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.
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
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.