Thursday, March 26, 2015

Meet the Left's Newest Capitalist Straw Man: The Shareholder as Mafia Boss

In a recent Washington Post op-ed, Harold Meyerson, an avowed socialist, compares corporations who buy back their own shares to Las Vegas mafia bosses who used to skim casino profits.  The basis for his smear is "a recent paper by J.W. Mason, an economist at the City University of New York and a fellow at the Roosevelt Institute, [who] documents the great shift in what U.S. corporations have done with their money."  Based on this paper, Meyerson writes:
In the 1960s and ’70s, about 40 cents of every dollar that a corporation either borrowed or realized in net earnings went into investment in its facilities, research or new hires. Since the ’80s, however, just 10 cents of those dollars have gone to investment. As a result of the shareholder revolution, the money that once went to expansion and new ventures has gone instead into shareholders’ pockets. 
Ironically, Meyerson decries the lack of capital investment and follows Mason (who follows William Lazonick and others) to imply that this purported lack of investment represents a kind of new class struggle between shareholder activists and employees who apparently stand to benefit only if the company invests its cash in something.  Meyerson writes:
Unlike the Vegas skim, which still allowed for sufficient floor show investment, the new skim, which is both ongoing and nationwide, has greatly reduced productive investment in the United States. The new skimmers have been the nation’s largest investors, and although they haven’t had anybody whacked, they have managed, as the mob never did, to bring America’s middle class to its knees.
So, have shareholders always been just a moral notch above mafia killers who brutally execute their enemies or has something changed?  According to Meyerson, the answer is that modern businessmen have become more greedy. You see, in the good old decades after World War II (you know, back when socialists like Meyerson were great advocates of big business), corporate investment was under the control of "the managers" whose high-minded "investments, chiefly from retained earnings, led to a generation of high productivity growth accompanied by steadily rising worker incomes, thanks to substantial unionization." [emphasis mine].  Then, along came Milton Friedman who "propounded the belief that the sole corporate mission was to reward shareholders" and corporations began linking top managers' performance to stock performance (pay based on performance - those darn capitalists!). This caused a new generation of evil businessmen from Wall Street to replace the good businessmen who used to not care so much about money.  He writes:
In the 1980s,...the managerially controlled firm was challenged by corporate raiders who sought to create leaner firms with lower wages in order to return more money to shareholders. A newly deregulated financial sector encouraged corporations to fund their endeavors more from borrowing — which enriched Wall Street — than from earnings.
These ideas appear to be reflecting throughout various left wing echo chambers and even promise to be a political issue in 2016 as "there are hints that Democrats might revisit it in the presidential campaign next year."  Meyerson and his ilk have created yet another capitalist straw man known as "large investors" (Big Investor?) who they attack for "skimming profits" and bringing "the middle class to its knees" while their leftist brethren surely nod their zombie heads in approval.

So, is it true, as Meyerson suggests, that linking manager pay to stock performance and distributing gains to shareholders is tantamount to violent criminal behavior?  Are the pension funds, 401k, and IRA participants (the middle class!) that benefit from rising stock prices really being brought to their knees?  Is it necessarily bad if corporations, on a relative basis, return a larger portion of earnings to shareholders rather than investing in new projects? What are these wonderful "new ventures" cited by Meyerson that should be funded by "the managers?" Does he presume the shareholders will reinvest the money in worse (less profitable) projects than the new projects he imagines?  Are the benefactors of the shareholders' new investments less worthy than those who would benefit from the projects envisioned by Meyerson?  Are "the managers" of corporations or central planners in Washington omniscient oracles who really know what's best?

If a business believes their capital is best deployed in X rather than Y then they will move their capital to X from Y.  Any one businessman or company can make egregious errors in their calculations, but the market will punish them with losses, and if they continue to make errors they will be put out of business.  In the long run and in aggregate, capitalism, ensures that capital will be allocated as profitably as human beings are capable of allocating.  Only government policies, in many different forms, can divert capital from its highest and best use.  So, if Meyerson is truly concerned that capital is being misallocated, he should start by analyzing Marxist inspired political policies themselves as the explanation.

For starters, Mason's own paper suggests that Meyerson (and perhaps Mason) has his logic backward.  Rather than view the 1980's as a turning point from the management practices of high minded businessmen to the vicious tactics of corporate raiders, it could be argued that it was various legal and regulatory changes which finally liberated shareholders to force stodgy corporations into being more productive and accountable. Mason provides a very good synopsis of the intellectual, legal, and institutional changes in financial markets that made the takeover movement possible.  For example, he cites "a number of legislative and administrative reforms that made it more feasible for shareholders to assert their notional power over management:"
Among these were legal challenges to laws limiting hostile takeovers of corporations, including the Supreme Court’s 1982 decision in Edgar v. MITE striking down Illinois’s anti-takeover law and similar laws in other states (Davis 2009). Also important was the revision of anti-trust regulations by the Reagan Justice Department, also in 1982, which relaxed the limits on concentration within industries. This opened up new possibilities for intra-industry mergers and undermined the logic of conglomerates, the major initial target of hostile takeovers (Roe 1996).
The "adoption of Rule 10b-18 by the SEC in 1982,... made large-scale share repurchases legal for the first time (Grullon and Michaely 2002)" and "made shareholder value the operational principle of corporate finance,  He notes that "institutional changes in financial markets...made takeovers and other changes of control more feasible." For example, the relaxation of "the rules on the classes of investments permissible by various institutional funds" resulted in a "broadening of the funds available to finance changes in corporate control" while compensation practices like stock options put top executives closer to the "worldview" of shareholders.

If anything, these changes should be seen as positive developments that utterly transformed the corporate landscape, and ironically, served as a factor in causing real wages to ultimately rise. Since it is productivity that actually raises real wages for labor, any policy which constrains or restricts productivity, diminishes the increase in real wages, a principle about which Meyerson is surely ignorant. The disruptions caused by intellectual, regulatory, and institutional changes in the 1980s actually benefited all to the extent that these changes resulted in more freedom, more productivity, and higher real wages.  To his credit, Mason recognizes this possibility:
Supporters of the shareholder revolution would argue that this is a change for the better and that the high level of internally funded projects under the old managerial regime included a large proportion of white elephants whose expected returns were too low to justify their expense. Whether or not the shareholder-dominated firm chooses its projects more wisely is beyond the scope of this paper.
So even Mason admits that shareholders actually can prevent managers from investing in "white elephants," a conclusion that Meyerson not only doesn't acknowledge in his diatribe, but contradicts when he claims "it was the coming of both globalization and the shareholder revolution in the 1980s that undid the broadly shared prosperity that Americans had enjoyed in the mid-20th century."    

Perhaps Meyerson was referring to the main theme of Mason's paper centered upon his empirical observation of the "weakening correlations of cash flow and borrowing with investment and a strengthening of correlations with shareholder payouts" - a development he attributes to a "shift from managerialism to rentier dominance."   In other words, he argues that since the managers lost control to the shareholders, there has been an increase in shareholder payouts and a decline in corporate investment.  He recognizes that "when profits are low and credit is expensive, there will not be much difference between the two regimes." However, he recognizes the role of cheap credit in creating this regime shift: 
[W]hen profits are high and credit is cheap, it’s a different story. If the cost of borrowing is less than the rentier opportunity cost, it will make sense for the rentier dominated firm to incur debt simply in order to increase payouts to shareholders — something the managerial firm would never do. [emphasis mine]
In other words, he identifies the distinguishing characteristic between the two regimes as an economic state in which profits are high and credit is cheap.  What causes such a state?    We know that credit expansion, brought about primarily by the government, affects the interest rate by creating a larger pool of funds and creating less demand for money holding in the short run.  It also boosts profits by inflating business revenue relative to costs which are depreciated over a longer time period.  Of course, credit expansion can affect the share buyback process by artificially decreasing interest rates and creating less demand for cash holding.  If interest rates are low and profits are high then it can pay for a company to borrow cheaply and buy back its shares and return profits to investors now versus investing in some longer term project.  Can this go on forever? 

In a free market, as corporations issue more and more debt to buy the shares, interest rates would tend to rise, while rising stock prices would result in higher (less attractive) valuations at the same or declining profit levels.  At some level of interest rate, it would no longer pay for a corporation to buy back its own shares.  The government can short circuit this natural process only by artificially keeping interest rates low by accelerating its credit expansion.  This is exactly what the Fed has accomplished through its various QE programs, and stock buybacks funded through corporate debt issuance have been taking place at an unprecedented rate.  

The creation of money out of thin air does not create real wealth, but it massively distorts the capital markets and enriches holders of assets in nominal terms relative to everybody else. The actual source of capital misallocation is credit expansion which distorts the interest rate and sends false signals to investors putting businessmen in the position of a doctor who takes an x-ray while some other force distorts the output. 

Rather than focusing on the causes of a persistent state of high profits and cheap credit, Mason attributes the empirical data to the conflicting interests (hurdle rates) of managers and shareholders. This leads to his arbitrary claim that payouts to shareholders are "something the managerial firm would never do."  Why?  Maybe it's true that managers would not borrow to buy back shares.  Maybe they would invest the capital instead.  But, in what?  Why are we to assume that investment, any investment, is necessarily good and that share buybacks are necessarily not as productive?    When the Fed distorts the market, there is no way to know. Even Mason seems to acknowledge the Fed's role in this mess but is at a loss to explain the outcome: 
In particular, the fact that low interest rates have encouraged increased corporate lending and borrowing without any accompanying boom in real investment should raise doubts about whether we can expect to achieve full employment through measures aimed at increasing the credit supply.
So, creating money out of thin air doesn't lead to real output and employment gains?  Mountains of government regulations, spiraling government debt, and the highest corporate tax rate in the developed world isn't working?  So will Meyerson argue for abolishing the Fed and returning to a system of private banking and laissez faire?    

Meyerson's and Mason's inability to reach the conclusion that it is government intervention in the economy that distorts capital markets, destroys productivity, and leads to declining real wages stems from a deep underlying premise - the Marxist premise that profit seeking behavior is necessarily exploitative, i.e., that one person's gain necessitates another person's loss. Meyerson's corporate raider (the term is a smear) is likened to a Mafia kingpin who crushes and destroys his enemy for personal gain and now serves as the latest capitalist straw man for pundits like him to justify, yes, more government intervention.   To them, the non-profit manager is a kind of omniscient caretaker looking out for the good of everybody, who would have the good sense not to buy back shares, and certainly not foolish enough print money to keep interest rates artificially low...   

Monday, March 9, 2015

The Deception of Central Banking - A Parable

Let's say a guy is about to counterfeit millions of dollars and spend it in his town (he's been empowered by secret government commission) with the goal of producing a perceived economic boom.  To have the greatest effect, would he be better off publicly announcing his intention to counterfeit with the proviso that if prices go up too much he will stop, or would he be better off spending the counterfeit money in secret?

If he announces his intentions, banks and businesses in the town will immediately begin to factor his future spending into their prices and inventory decisions.  His promise to stop counterfeiting if prices go up too much will also be taken into account.  Knowing that an indefinite counterfeiting operation will ultimately force prices higher, they will conclude that it is unlikely he will counterfeit indefinitely and will regard the increased spending as temporary.  As he buys more of their goods, they will experience an improved bottom line in the near term, but they will not be incentivized to expand their operations or hoard inventory in the hopes that prices will just keep going up and up as he spends and spends.  The boom is unlikely to ever materialize.    

On the other hand, if he secretly counterfeits and begins spending the money, businesses will notice that they are selling more and more.  Even if they raise their prices a little they will see their sales increase and conclude it is part of a new trend.  As prices go up everywhere, they will realize they can purchase more inventory and just wait for prices to go up further.  Banks will be flush with deposits and able to make loans on more generous terms.  Businesses will expand their operations.  The town will believe they are experiencing a boom.

Notice that for his counterfeiting to result in a perceived boom, he had to trick everyone into thinking that the increased spending volume is real and would continue indefinitely.  It needed to appear that the increased deposits in the bank reflected the real desire of individuals to save more money for longer periods so that businessmen would be fooled into pursuing longer term projects that consume massive amounts of capital.  Conversely, when the businesses anticipated the end of counterfeiting, the whole effect of his actions was relatively inconsequential.  As Ludwig Von Mises wrote in his economic treatise Human Action:
The boom-creating tendency of credit expansion can fail to come only if another factor simultaneously counterbalances its growth.  If, for instance, while the banks expand credit, it is expected that the government will completely tax away the businessmen's "excess" profits or that it will stop the further progress of credit expansion as soon as"pump-priming" will have resulted in rising prices, no boom can develop.  The entrepreneurs will abstain from expanding their ventures with the aid of the cheap credits offered by the banks because they cannot expect to increase their gains.  
Unless the businesses believed they could continually gain from the trend, they will not act to expand their business.  In this way, the example shows that even if the man had kept counterfeiting, he would have had to accelerate his pace of counterfeiting to keep the boom going (increasing the gains of the gains) and eventually he would have destroyed the town's monetary system. Von Mises wrote:
The boom can last only as long as the credit expansion progresses at an ever-accelerated pace.  The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market.  But it could not last forever even if inflation and credit expansion were to go on endlessly.  It would then encounter the barriers which prevent the boundless expansion of circulation credit.  It would lead to the crack-up boom and the breakdown of the whole monetary system.  
Von Mises's principles relate to recent events.  In the housing bubble leading up to the 2008 crisis, it was believed that home prices would rise indefinitely.  Credit expansion supported by central bank rate policy, fractional reserve banking, and the federal government's underwriting of mortgages through GSE's caused a massive boom in real estate prices.  More credit begat home price increases and house price increases begat more credit.    

Since that bubble burst in the 2008 crisis, global central banks such as the Federal Reserve, ECB, and Bank of Japan have embarked on an effort seemingly to create another phony credit boom.  But this time, they have maintained a policy of publicly announcing their so-called "quantitative easing" efforts in advance.  They have generally pledged to buy their government's bonds (with fake money) of a certain magnitude for a certain period of time with the goal of increasing consumer prices along with the proviso that if prices rise too quickly then they will stop and potentially even go in reverse, i.e., remove money from the monetary system.    As we would expect based on the above, despite their best efforts, these central banks have been unable to create the kind of phony boom they so desperately crave.

Central banking requires that government bureaucrats act in a way to distort the entire economic system by introducing counterfeit credit into the monetary system in such a way that businessmen are continually fooled into acting in a way that mimics the behavior of businessmen operating in an actual economic boom.  The fact that central banking requires deception does not imply that we should advocate deception. On the contrary, the point is that central banking, by its nature, requires massive deception and is a symptom of its evil and impracticality.  

Thursday, March 5, 2015

The Real Problem is Strong Central Banks - Not Strong Currencies

One myth driving the irrational policies of central planners is the idea that a depreciating currency is good for a domestic economy.  Presently, this myth is fueling a so-called "currency war" in which each country attempts to depreciate its own currency relative to others.  In essence, the idea is that if you make your currency cheaper relative to other currencies, then people in the other country will buy more of your stuff.  In turn, this will help the export industry in your country thus constituting an economic advantage.  Of course, this idea is hundreds of years old and a major feature of the infamous economic theory known as mercantilism.

Bastiat and Hazlitt taught us that most economic myths persist because people only focus on one direct effect of a policy rather than on all the direct and indirect effects or unintended consequences.  In fact, the value of currency depreciation can be debunked with a simple example.  Let's assume on Day 1,  the currency exchange rate between euros and dollars is 1 to 1 and let's focus on the German company BMW selling one car for 100 euro:

Day 1

     Exchange rate = 1 $/Euro
     BMW (euro) = 100 Euro
     BMW (dollar) = 100 euro * 1 $/euro = $100

Say the Germans depreciate their currency, and further assume that BMW produces all of its cars in Germany and uses all of its inputs from other German companies, and maintains its euro price at 100.

Day 2

     Exchange rate = 0.25 $/Euro
     BMW (euro)  = 100 Euro
     BMW (dollars) = 100 euro * 0.25 $/euro = $25

In the U.S., the BMW now only costs $25!  The total American demand for cars was $100 and at the previous rate, Americans could afford to buy 1 car.  But now, Americans can afford 4 cars at $25 each and be no worse off.

     BMW revenue (Dollars) = 4 cars * $25 = $100
     BMW revenue (Euro) = $100* 1/0.25 Euro/$ = 400 Euros

BMW and its employees are thrilled!  They have made $100 which is now worth 400 Euros whereas before, they were likely to only make 100 Euros from the sale of 1 car. BMW's stock price (in euro) may even go up as would other company's stock who are similarly affected.  BMW is better off, but is the German economy better off in aggregate?

Well, what does BMW do with the $100 it received?  It can only spend the $100 in the U.S.  Even if BMW converts the currency and gets the 400 euros, then the exchanger paid out 400 euros to BMW and now has the $100.  What can the $100 buy?  The $100 can only buy the same amount as before in the U.S., even though it costs 4 times as much for a German in euro.   For example, let's look at this from the perspective of a German who wishes to buy a US Farm Tractor.    


Day 1

     Exchange rate = 1 $/Euro
     US Farm Tractor (dollars) = $100
     US Farm Tractor (euro) = $100 * 1 euro/$  =  100 euros


Day 2

     Exchange rate = 0.25 $/Euro
     US Farm Tractor (dollars) = $100
     US Farm Tractor (euros) = $100 * (1/0.25) euro/$  =  400 euros

The German tractor buyer's cost has gone up to 400 Euros.  While BMW is thrilled that it is making 4 times more money selling its cars, the German farmer has to pay 4 times as much for the same American tractor.  BMW benefited, but the German farmer lost.

In general, the $100 received by the Germans will be spent in the U.S. for something - if not by BMW or a farmer, then by someone further down the line in Germany who exchanged the euros.  If the purchaser of the $100 does not want a consumer product, they would deposit it in a U.S. bank or more likely, buy a U.S. dollar bond.  But whether they buy $100 worth of U.S. bonds or $100 worth of U.S. products, since it now costs them 400 euros, they get 1/4 as much U.S. stuff on day 1 as on day 2.  On Day 1, in aggregate, Germans produced 1 car in exchange for 1 tractor.  Now they have to produce 4 cars in exchange for 1 tractor.  How is this good for the German economy?

Even from this contrived example, you'd have to conclude that currency depreciation is at best a zero sum game in which some (exporters) benefit at the expense of others (non-exporters).  In fact, it's much worse than a zero sum game as Robert Murphy and Patrick Barron demonstrate in more detail. In Bad Idea: Devaluing Currency to Help Exporters, Frank Hollenbeck demonstrates the negative effects of currency depreciation on workers who must "pay higher import prices resulting from depreciation" reaching a familiar conclusion when analyzing central banking:
Few journalists seem to understand that a policy to reduce the foreign exchange value of a currency is, in reality, a policy to transfer wealth from workers — the middle class and the poor — to the wealthier owners of export industries. It is another example of the central bank acting as a reverse Robin Hood, taking from the have-nots to give to the haves.
So why would the central planning bureaucrats engage in "currency wars?"  The reason is that central planners are politicians who do what is in their own short term best interest.  In this case, they seek to politically appease their domestic export lobbies cheered on by Keynesian cranks like Paul Krugman.

As central banks engage in currency depreciation and the so-called "race to the bottom" goes on, it becomes even more clear that the real threat to any economy is not a strong currency, but a strong central bank.  The solution is to end the regime of central banking and to replace political control of our money with a private banking system based on a 100% reserve gold standard.