Searching for an Honest Debate on Economics

Jul 18, 2012Jeff Madrick

Glen Hubbard's column in today's Financial Times detracts from meaningful academic debate by ignoring counter-arguments and citing discredited research (when he cites evidence at all). 

Glen Hubbard's column in today's Financial Times detracts from meaningful academic debate by ignoring counter-arguments and citing discredited research (when he cites evidence at all). 

Glenn Hubbard, an economic adviser to Mitt Romney, and more relevant to this commentary, dean of the Columbia Business School, has published a column in today’s Financial Times so devoid of basic academic credibility that it is fair to call it disingenuous.  Hubbard claims research shows that reducing debt levels will create more rapid growth. Any such research is highly controversial. You wouldn’t know it to read Hubbard.  He does not deal with counter-arguments at all.

He cites Harvard economist Alberto Alesina who claims that the way to get debt-to-GDP ratios down is to reduce social transfer spending.  He does not note how profoundly the Alesina research has been discredited by researchers at the decidedly neo-classical IMF. Austerity has rarely - if ever - worked to generate growth

He cites work by the conservative Hoover Institution that reducing federal spending to GDP to pre-crisis rates would increase GDP.  The crisis was caused by a collapse in tax revenues - not by too much spending. Few would agree that reducing such spending so drastically in the near- or medium-term would generate growth. Again, austerity.  And the economy performed poorly at those debt levels anway, failing to create adequate jobs or raise wages.

He claims that the tax system discourages work. One would have liked more detail here, but he wants reduced marginal tax rates.  The evidence is abundantly clear that there is no serious academic evidence to support his claim.

On our website, you can find work by Peter Lindert and Jon Bakija, which thoroughly refute these claims. But more to the point, Lindert and Bakija, both serious academics, look at the research of others, they just don’t ignore it, as does Hubbard in this FT piece.  They confront it and  show where the research fails. 

Is this the job of academics? Is this what Hubbard teaches his students?  Small-government economists might counter that public economists must be given more leeway.  But in truth, Pauk Krugman, the focus of so much right wing criticism,  usually deals explicitly with counter-arguments in his blog and often in his column; he does not simply does cite evidence to support his case without a broader context.

We intend our web site to offer broad, honest argument, to enrich the public discussion, not to narrow it.

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A Shameful Few Weeks Begs the Question: Where’s Government?

Jul 17, 2012Jeff Madrick

With the recent crises in the financial world, it's clearer than ever that we need government to step up and address our problems.

With the recent crises in the financial world, it's clearer than ever that we need government to step up and address our problems.

There are certain periods in our history during which one can only sit back and wonder what the limits of astonishment really are. A couple of years since Dodd-Frank first passed, we have come through a period of such disrepute for business that one wonders why the working class has not risen as one — except, of course, because it is exhausted with efforts at reform that seem so futile. We have uncovered many disreputable and perhaps fraudulent business activities, but they essentially represent a failure of government. 

Facebook's initial public offering collapsed in price, leaving small investors holding the bag. Brokers took care of their big customers far better than their small ones. Where was the SEC?

New insider trading convictions, most recently of the widely respected Goldman Sachs director Rajan Gupta, show how rampant trading on insider information really is. The $6 billion losses at JPMorgan Chase by a department that was supposed to neutralize risk showed that trading risk is too profitable to be foregone voluntarily.

And now we find out that LIBOR is incontrovertibly rigged. Some may not realize that Barclays, which agreed to pay a $450 million fine, signed a Statement of Facts that admitted its traders rigged this key rate to make profits on positions, and collaborated with bankers/traders at other banks. Now we find out that Treasury Secretary Tim Geithner, while president of the New York Fed, was worried and even wrote British regulators about this. That’s nice. But why didn't government — and Tim Geithner himself — actually do something about it? Are government regulators that feckless?

Of course, there was a certain political advantage in a LIBOR that could be fudged. LIBOR is the rate at which banks lend to each other. It should be nearly riskless, and is therefore used as such in many transactions. LIBOR was the basis, in fact, for up to 100 percent of subprime mortgages. It is often a key input into complex pricing models for securities like derivatives and collateralized debt obligations.     

It could be that the Bank of England looked the other way when some bankers, including Barclays's, lied and said they were paying a lower interest rate than they were in order to make it seem their credit was good. Especially in the fall of 2008, after Lehman’s collapse, governments wanted to calm the waters. Did the Fed also tolerate fudging the numbers?

Why wouldn’t they? The Treasury puts a better face on matters all the time, as does the White House, no matter who is president. PR is an integral part of government. Has the practice in this age of greed slid off onto regulatory agencies? Surely Ben Bernanke was overly optimistic about controlling any impending subprime wreckage in 2007 because he knew it was better to err on the side of Pollyanish hopes that risk precipitating a crisis. What better way to underplay a crisis than to let the banks do it for you?

But for all these remarkable events — and government failures — most disturbing is the ongoing demands for austerity that even President Obama himself makes. The president wants to extend tax cuts for all except those who make $250,000 or more. But he cannot make the case without saying we have to get our fiscal house in order. The nation is likely to need stimulus. But Obama bought into the budget balancing process so early on by appointing Bowles and Simpson to come up with a solution that there is no effective opposition to impending obtuse budget policies in late 2012 and 2013. The classic case is made by the CEO of Honeywell on the front page of the Financial Times. Seeking to blame Republicans and Democrats alike, the esteemed chairman and member of the Bowles-Simpson Commission claims that business has no confidence until this is resolved.

The truth is more simple. Uncertainly surrounds the possibility that the Republicans will hold up the government again, claiming they demand budget cutting. And Mitt Romney promises to do far more damage. There is no contest between the two, and let’s keep in mind that Obamacare, and even Dodd-Frank, contain very good measures that Romney would try to overturn.  

As we end a bad few weeks and start a period of remedying the damage, let’s keep in mind that America’s fiscal problems in the near run are highly exaggerated. But even down the road, the problem is not what we spend, but the tax cuts we have been giving ourselves for 30 years. I will begin to believe the sincerity of arch deficit hawks when they argue for tax hikes, not only cuts in Medicare and Social Security. And so should the chairman of Honeywell and others of influence like him.

The myths of austerity economics are paralyzing the government and keeping the nation from getting its house in order. How may times can one say it? Not often enough, apparently.

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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What the D.C. Mayor's Scandal Tells Us About Disclosure of Political Spending

Jul 13, 2012Mark Schmitt

Vincent Gray's "shadow campaign" that gave money to both the incumbent and challenger exposes the real reason some fight transparency: the desire to cover up the favors they buy with contributions.

Vincent Gray's "shadow campaign" that gave money to both the incumbent and challenger exposes the real reason some fight transparency: the desire to cover up the favors they buy with contributions.

The Senate finally took up the DISCLOSE Act today, which would respond to the post-Citizens United explosion of large and secret political spending by requiring SuperPACs and political nonprofits to promptly reveal their own political spending and their large donors. While Republicans will block it, as they did in 2010, they have developed a new argument that was unveiled by Senate Minority Leader Mitch McConnell in a speech at the American Enterprise Institute on June 15: Disclosure would feed the Obama administration in its efforts to “silence” and intimidate its opponents. This new argument was mostly developed by Brad Smith, Steve Hoersting, and their colleagues at the anti-reform Center for Competitive Politics. I wrote about it before the McConnell speech, noting that the conservative argument in the past was to oppose restrictions on political money in favor of disclosure, but now that disclosure is the only option, they have to find a way to oppose that too.

There is a lot that's silly about the “intimidation” argument, most notably that if it were really true that the Obama administration has “got the IRS, the SEC, and other agencies going after contributors, trying to frighten people and intimidate them out of exercising their rights to participate in the American political discourse,” as McConnell said on Fox News, the appropriate remedy would be impeachment. (One of the articles of impeachment against Richard Nixon in 1974, the one that got broadest bipartisan support, was for just such activities.) Instead, McConnell's remedy for what he claims is a lawless administration is that his party's donors alone should get a special exemption from campaign disclosure laws.

Not only does McConnell have less than zero evidence of actual intimidation, his model of how money works in politics is an imaginary one. Let's look at a case of real corruption here in Washington, D.C. On Tuesday, a fundraiser and friend of Mayor Vincent Gray agreed to plead guilty for her role in a $658,000 "shadow campaign" on behalf of Gray, funded by city contractor Jeffrey Thompson.

According to the Washington Post, the fundraiser, Jeanne Clarke Harris, “said Thompson opted to hide his campaign largesse in large part to avoid angering [incumbent mayor Adrian] Fenty, whose administration his businesses relied on for contracts. The Medicaid deal held by his D.C. Chartered Health Plan is the city’s largest contract: It is worth more than $300 million yearly. 'He did not want the sitting mayor to find out he was supporting his opponent,' Harris said. 'If somehow the sitting mayor won, he would be in some serious contractual problems.'"

On the surface, then, this looks exactly like the kind of situation McConnell and his allies have been warning about. Harris may not be telling the truth or accurately representing Thompson's fears, but let's assume she is. Here we have an example of a businessperson fearing retaliation from government for expressing his political views. But I don't see the campaignfreedom.org blog rallying to the defense of Mr. Thompson.

Perhaps that's because its obvious that Thompson was not expressing political views by secretly supporting Gray. He was covering his bets. Like most large political donors, his main view is his interest in making more money. He expected to have more clout in a Gray administration, especially because that administration will feel more obligated to him, but he did not want to jeopardize his partial success with the Fenty administration. So he made his expenditures secretly, through Harris and other channels.

Nondisclosure allowed Thompson to basically operate without expressing a political choice, by making contributions that he hoped would ensure access and influence no matter which candidate won. That's the more general explanation for corporations and individuals wanting to keep large expenditures undisclosed. "Retaliation," if and when it happens (and I'm not including plainly illegal actions like turning the IRS on an opponent's supporters), is just the inverse of the influence and access that motivates giving. And nondisclosure, of course, doesn't mean that the politicians and elected officials who benefit from the money don't know about it. It should really be called uneven disclosure or asymmetrical disclosure.

Disclosure generally, and the DISCLOSE Act in particular, hardly solve all the problems of political inequality. But at least they allow us to begin to see the patterns of corruption, such as the connections between Thompson's spending and his contracts, and demand better – just as D.C. voters and councilmembers are doing in calling for the mayor's resignation.

Mark Schmitt is a Senior Fellow at the Roosevelt Institute.

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Reagan Redux: The Truth About Romney Economics

Jun 15, 2012Jeff Madrick

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

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

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

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

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

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

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

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

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

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

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

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

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

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How Does Private Equity Really Make Money?

Jun 12, 2012Eileen Appelbaum

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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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