Jon Taplin's Home Page

A rainy Saturday in Los Angeles seems like a good time to put down some random thoughts.

The SOPA Battle

So SOPA is dead, and as I said earlier in the week, it was a fatally flawed piece of legislation. But before the Free Culture crowd gets too self-righteous, please consider your new hero and spokesperson, Kim Dotcom.

Kim’s a fun loving guy with 30,000 square foot mansions in three countries, a fleet of Ferraris all made possible by selling stolen content from artists around the world. A bunch of the musicians I worked with in the 1960′s and 1970′s, who made wonderful records that are still on everyone’s I Pod, have seen their royalties cut by 80%. Not enough for a retired 70 year old to live on. American’s are truly stupid when it comes to discussing this issue. The one thing we make that everyone else in the world wants to get a hold of–our music, our movies, our video games—the knuckleheads on the copyleft want to fight a death match to make sure they are free to the whole world. Of course these same people don’t mind paying an arm and a leg for their German car or their Japanese TV. Read more…

I had dinner last night with one of the most important conservative media voices in America and some of his friends. I had gone to the dinner expecting some fireworks, but was totally caught off guard by his charm and what he had to say.

First, he was disgusted by “the pygmies” in the Republican Presidential Race. As much as he dislikes Obama, there was not a one of the current Republican candidates that he could be enthusiastic about.

Second, we found ourselves in agreement that the issue of Crony Capitalism is perhaps the most pernicious threat to our Republic. Crony Capitalism distorts everything from Crop subsidies flowing to agribusiness to our inability to cancel useless Pentagon weapon systems. And the disease effects both political parties.

As the evening progressed I kept trying to move us beyond the Left-Right dialectic we are trapped in and to suggest that we might find some common ground in the liberal principles that are the basis for our Republic:

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

Now the word “liberal” is seen as poisonous to conservatives, but it’s origins in John Locke’s Natural Rights theory were the basis for our revolution. Read more…

In this time of constant bickering between the right and the left, the movie Avatar has become the highest grossing film in history. To achieve these astonishing grosses of $1.86 Billion (besting Cameron’s own Titanic in record time), the movie has appealed across all demographics and all political profiles. This is not to say that right wing critics didn’t try to discourage their partisans as Jonah Goldberg points out.

The film has been subjected to a sustained assault from many on the right, most notably by Ross Douthat in the New York Times, as an “apologia for pantheism.”

It would be a cop-out on my part to say the huge success was due only to the gee whiz special effects and the immersive 3D environment. Read more…

This is the most frightening economic chart I have seen in the last decade.

Net private investment, which includes spending on everything from machine tools to new houses, minus depreciation, fell to 0.1% of gross domestic product in the second quarter of 2009, according to the latest government data. That’s the lowest level since at least 1947.

Capitalism’s most vulnerable point is the death spiral of overcapacity. In the easy credit boom times we built too many malls, too many car factories, too may fast food joints, too many houses. Now the only way for businesses and consumers to survive is too cut back drastically.

That creates a chicken-and-egg problem at a time when the unemployment rate is already nearly 10%: Without more jobs, U.S. consumers will have a hard time increasing their spending; but without that spending, businesses might see little reason to start hiring Read more…

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.

USC/Annenberg School has put a new version of my America 3.0:Rebooting After the Crash up on their You Tube Site. Watch it in the High Quality Setting. It will be up on I Tunes U next week as a free download.

Googleplex

President-elect Obama needs to be more ambitious.

Now that I’ve got your attention, here’s what I’m thinking about. The Chinese government has just announced it’s going to spend about 7% of its GDP on infrastructure investment in the next two years. Obama has mentioned numbers like $100 billion on infrastructure investment. If we spent 7% of our GDP in two years, it would come to $910 billion! As Paul Krugman reminds us this morning, FDR’s original New Deal fiscal stimulus was too timid and it wasn’t until the massive stimulus of war production that the economy really recovered.

Now I’m not saying all of this investment would come from the taxpayers, but rather that it’s going to take close to a trillion dollars to rebuild our broken infrastructure which has been starved for investment since the start of the Reagan administration. Read more…

One of the first major economic tests that may face the next President is whether to use taxpayer funds to keep GM and Chrysler out of bankruptcy.

As talks between General MotorsCorp. and long-time rival Chrysler LLC continued over the weekend, a harsh reality has emerged: Without a merger and possibly an assist from the federal government, two of Detroit’s Big Three auto makers could run out of cash within a year.

At the same time that GM and Chrysler are hemorrhaging, Toyota, Honda and Nissan are manufacturing cars at a profit, paying American workers $22 an hour. There is a reason the bankruptcy statutes are set up the way they are. As we have seen with the Airline industry, they allow a company to renegotiate on good terms obligations that no longer are needed. Leases on unwanted real estate can be shed, union contracts renegotiated, vendor obligations settled. The U.S. government should let GM and Chrysler go into the bankruptcy process and clean up their balance sheets and their obligations before a single dime of taxpayer loans are extended to these companies. As both airlines and department stores have found, getting DIP (debtor in possession) financing after a bankruptcy is still very viable.

GM and Chrysler are in this pickle because their managements were blind to the reality of a changing oil landscape. Even if gas falls back to $2.25/gallon in this long recession, the days of the Chevy Suburban getting 14 MPG are over. When these two companies go through the creative destruction and prove to America that they can make cars for the next century, they may be deserving of some government loans.

One of the first major economic tests that may face the next President is whether to use taxpayer funds to keep GM and Chrysler out of bankruptcy.

As talks between General MotorsCorp. and long-time rival Chrysler LLC continued over the weekend, a harsh reality has emerged: Without a merger and possibly an assist from the federal government, two of Detroit’s Big Three auto makers could run out of cash within a year.

At the same time that GM and Chrysler are hemorrhaging, Toyota, Honda and Nissan are manufacturing cars at a profit, paying American workers $22 an hour. There is a reason the bankruptcy statutes are set up the way they are. As we have seen with the Airline industry, they allow a company to renegotiate on good terms obligations that no longer are needed. Leases on unwanted real estate can be shed, union contracts renegotiated, vendor obligations settled. The U.S. government should let GM and Chrysler go into the bankruptcy process and clean up their balance sheets and their obligations before a single dime of taxpayer loans are extended to these companies. As both airlines and department stores have found, getting DIP (debtor in possession) financing after a bankruptcy is still very viable.

GM and Chrysler are in this pickle because their managements were blind to the reality of a changing oil landscape. Even if gas falls back to $2.25/gallon in this long recession, the days of the Chevy Suburban getting 14 MPG are over. When these two companies go through the creative destruction and prove to America that they can make cars for the next century, they may be deserving of some government loans.

As Merrill Lynch brokers arrived at their desks this morning they were greeted with an urgent memo as to how to deal with the possibility that the stock exchange might not open this morning. Europe and Asia had crashed over night and the futures were showing a possible 1000 point fall at the open, which would trigger curbs that would keep the market from opening. Talk about panic.

It didn’t happen and now the market is fighting back from a 500 point drop. My guess is the fear is twofold. First to hear Greenspan admit that the current crisis “didn’t fit his model” was not exactly confidence building. As Vince Farrell wrote this morning.

Greenspan was “shocked” that managements of financial institutions didn’t look to their own self-interest to protect the capital of their firms. The “shock” is at best naive. Companies don’t have self interest, people do. Since huge bonuses were paid to reward short-term results, the investment bankers were motivated to put out what would sell and sell today. The devil take tomorrow. Protecting the balance sheet was senior management’s job and there was a collective failure on that score. He also bemoaned the fact that the models that had been so reliable turned so bad. The models he used had been compiled during the good times. They should have been stress-tested for bad times. He as much said so. “Beware of geeks bearing models,” Warren Buffett has said. Models pre-suppose rational behavior.The geeks don’t know how else to proceed. Read more…