January 31st, 2009 by Jon Taplin
For the last month, I have been gripped by the gnawing sensation that all of the conventional wisdom about our current economic crisis is wrong. I think we are facing a crisis of capitalism, not just a periodic bout of market failure. What was most startling about yesterday’s GDP drop, was that consumer spending literally stopped. We have been riding in a vehicle turbo-charged with leverage and we just hit a brick wall.
“The drop in spending was so fast, so rapid, that production could not be cut fast enough,” said Nigel Gault, chief domestic economist at IHS Global Insight. “That is happening now, and the contraction in the current quarter, as a result, will probably exceed 5 percent.”
As I have said before, we are entering an Interregnum. Now the reason there was so much uproar about the Wall Street Bonuses this week is that the bankers didn’t realize this. The election of Barack Obama reintroduced the notion of a social contract. This is a very old notion as Karl Polanyi notes in his landmark book, The Great Transformation
.
Take the case of a tribal society. The individual’s economic interest is rarely paramount, for the community keeps all its members from starving unless it is itself borne down by catastrophe, in which case interests are again threatened collectively, not individually. The maintenance of social ties on the other hand is crucial. First, because by disregarding the accepted code of honor, or generosity, the individual cuts himself off from the community and becomes an outcast; second, because in the long run, all social obligations are reciprocal, and their fulfillment serves also the individual’s give-and-take interests best.
Of course these notions of community and honor have long since vanished from the canyons of Wall Street, but that does not mean they have vanished from our society. But this leads me to the question of the crisis of capitalism. What I want to uncover is if there is some inherent flaw with the system that caused the Wall Street traders to push it to a breaking point?
There are very few things that Adam Smith and Karl Marx agreed upon–but one was the “tendancy of the rate of profit to fall”. This term is so well known by economists that they use TRPF as the acronym. Here’s Adam Smith from The Wealth of Nations 
.
It may be laid down as a maxim, that wherever a great deal can be made by the use of money, a great deal will commonly be given for the use of it; and that wherever little can be made by it, less will commonly be given for it. According, therefore, as the usual market rate of interest varies in any country, we may be assured that the ordinary profits of stock must vary with it, must sink as it sinks, and rise as it rises. The progress of interest, therefore, may lead us to form some notion of the progress of profit.
And here is a description of Marx’s TRPF theory.
Even as investment in constant capital (factories, technology,etc) increases productivity (i.e. the margin of surplus labor relative to regular labor, and thus of surplus value relative to variable capital), it reduces profits (i.e. the margin of surplus value relative to total capital). The capitalist then responds by investing more in raising productivity, which in turn reduces profits further, and so on and so forth, in a vicious cycle of diminishing returns.
This tendency, in concert with the other dialectically interrelated crisis factors developed in the course of Marx’s overall critique of capital, eventually leads to a catastrophic breakdown in the capital cycle.
So what do the theories of these two philosophers from the 18th and 19th Centuries have to do with our current crisis? When I arrived on Wall Street as a Merger and Acquisitions VP at Merrill Lynch in 1984, the age of the corporate raider and the leveraged buyout was just beginning. Up to that point debt to equity ratios in the S&P 500 companies were fairly conservative and the average investor was happy to collect dividends and hope for overall share appreciation (chart below)
But men like Henry Kravis, Boone Pickens and Ron Perlman were not satisfied with these steady returns and Mike Milken, the junk bond king showed how with a lot of leverage they could “juice” those 4% returns into the mid 20% level. So in 1985 when Kravis’ KKR bought the Beatrice Companies (Tropicana, Samsonite) for $6.1 billion, most of the money used was junk bond debt. They then sold off individual brands, retired the debt and made a 30:1 return on their investment. Now everyone wanted in on the leverage game. Pension funds, college endowments and private investors battled their way to get in on these deals. The new normal was that money should earn 10%+ per annum. Like Adam Smith said, this was unsustainable.
Next, this mentality began to affect the CFO’s of even the most successful business. Joseph Schumpter in his classic text, Capitalism, Socialism, and Democracy
talks about the “vanishing of investment opportunity”. In 2003 even after the tech crash, Microsoft had cash holdings of $49 billion. But did they invest it in some new breakthrough technology? No–they used the money to buy back their own shares! So Bill Gates, our genius inventor, felt the investment opportunities had vanished and so he bought back shares to keep his stock price up. This same strategy was deployed in boardrooms all over the country, but on Wall Street, big hitters desperate for “Juiced returns” demanded even more leveraged product. And so the genius quants in the basement invented new derivatives to which 30:1 and 40:1 leverage could be applied.
So here’s my conclusion. If modern market capitalism can only be sustained through the “juice” of such leverage, then we are in a crisis. Just as the average consumer has now realized that her home equity is no longer an ATM and that carrying 10 credit cards is bad for your health, the whole economy is going to have to return to being content with a reasonable return on investment. Because for years our GDP was”juiced” in the same way that hedge fund returns were hyped, I imagine that total output will continue to drop for many quarters until we reach a sustainable level of debt to equity ratios on both corporate and personal balance sheets. And that is why groups like The Club for Growth, originally financed by Mike Milken and his ilk are so up in arms over the Obama election that they are running this contest.
Here are the proposals from the Club for Growth on how to solve our crisis.
Making the Bush tax cuts permanent
Death tax repeal
Cutting and limiting government spending
Social Security reform with personal retirement accounts
Expanding free trade
Legal reform to end abusive lawsuits
Replacing the current tax code
School choice
Regulatory reform and deregulation
It somehow escapes the pea-brains of these dinosaurs, that these are the very policies that have brought us to this crisis. So when a New York Times reporter has the temerity to question a Wall Street bank lawyer on Obama’s anger at his bonus, we get this.
“I think President Obama painted everyone with a broad stroke,” said Brian McCaffrey, 55, a Wall Street lawyer who was on his way to see a client. “The way we pay our taxes is bonuses. The only way that we’ll get any of our bailout money back is from taxes on bonuses. I think bonuses should be looked at on a case by case basis, or you turn into a socialist.”
This logic is so twisted it’s comical. If we don’t pay Mr. McCaffrey his bonus, then he won’t pay his taxes, so we won’t have the money to recover all the cash we put in his bank. OMG! And of course if we complain–We’re socialists.
It seems to me we are going to have a really interesting conversation about the nature of capitalism in the next few months. Regular readers of this blog know that I am not a fan of centralization and so classic notions of Socialism have no appeal for me. However the basic question of TRPF, vanishing investment opportunity and need for outsized returns depending on leverage juice remain. One of the questions we may find our selves wrestling with is the allocation of resources in a mixed economy. What if the states and cities take on the task of investing in our basic productivity infrastructure–roads, trains, broadband, electricity grid (solar, wind and geothermal) thus freeing private capital to provide the “value added” services where higher returns can be generated? Any investor in Google knows that their returns are not juiced by leverage. But on the other hand, Google could not succeed without a commodity broadband infrastucture. There is no reason that government run infrastructure should need the kinds of high returns that Wall Street demands.
All of these are questions I’m going to try to grapple with in the next few months. I don’t pretend to have the answers. What I do know is that the conventional wisdom is wrong and name calling from the The Club for Growth and Rush Limbaugh is not going to help us find a solution.
January 31st, 2009 by Jon Taplin
From the Wall Street Journal.
Sen. Claire McCaskill (D., Mo.) introduced legislation Friday that would limit the salary, bonuses and stock options of executives at financial companies getting federal bailout aid to no more than what the U.S. president earns: $400,000 a year, excluding benefits. In 2007, Goldman Sachs Group Inc. Chief Executive Lloyd Blankfein earned that much in about two days.
January 30th, 2009 by Jon Taplin
Tom Toles gets it right.
January 30th, 2009 by Jon Taplin
This old tape of Rush Limbaugh’s aborted TV show demonstrates why he can only work in a studio without an audience, surrounded by toadies and bootlickers like Snerdly. The guy just can’t handle criticism. It’s about 11 minutes long. Stay to the end, when he throws the non cooperative audience out and finishes his rap in an empty studio.
[youtube=http://www.youtube.com/watch?v=LNK4byQkn7w&eurl]
January 30th, 2009 by Jon Taplin
Those moderate Republicans in the Northeast are going to be under some serious pressure in the next two weeks to vote with Obama on the Recovery Act. Here’s a Move-on spot aimed at Judd Gregg of New Hampshire. Of course Gregg could really do the right thing and become Obama’s Commerce Secretary, thereby allowing the Democratic Governor of New Hampshire to appoint the 60th Democratic Senator.
Filibuster that!
[youtube=http://www.youtube.com/watch?v=sKylVXv3tCM&eurl]
January 30th, 2009 by Jon Taplin
This is Peter Ferrara, a lawyer who pretends to be an economist. He fronts for a phony “Civil Rights” organization called The American Civil Rights Union. As you can see from their mission statement, the only rights the ACRU is interested in protecting are those of the ruling class.
I heard him on To The Point today railing against Obama, spouting 80′s Supply-side platitudes as a solution to our current economic woes. Fortunately, a real economist, Bruce Bartlett who also worked for Reagan had the courage to call Ferrara “an idiot” on the air. It was one of those lovely moments of truth in radio.
I think it was George Carlin who used to talk about the comedy police–making citizen’s arrests of comics who weren’t funny. Maybe we should establish a pundit police–and take away Ferrara’s license to spout nonsense on the public airwaves.
January 30th, 2009 by Jon Taplin
I see folk with long cars and fine clothes
That’s why they’re called the smarter set
Because they manage to get
When only them that’s got supposed to get
And I ain’t got nothin yet
–Ray Charles
There is a populist anger that is swelling in the land. George Bush and Dick Cheney slunk out of town, but their friends are mighty grateful for the last 8 years.
The income of the 400 wealthiest Americans swelled in 2006, soaring nearly 23 percent from the previous year, to an average of $263 million, according to data released Thursday by the Internal Revenue Service. Since 1996, this group has nearly doubled its share of all income earned in the United States.
The top 400 paid just more than $18 billion in federal income taxes in 2006, or an average of $45 million, on a record $105 billion in total income — the lowest effective tax rate in the 15 years since the agency began releasing such data.“Until recently, we had a financial system that rewarded investors, and we have a tax system that does as well,” said Robert S. McIntyre, the director of Citizens for Tax Justice.
Now wealthy people, he said, pay income tax rates well below those of working-class citizens because of a myriad of tax breaks. A lower capital gains tax, now at 15 percent, down from 28 percent in 1997, benefits investors with big portfolios.
The average adjusted gross income in 2006 of more than $263 million for the top 400 taxpayers compared with an average of $214 million in 2005. It was three and a half times what they earned in 1996, which was $74 million.
January 30th, 2009 by Jon Taplin
Since the very beginning of this blog I have been writing about a concept called New Federalism. Whatever contact I had with the Obama staff during the campaign, had always related to this subject. Put “New Federalism” into my search box and you will find 30 entries.
From the front page of this morning’s New York Times.
The Obama administration seems to be open to a movement known as “progressive federalism,” in which governors and activist state attorneys general have been trying to lead the way on environmental initiatives, consumer protection and other issues, several constitutional experts say.A recent decision by President Obamathat could open the way for California and other states to set their own limits on greenhouse gases from cars and trucks represents a shift in the delicate and often acrimonious relationship between the federal government and the states, legal experts say, possibly signaling a new view of federalism.
“I think it’s quite significant,” said Samuel Issacharoff, a professor of constitutional law at New York University law school. “It shows the Obama administration’s more benign view of government intervention,” Professor Issacharoff said, and “may indicate a spirit of cooperative federalism” in which Washington will look to the states for new ideas and even a measure of guidance.
Progressive Federalism or New Federalism–I don’t really care what you call it. It just feels good that some of the ideas have gotten into the White House.
January 29th, 2009 by Jon Taplin
Our President takes the exactly right tone on the issue of Wall Street’s scandalous bonus payments. It was like raiding the corporate treasury in the months before the inevitable nationalization. I think Barack combines the Reformist politics of Teddy Roosevelt with the Keynesian recovery strategy to Franklin Roosevelt.
President Barack Obama hammered Wall Street institutions Thursday for what he called “shameful” bonuses, saying it is the “height of irresponsibility” to ask for help from taxpayers and continue to reward executives with handsome pay packages.
“There will be time for them to make profits, and there will be time for them to get bonuses. Now is not that time,”"When I saw an article today that indicates that Wall Street bankers had given themselves $20 billion worth of bonuses, the same amount of bonuses as they gave themselves in 2004, at a time when most of these institutions are teetering on collapse and they are asking for taxpayers to help sustain them, and when taxpayers find themselves in the difficult position that if they don’t provide help then the entire system could come down on top of our heads, that is the height of irresponsibility,” President Obama told reporters.
Right fuckin’ on!
January 29th, 2009 by Jon Taplin
Sometimes you come across some writing that is just so perfect that all you can do is stand back and admire it. In that spirit, I give you a long quote from Dennis Overbye’s essay celebrating our new President’s commitment to “restoring science to its proper place”.
Science is not a monument of received Truth but something that people do to look for truth.
That endeavor, which has transformed the world in the last few centuries, does indeed teach values. Those values, among others, are honesty, doubt, respect for evidence, openness, accountability and tolerance and indeed hunger for opposing points of view. These are the unabashedly pragmatic working principles that guide the buzzing, testing, poking, probing, argumentative, gossiping, gadgety, joking, dreaming and tendentious cloud of activity — the writer and biologist Lewis Thomas once likened it to an anthill — that is slowly and thoroughly penetrating every nook and cranny of the world.
Nobody appeared in a cloud of smoke and taught scientists these virtues. This behavior simply evolved because it worked.
It requires no metaphysical commitment to a God or any conception of human origin or nature to join in this game, just the hypothesis that nature can be interrogated and that nature is the final arbiter. Jews, Catholics, Muslims, atheists, Buddhists and Hindus have all been working side by side building the Large Hadron Collider and its detectors these last few years.
And indeed there is no leader, no grand plan, for this hive. It is in many ways utopian anarchy, a virtual community that lives as much on the Internet and in airport coffee shops as in any one place or time. Or at least it is as utopian as any community largely dependent on government and corporate financing can be.
I would hope that our best efforts here are part of that utopian anarchy.