evidence that the real problem holding back investment is excessively high wages (many corporations reduced overtime and benefit contributions, and even cut wages during the recession)." Empirically that means that there shouldn't be any bunching of wage changes at the zero mark. Here's what the San Francisco Fed found early this year:

Whoops.

Apparently none of that changed anything for anyone. So what do we have now? I want to address three specific points in Brooks's essay which I think are wrong in a very useful way. First, Brooks argues that "Running up huge deficits without fixing the underlying structure will not restore growth." The argument here is that a larger deficit will not help with short-term growth. I'll outsource this to Josh Bivens, addressing a similar argument from Adam Davidson:

This is the reverse of the truth – there is wide agreement that debt-financed fiscal support in a depressed economy will lower unemployment. Now, it’s true that there are holdouts from this position. And others who think the benefits of lower unemployment are swamped by the downsides of higher public debt (they’re wrong, by the way). But, the agreement is much more widespread – ask literally any economic forecaster, in the public or private sector, that a casual reader of the Financial Times has heard of if, say, the Recovery Act boosted economic growth. They will all tell you “yes.”

You won’t find anywhere near such a consensus on long-run tax or education or health care policy. In fact, public finance economists can’t get unanimous agreement on if, in the long run, income accruing to holders of wealth should be taxed at all (it should, by the way). In short, anybody waiting for the current unpleasantness to pass and for economists to unite in harmony in future policy debates shouldn’t hold their breath...

Lastly, Davidson notes that there is a rump of economists (he calls them, reasonably enough, the Chicago School) that argue that debt-financed fiscal support cannot help economies recover from recessions. But, it’s important to note that there is pretty simple evidence that can be brought to bear on this Keynesian versus Chicago debate. Nobody denies, for example, that the government could borrow money and just hire lots of people – hence creating jobs. What the Chicago school argues is that this borrowing will raise interest rates (new demand for loans will increase their “price,” or interest rates) and this increase in interest rates will dampen private-sector demand. But interest rates have not risen at all since the Recovery Act was passed and private investment has risen, a lot.

Second, Brooks argues that "there are the structural issues surrounding the decline in human capital. The United States, once the world’s educational leader, is falling back in the pack." If this is the case -- that our problems are a lack of education and investment in human capital -- then recent college graduates would have significantly lower unemployment rates than most, or they would be the same, or if they were higher then they'd come down even faster. Also from EPI, Heidi Shierholz, Natalie Sabadish, and Hilary Wething, "The Class of 2012":

Young people with recent college degrees have high unemployment rates. That's not good, either for Brooks's argument or for the huge number of young people being devastated by the weak economy and the weak response of elites.

Third, we have Brooks arguing that there are issues "surrounding globalization and technological change. Hyperefficient globalized companies need fewer workers. As a result, unemployment rises, superstar salaries surge while lower-skilled wages stagnate, the middle gets hollowed out and inequality grows." Some occupations require high skills and have sufficient demand, but some occupations require mid-skills and are disappearing. (Low-skill jobs should be fine on unemployment, but low on wage growth, in most versions of this "job polarization" theory.)

Let's take BLS CPS unemployment data by occupation, March 2007 and March 2012, and see if you can tell me which occupations require these high-end skills from their low 2012 unemployment rates:

I'm having trouble seeing them in the data.

So here's the important thing about the demand-side recessions: If I wanted to come up with a "supply" theory for Brooks, I'd say, looking, at the data above, that we have too many college graduates and too many business and professional workers. I'd also say we have too many non-college graduates and too many service workers. I'd also say we have too many of all ages, all educations, and all occupations. Something is weak at a fundamental level in the economy, which is impacting everything, even before we get to the pressing issues related to job polarization or education. That weakness is demand, and that is where the policy response should be. Don't tackle it, and the longer-term problems are even harder to manage.

As David Beckworth noted, "[t]his evidence in conjunction with that of downward wage rigidity excess money demand, and the Fed handling the housing recession just fine for two years should remove any doubt about there an aggregate demand problem. The real debate is how best to respond to this problem." The evidence he referred to was the SF data noted above along with the tracking he found between sales being reported as the "single most important problem" by small businesses and the unemployment rate:

Mike Konczal is a Fellow at the Roosevelt Institute.

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A Message to World Leaders: Ignore the Financial Markets

May 7, 2012Jeff Madrick

A solution for the eurozone? Listen to the people, not to the markets.

For 40 years, there has been a tug of war between government in democracies and what we may call “the other government.” By the latter I mean, of course, the financial markets. James Carville highlighted his concerns when he announced that in the next life he would want to be a bond trader. Alan Greenspan followed the bond markets religiously for signs of increased or reduced inflationary expectations.

A solution for the eurozone? Listen to the people, not to the markets.

For 40 years, there has been a tug of war between government in democracies and what we may call “the other government.” By the latter I mean, of course, the financial markets. James Carville highlighted his concerns when he announced that in the next life he would want to be a bond trader. Alan Greenspan followed the bond markets religiously for signs of increased or reduced inflationary expectations.

Now Europe faces the threat of a financial market rebellion. Democracy has spoken loudly in this weekend’s elections on the Continent and in England. Voters said, "We have had all the austerity economics we can take."  They threw over Sarkozy in France and many Conservative and Liberal candidates in England. In Greece they ran for the extremes. The moderate liberal Pasok party won the least votes in memory, but it may yet form a coalition to run a new government. Italian election results will be in soon.

And democracy is working! The instinct among those in the financial markets is that democracy usually reflects the weak-willed demands of the public. But the public is generally right this time, and it has been many times before. Austerity economics is self-destructive when economies are so weak.   

Yet of course the financial markets’ initial reaction to the European elections was to sell, as if austerity economics was actually working to make nations' bond payments easier to handle. It was not! But the markets fear that a new strategy will make matters worse.

Political leaders should ignore the financial markets in the short run, pure and simple. This may drive up financing costs for a while, but the eurozone should absorb those and adjust policies. The European Central Bank (ECB) ought to accommodate its needs. The right policies are stimulus from the current account countries and the end of extreme austerity in the periphery. Wages should rise in the eurozone core and stabilize in the periphery; they can even rise from their current lows in places like Greece. The 17-nation Eurozone or the 27-nation EU should issue jointly backed bonds to provide social safety net support to the financially weak nations, to raise demand for them and get their economies going, while reducing the extreme financial pain and sacrifice that now jeopardize social stability. As examples, the Greeks voted for extremist parties, the Le Pen party did well in France, and the Tea Party runs amok in the U.S. Austerity fever even grips Washington, which makes the November election especially important.

What the crisis requires is elected government, not bond trader government. Any idea that the financial markets are rational should have been discarded four years ago. They have been absurdly wrong for decades. In the U.S., they persistently overestimated future inflation by driving interest rates too high compared to the CPI and the GDP deflator. Greenspan treated them as the height of rational forecasting, when indeed they were simply following the latest conventional wisdom. In my informal opinion, he used long-term rates as a guide to policy. Now the ECB remains too tight as well. In the U.S., the “rational” bond traders actually traded what they thought the market would think, rather than what rational foretellers of the future would think. It was Keynes’ beauty contest analogy—choose the woman you think others believe is beautiful. The belief that the markets were right was the fallout of extreme efficient markets theory.

The media too often treated the markets as rational as well. Bond traders implicitly endorsed austerity economics until fairly recently, and the media usually reported them as being right. The supposedly sophisticated financial media (with some noted columnists as exceptions) wondered what could possibly work if not austerity. Now there are signs that the press is waking up to reality and realizing that it, along with the financial markets, is not working.

There are some signs of the ice breaking. The German finance minister announced it was okay for German wages to rise. They have actively restrained wage growth to make their exports more competitive for over ten years. The main sources of their demand were the European periphery, where wages were rising a bit due to a property bubble caused by irrationally low interest rates offered in the financial markets. But there are still signs of backward thinking. Many in Europe think of growth policies as nothing more than making labor markets more competitive through deregulation and reduced wages. As if the more flexible labor markets in the U.S. are leading to rapid recovery.

In sum, what’s needed in Europe is fiscal stimulus, a more accommodative ECB, social transfers from rich states, higher wages in many nations, a change in the silly EU agreement to keep deficits absurdly low, and industrial policy to gear capital investment across the continent, free of prejudice and nationalistic tendencies. The elections may bring some of this about. Then, once policies are working to support growth and reduce financial burdens as tax revenues rise, the financial markets will at last respond constructively. They must be waited out for now.

To put it most simply, what’s needed is the will of the government of the people to ignore the financial markets and stop treating them like a more rational government than democracy itself.   

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 EEOC Stands Up for Transgendered Workers While Congress Stalls

Apr 30, 2012Tyler S. Bugg

genderless-icon-144The EEOC's decision to extend protections against discrimination to transgender workers is an important step toward social justice and a stronger economy.

genderless-icon-144The EEOC's decision to extend protections against discrimination to transgender workers is an important step toward social justice and a stronger economy.

Two months ago, I wrote that our country should pass the Employment Non-Discrimination Act (ENDA) and expedite the process of ending discrimination based on sexual orientation and gender identity in the workplace. This month, we’re one step closer. A groundbreaking ruling handed down from the Equal Employment Opportunity Commission (EEOC) on April 20 dictates that protections against gender identity discrimination are covered by Title VII of the 1964 Civil Rights Act and can be called upon in gender and sex discrimination complaints to the bureau and in subsequent lawsuits. This is a major leap forward for transgender Americans and for their job security.

The landmark change came as a response to the case of Mia Macy, a transgender woman and former Phoenix police officer who applied for and was tentatively accepted for a ballistics job -- until the employer conducted a background check. After obtaining information about Macy’s transition from a man to a woman, the employer allegedly (and untruthfully) informed Macy the offer was eliminated due to budget cuts and then promptly filled the position with another (not transgender) applicant. EEOC policy has been vague on exactly the types of cases are covered under its statutes, and are therefore under its legal jurisdiction, and detrimentally so. But under the new ruling, Macy’s filing of a complaint of gender discrimination with the EEOC can move forward to the next investigative steps.

The new ruling, however, has ramifications much larger than Macy’s case alone. It clarifies existing national policy and makes stronger what’s often been a too slowly evolving area of employment law. It sets into motion protections for potential employees from workplace discrimination regardless of their gender identification, expression, or status. The policy holds obvious significance for cutting away unnecessary pressures within the workplace environment, pressures that are both bad social policy and bad business policy.

Human Rights Watch’s “Corporate Equality Index” has striking evidence in support of the last point. Not only are employees who usually face discrimination finding more inclusive employment laws beneficial, so are employers. While employees experience higher confidence in their job searches and eventual careers, employers can access improved applicant pools. Benefits like more inclusive health plans and policies, gender-minority support and focus groups, and diversity councils are all additional assets that strengthen the commitment to productive and respectful employer-employee relations, guided by principles of fairness and equity. The economic outlook, in the long run, is the real winner.

The EEOC ruling will also have profound effects in curbing some disturbing trends. Data from the National Center for Transgender Equality (NCTE) shows that mistreatment at work is widespread. A disturbingly high 90 percent of transgender individuals reported feeling harassed or mistreated at work, and 47 percent reported being fired, not hired, or denied a promotion or salary increase as a result of their non-conforming gender status.

On top of this, the lack of protection against discrimination in the workplace has long had alarmingly adverse effects on gender-minority individuals elsewhere. The NCTE further reports that as transgender employees face workplace discrimination, their personal lives suffer as well. As a result of negative workplace environments, transgender individuals are four times more likely to be homeless, 70 percent more likely to abuse drugs and/or alcohol, and 85 percent more likely to be incarcerated.

The EEOC ruling is a vital first step with the potential to be a game changer in the job market. Its potential for setting a precedent for the passage of laws like the ENDA, one of the most stagnant pieces of legislation of the past two decades, is also promising. But it’s not the whole solution. While it's certainly a strong deterrent for employers with histories or ongoing incidents of gender discrimination, it’s only a mechanism as strong as we make it. It shouldn’t only be a reactive method that penalizes discrimination by threatening lawsuits, legal fees, and unwanted government intervention. Rather, it should foster a culture of prevention aimed at normalizing acceptance of all workers.

Tyler S. Bugg is a member of the Roosevelt Institute | Campus Network and an Organizing Fellow with Obama for America studying international affairs and human geography at the University of Georgia.

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