Who's Going to Build the Next American Economy?

Aug 6, 2012Bo Cutter

President Obama's "you didn't build that" comment highlighted the importance of public investment, but we're not doing anything to make it happen.

President Obama's "you didn't build that" comment highlighted the importance of public investment, but we're not doing anything to make it happen.

I'd like to restart "The Cutter Report" with a commentary about President Obama's remark that "you didn't build that." Relax; I'm not going to pile on the endless series of brainless remarks about how the president hates the private sector. For the record, I don't think he does. I think the endless spinning of the president's remarks by Governor Romney, a whole slew of Republican political "experts" (how do you get to be one of those?), and every half hour of Fox News is only another sign of the apocalypse and nothing to be taken as actual real thought about anything that matters.

Rather, I'd like to take his comments seriously, as I think he intended. So let's start with the fact that President Obama is simply correct. It's no more complicated than that.  I've spent two-thirds of my career in business and I think he's right, and so would every businessperson I know outside of the brainless debates of this presidential campaign. We are all damn lucky to have started, run, and been in businesses in America. Not one of us could have done any of this if we were trying to do it in the Eastern Congo. We have a Constitution, a sense of private property, laws, honest courts, decent infrastructure, great R&D, and on and on.  

But right now, we risk losing some or many of these advantages. As I detailed last year, and as Third Way, a centrist think tank, spells out in its new paper, "Collision Course: Why Democrats Must Back Entitlement Reform," we have entered an era when as a nation we have decided not to invest in either hard or soft public infrastructure any longer. I estimated then that our total domestic public sector investment is about 5 percent of GDP and I calculated that this will fall to around 2 percent of GDP over the next 10 years (I used OMB numbers, but the projections are my interpretation). Third Way's numbers show similar trends. Federal investment spending will drop from 6 percent of GDP in 1962 to a projected 2 percent in 2018, or from 3 percent of the federal budget to 10 percent. As I've said before, I think this is a disaster. Why?

First, I completely agree with the central implication of Ben Friedman's classic book, The Moral Consequences of Economic GrowthThere may be problems that come along with economic growth, but they are nothing compared to the problems of no growth, as we have all seen. And none of the problems progressives care about can be solved in the absence of growth.

Second, as a general proposition, growth is not possible in the middle or long term without investment, and I mean both public and private investment. 

But third, investment is even more important to us today, right now. The core truth is that if we are to grow as rapidly over the next 20 years as we did in the last 20, we have to have a productivity revolution. More of our growth will have to come from productivity -- about 80 percent in the next decade, as opposed to 35 percent to 50 percent in the last three decades. To keep growth constant with the last three decades, labor productivity will have to grow by about one-third. If none of this happens, the generation born during the last decade will experience only about 60 percent of the per capita income growth as did the generation born in the '60s. And creating a productivity revolution is going to require an investment revolution in both the private and the public sectors. 

But we're not going to get investment or a productivity revolution or decent long-term growth. Growth is certainly not at the core of either political campaign now. Public investment is disappearing from the federal budget, and private sector investment is at best mediocre. Neither end of our ideological spectrum cares enough about growth to make it a priority. (As the loading dock foreman said, "Sure my boss cares about quality; he mentions it at least twice a year. But he talks 'shipping boxes' about three times a day.")

So if you take President Obama's comments as true -- as I do -- and you see them as a shorthand view of the combination of elements that actually creates growth, and if you project forward a little bit, then we aren't going to be building much of anything in the future.    

(Note: Many progressives strongly disagree with Third Way's paper. I refer you this post on Bill Keller's New York Times blog, "Boomers and Entitlements: The Next Round," for a debate between James Galbraith of the University of Texas, who also critiqued the paper here at Next New Deal, and Jim Kessler of Third Way. Keller's issue is not my issue in this particular post, but I agree with him, and after reading the Third Way paper and the debate, I mostly agree with the Third Way perspective.)  

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


Construction workers image via Shutterstock.com.

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A Big Banker’s Belated Apology

Jul 30, 2012Jeff Madrick

This op-ed originally appeared at NYTimes.com.

This op-ed originally appeared at NYTimes.com.

Last week, in a CNBC interviewSanford I. Weill, the former chairman of Citigroup, said that America should separate investment banking from commercial banking. This separation, of course, was the prime purpose of the Glass-Steagall Act of 1933, a piece of legislation that Mr. Weill and other bankers had successfully watered down, with Alan Greenspan’s support, before Mr. Weill helped engineer its official demise in 1999. Now, Mr. Weill, the creator of what was once the largest financial conglomerate in the world, suggests that Citigroup and others should be broken up. Banks can no longer “be too big to fail,” he told CNBC.

But what was most eye-catching was Mr. Weill’s claim that the conglomerate model “was right for that time.” Nothing could be further from the truth.

Mr. Weill’s original business concept — the justification of financial conglomeration — was to provide one-stop shopping to any and all customers. This could now include clients for investment banking, stock research, brokerage and insurance. Then, with the 1998 merger of his Travelers Group with Citicorp, it could include savers, business borrowers and credit card users, too. But few, even among his own executives, ever believed the strategy would work.

Rather, conglomeration bred conflicts of interest in Mr. Weill’s firms, and others — the very conflicts that the original Glass-Steagall Act was designed to prevent. This inevitably led to investment in and promotion of risky, poorly run and, in some cases, deceitful companies that brought us the high-technology and telecommunications bubble of the late 1990s.

Indeed, Mr. Weill’s Citigroup was a primary underwriter of and one of the two largest lenders to the oil and futures trading firm Enron, whose accounting charade resulted in what was in 2001 the biggest bankruptcy of its time. Citigroup was a major underwriter for the telecommunications giants Global Crossing and WorldCom, which would later go bankrupt as a result of flagrant accounting deceptions. There were many other, if less visible, debacles.

Read the full article here.

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New Deal Numerology: Makers and Takers

Jul 26, 2012Tim Price

This week's numbers: $1.8 million; $560,000; $1.5 billion; $1.1 billion; $1 billion

$1.8 million... is a self-made number. That’s how much government aid has been given to Gilchrist Metal, a company highlighted in Romney ads as an independent success. The owner says he was just reclaiming his own tax money, which the government must have socked away in a special Gilchrist-only fund.

This week's numbers: $1.8 million; $560,000; $1.5 billion; $1.1 billion; $1 billion

$1.8 million... is a self-made number. That’s how much government aid has been given to Gilchrist Metal, a company highlighted in Romney ads as an independent success. The owner says he was just reclaiming his own tax money, which the government must have socked away in a special Gilchrist-only fund.

$560,000... is a patronized number. That’s how much Brian Maloney, another small business owner who criticized Obama’s comments, received from a federal contract on top of a preferential loan. Nearing retirement, Maloney is also deeply concerned about keeping the government’s hands off his Medicare.

$1.5 billion... is a chilling number. That’s how much taxpayer money went to support the 2002 Winter Olympics in Salt Lake City. If Romney has to distance himself from that like he did with Bain and his governorship, all he'll have left to brag about are his five World’s Greatest Dad mugs.

$1.1 billion... is a devious number. That’s the size of Obama's proposed 2013 budget for the Small Business Administration. This is all part of his secret plan to destroy the private sector by bribing the ownership class to convert to socialism and overthrow itself.

$1 billion... is a capitalizing number. That’s how much additional funding President Obama wants to give Small Business Investment Companies. Next he’ll be handing out free bootstraps instead of letting people pull themselves up by the ones they inherited from their dad, the governor of Michigan.

Tim Price is Deputy Editor of Next New Deal. Follow him on Twitter @txprice.

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Bubble Standards: Why the Poor Are on the Hook for the Housing Crash

Jul 23, 2012Mike Konczal

When it comes to assigning losses from an economic bubble, we apply one set of standards to elite investors and another to struggling homeowners.

When it comes to assigning losses from an economic bubble, we apply one set of standards to elite investors and another to struggling homeowners.

Many are discussing a potential collapse of a housing bubble in Canada and what could be done about it right now. Here are posts on that subject from Matt Yglesias, Dean Baker, and Worthwhile Canadian Initiative. As I read the literature being written on this crisis, the key issue to watch for is whether the rapid growth in housing prices is matched by a similar growth in household mortgage debt. To see why, it might be useful to contrast the aftermath of the United States' housing bubble with the stock market bubble.

The IMF recently studied a series of 25 OECD countries from 1980 to 2011. These countries experienced a total of 99 housing busts ("turning points (peaks) in nominal house prices"). It divided these housing busts into ones with a high run-up in household debt and ones with a low run-up, and found that "housing busts preceded by larger run-ups in household debt tend to be followed by more severe and longer-lasting declines in household consumption...real GDP typically falls more and unemployment rises more for the high-debt busts." This happens with or without a financial crisis occuring at the same time as the housing bust.

Why is this the case? Let's look at the allocation of losses that occur from the collapse of a bubble.

Within a short time after the internet dot-com bubble popped in 2000-2001, people had a sense of the size of the losses and who would take those losses. The equity holders of collapsing dot-com firms, the ones who held companies' stocks, would be wiped out, and the creditors would take huge hits, as there was very little property to be auctioned off or value to be retained. Trying to reorganize and resurrect the dot-com firms under Chapter 11 bankruptcy wouldn't have helped because they were new firms with no real revenues sources, their high-skill employees would flee, and there was little in terms of assets to use as collateral to secure future funding.

Since the firms were mostly webpages and had small-scale intellectual property, they were auctioned off very quickly under Chapter 7 bankruptcy rules. Even telecom firms that went bankrupt but had a large amount of assets and were eventually relaunched took less than two years. Global Crossing, for example, went bankrupt in January 2002 and relaunched in December 2003. These bankruptcies involved heavy losses for creditors. According to bankruptcy expert Edward Altman, "Default recoveries continued at persistently low average levels, weighed down by the enormous supply of new defaults and communication firms’ 16.6% average recovery." (h/t Greg Ip) But within a two-year span, the losses were understood and allocated.

It has been roughly five or six years since the United States' housing bubble popped. Have we finished assigning the losses yet? Robbie Whelan at the Wall Street Journal reports that we have a range of estimates from 23 percent of homes with a mortgage being underwater, owing a total of $715 billion more than their homes are worth (CoreLogic's estimates), to 31 percent of homes with a mortgage being underwater, owing a total of $1.2 trillion more than their homes are worth (Zillow's estimate). The evidence is clear that where households are most underwater on their mortgages, consumption is weakest, job losses are the worst, and income gains are struggling.

Mortgage debtors aren't shareholders, but it is fascinating to contrast their fates. In the dot-com bust, losses were assigned very quickly. In the housing bust, losses stick with the equivalent "equity" holder years and years out (and hang like an albatross around the neck of the economy as a whole). The losses that are allocated come about in large part through painful foreclosures, which create more losses by fire-selling assets into a weak marketplace. This system is designed to destroy all possible value and drag out the procedures in long, painful ways.

Crucially, in the dot-com bust there weren't the same moral and political arguments that we see in the current one. Economists who demand to know why U.S. mortgages don't stay with people who walk away from their homes didn't demand to know why the equity holders of Pets.com didn't have to dip into their personal savings to pay off the losses creditors took. Very Serious People wonder if debtors' prisons are necessary for homeowners who would walk away from a mortgage or view bankruptcy as an exit strategy, yet no Very Serious People called for the mass imprisonment of Webvan or Flooz shareholders after those firms declared bankruptcy as an exit strategy. Nobody argues that the shareholders of the dot-com era received a gigantic government bailout through the law when they were not personally on the hook for sticking creditors with an 83.4 percent average loss. Meanwhile, efforts to allow for a cleaner way of allocating the housing bubble losses, from retaining value of the household through bankruptcy reform to local municipalities taking action through eminent domain, face a minefield of political and financial industry opposition that gives the impression that the banks "own the place."

When it comes to assigning losses among elite financial institutions, like shareholders and creditors, there is a clean system in place to make sure that it runs efficiently without dragging the entire economy to a halt. When it comes to assigning losses between household mortgage debtors and elite financial creditors, we sit in a perpetual quasi-recession six years out. As the antropologist David Graber finds historically, "[d]ebts between the very wealthy or between governments can always be renegotiated and always have been throughout world history. They’re not anything set in stone... It’s, generally speaking, when you have debts owed by the poor to the rich that suddenly debts become a sacred obligation, more important than anything else. The idea of renegotiating them becomes unthinkable." This time isn't different.

Mike Konczal is a Fellow at the Roosevelt Institute.

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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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