The Wrongologist

Geopolitics, Power and Political Economy

How Do You Solve a Problem Like Ohio?

Our industrial heartland has withered away, in that there are fewer manufacturing jobs than ever, while manufacturing revenues have never been higher. Forty years of promises by politicians have come to nothing: These people are victims of a world order in which corporations have either exported or automated those jobs, with no responsibility to workers. It is left to the towns of Middle America and the federal government to clean up their mess.

This world order we live in today was born in 1980, with Thatcher and Reagan. According to Ian Welsh, the world order made a few core promises:

If the rich have more money, they will create more jobs.

Lower taxes will lead to more prosperity.

Increases in housing and stock market prices will increase prosperity for everyone.

Trade deals and globalization will make everyone better off.

Those promises were not kept, and in America’s Midwest, economic stress is now the order of the day. That stress has contributed to rising rates of drug addiction and falling life expectancy.

Understandably frustrated, Ohioans and other Midwesterners gave Donald Trump a victory in November. His win has refocused attention by pundits and pols on the plight of our failing de-industrialized areas. While we have economic growth, we also have growing inequality. Here is a graphic illustration of the problem, comparing the US with the EU:

The Economist reports that from 1880 to 1980, the incomes of poorer and richer American states tended to converge, at a rate of nearly 2% per year. The chart above shows that the pattern no longer exists. This causes us to ask if the shift of resources and people from places in decline to places that are growing is simply taking longer to adjust, or has the current world order failed our people? In econo-speak, the gains in some regions should compensate those regions and towns harmed by the shift, leaving everyone better off.

But that is a political and financial lie promulgated by the very corporations that benefited, and by their political and economist cheerleaders.

With economic decline, some towns and cities became poverty traps. A shrinking tax base means deterioration in local services (think Detroit). Public education that might provide the young with new skills and thus opportunities, fails. Those that remain are on government subsidies or hold low-wage service jobs, or both. It is impossible to tell these citizens that the decay of their home town is an acceptable cost of the rough-and-tumble of the global economy.

Politicians are short on solutions. Since housing costs have risen sharply in towns and cities that are growing, underemployed Americans are less likely to move, and those who do, are less likely to head for richer places. Enrico Moretti of the University of California, Berkeley and Chang-tai Hsieh of the University of Chicago argue that our GDP could be 13.5% higher if this wasn’t the situation in America.

But if moving isn’t an option, what can be done to improve the outlook for those who are left behind?

Would more government subsidies help? Prosperous tax payers already support poorer ones. Subsidies for health insurance costs with Obamacare, as well as industrial tax incentives provide some cushion, but they are not likely to deliver long-run economic recovery, and they have not stemmed the growth of populist political sentiment.

To be fair, many people in Ohio and elsewhere want good jobs, but without having to move too far to get them. That may be impossible.

In the 19th century, the federal government gave land to states, which they could sell to raise proceeds for “land-grant universities”. Those universities, including some that are among our finest, were given a practical task: to develop and disseminate new techniques in agriculture and engineering. They went on to become centers of advanced research and, in some cases, hubs of local innovation and economic growth.

Politicians and academic economists might disdain a modern-day version of the program, one that would train workers, foster new ideas, and strengthen weakened regional economies.

But if our politicians do not provide answers, our populist insurgents will.

Time for a Christmas song. Here is Elvis with “Santa Claus Is Back in Town & Blue Christmas”, from his comeback special on NBC. This was recorded over six days in June, 1968 and aired on December 1, 1968. Elvis flubs “Santa Claus is Back in Town”:

Despite his flub, he does get this line right:

You don’t see me comin in no big black Cadillac

Kind of like out-of-work Ohioans.


Will We See a Recession Soon?

With Trump vs. Clinton vs. Sanders sucking all of the oxygen out of the news cycle, it’s probable that you missed the release by the Federal Reserve on May 18th of its delinquency and charge-off data for all commercial banks in the first quarter. It isn’t a pretty picture.

Here’s a few nuggets:

  • Delinquencies of commercial and industrial (C&I) loans at all banks, after hitting a low point in Q4 2014 of $11.7 billion, have ballooned. C&I loans are classified delinquent when they are 30 or more days past due.
  • Between Q4 2014 and Q1 2016, delinquencies have increased by 137% to $27.8 billion. Currently, they are halfway to the all-time peak during the Financial Crisis in Q3 2009 of $53.7 billion. And they’re higher than they were in Q3 2008, when Lehman Brothers melted down.

Below is a chart of delinquencies released by the Board of Governors of the Fed. The shaded areas are times of economic recession. Wolf Richter of Wolf Street added the emphasis in red to point out where we stand in relationship to the 2008 Lehman moment:

C&I Deliq Q1 16

As you can see from the chart, business loan delinquencies are usually a leading indicator of economic trouble. They begin rising at the end of the credit cycle, since loans made in the good times start to go bad when the economic situation changes. Then, the obligations of interest payments and loan repayments begin to pose a problem for weaker borrowers whose sales, instead of rising as expected when times were good, may be flat or shrinking while expenses can be rising. Suddenly, there’s not enough money to service the loan.

This started with the oil and gas sector reacting to lower crude oil prices in 2015, but it has moved beyond the oil patch. Total US commercial bankruptcy filings in April, 2016 rose 3% from March, and are up 32% from a year ago, to 3,482, according to the American Bankruptcy Institute.

This is happening at an interesting time.

First, the health of the economy will be a huge deal in the General Election. Both Trump and Clinton have a stake in saying it isn’t as good as it could be. Yet, it is highly unlikely that we will be in a recession in November 2016, because our current economic momentum will carry us for at least another 6 months.

Second, the Fed is now indicating that it believes the economy is strong enough to raise rates for a second time this year, perhaps as soon as June, according to the Fed’s recent Open Market Committee minutes. That supports the idea that no recession is imminent.

But we still have this pesky loan delinquency data.

Loan delinquencies must be cured within a specified time. If not, they’re taken from the delinquency bucket and dropped into the default bucket. If defaults are not cured within a specified time, the bank deems a portion (or all) of the loan balance uncollectible, and writes it off, therefore moving it out of default and into the write-off bucket.

That’s why the delinquency statistics usually do not get very large – loans don’t stay delinquent for a very long period.

The Fed has painted itself into a corner. They have to raise rates because low rates are destroying many pension funds and they hurt retirees who rely heavily on interest-bearing investments. Pension funds have been modeled on interest rates of between 6%-8%, which have not been seen for at least 10 years.

But, a Fed rate hike would add more risk of more loans becoming delinquent.

And the largest American corporations are awash with the debt that they used to fund buy-backs of their shares. That debt has to be renewed periodically. If rates rose high enough to help pension funds, it could wound quite a few large companies.

If that wasn’t bad enough, South America, Europe and the Chinese are looking increasingly fragile. Even if the Fed engineers a domestic miracle of sorts, it may not be enough. The financial world can be a minefield when we are trying to hang on to our hard-earned money.

So, prepare to hear both Trump and Hillary tell you they have the answers.

Since their global corporate benefactors now rule the world, they should be able to figure out what to do with it.


Workin’ in a Coal Mine

American Experience ran a documentary called “The Mine Wars” on January 26th. It told the story of West Virginia coal miners’ battle against mine owners at the start of the 20th century.

Few know that the WV mine workers struggle against the mine owners led to the largest armed insurrection after the Civil War and turned parts of West Virginia into a war zone that required federal troops to pacify.

The battle started in 1920 with a shootout in Matewan, WV. It was triggered by a plan by the United Mine Workers (UMW) to organize Mingo County, where Matewan is located, and the thuggish reaction by mine owners. There is a fine movie that documents this, “Matewan”, by John Sayles.

The town’s union-sympathizing Police Chief Sid Hatfield confronted a group of private detectives from the Baldwin-Felts company who were hired by the coal mine owners. The detectives had come to Matewan to evict the families of unionized miners. The “Battle” of Matewan left seven Baldwin-Felts men dead, along with the mayor and two townspeople.

Some background: Workers were paid based on the weight of the coal they mined. Each car brought from the mines theoretically held a specific amount of coal (2,000 pounds). However, cars were altered by owners to hold more coal than the specified amount, so miners would be paid for 2,000 pounds when they actually had brought in 2,500. In addition, workers were docked pay if rock was mixed in with the coal. Miners mostly lived in company-owned homes, and were forced to shop at company-owned stores.

The UMW started organizing and striking in WV in 1912. When the strikes began, the mine owners used hired guns to inflict plenty of violence on miners and their families.

There is a sordid history of similar efforts throughout the US. Check out the Ludlow Massacre in 1914.

But before WWI, the UMW was unsuccessful in changing working conditions or wages for miners. The US entry into WWI in 1917 sparked a boom in demand for coal, also bringing increasing wages. After the War, demand for coal fell, and so did miners’ wages.

At that time, the largest non-unionized coal region in the eastern US were WV’s Logan and Mingo counties, and the UMW made them a top priority. Mine owners in Logan bought off the Logan County Sheriff Don Chafin to keep the union out of the county. In 1921, after increasingly violent confrontations with the owners and their hired guns, miners moved to fight back.

In August, approximately 5,000 armed union men entered Logan County. Logan city was protected by a natural barrier, Blair Mountain. Chafin’s forces took positions at the top of Blair Mountain, while the miners assembled near the bottom of the mountain. There were skirmishes and deaths. On September 1, President Harding sent in federal troops to break up the battle, and the miners soon surrendered to the feds.

By 1924, UMW membership in the state had dropped by about 50% of its total in 1921.

Mine owners also engaged in a PR campaign that portrayed the UMW as “Bolsheviks”. The Red Scare in 1919-1920 was based on fears that the labor movement would lead to radical political agitation, or would spread communism and anarchism within the country. This sense of paranoia was driven in part by the mining companies.

Does any of this sound familiar? How many red scare equivalents have we had in the last 100 years?

Corporations have always been at war with workers. Here’s the real question: Is it possible for capitalism, by its very nature, NOT to incite a constant battle between the .01% and everyone else?

Probably not. Class is a feature of capitalism, so it follows that class conflict will always be part of capitalist economies. We may find ways to mitigate the effects of that conflict, but it will always be a struggle to do so.

At the same time, we see every day that the interests of private capital are not aligned with the needs of society as a whole. We re-learn these lessons because our public institutions periodically get co-opted by capital. Until private capital’s stranglehold over our political process is ended, it will always try to rig the system.

The miners’ struggle in West Virginia was not just a backwoods conflict. The WV experience has direct relevance to today’s American economy, to today’s capitalists, and to the state of labor in America today.

What happened in West Virginia is an object lesson for what all of America might look like with unfettered corporatism.

Take a look and listen to Lee Dorsey’s 1966 hit “Workin in Coal Mine” written by the late, great Alan Toussaint:

For those who read the Wrongologist in email, you can view the video here.


End Government Subsidies of Private Equity

We have written about taxpayer-funded corporate subsidies this week. Let’s talk about the Private Equity (PE) industry, where profit margins are pretty high. By PE we mean investing in assets that include equity securities and debt of operating companies that are not at the time of the investment, publicly traded. PE is a re-branding of leveraged buyouts (LBOs) which were the way Wall Streeters built wealth in the 1980s.

In the past 35 years, we have seen a finance-led revolution that has generated fantastic wealth for PE managers. PE has in large part, helped create the growing chasm between America’s most wealthy and everyone else. This is shown in the disproportionate numbers of private equity and hedge fund principals in the top .1% of American wealth. That wealth doesn’t only come from just making a killing when the target company goes public or is acquired, it also comes from favorable tax treatments for the PE company principals and investors.

Although the PE industry is often held up as an exemplar of free-market capitalism, it is surprisingly dependent on government subsidies for its profits. In a typical deal, a PE firm buys a company, using some of its own money and some borrowed money. It then tries to improve the performance of the acquired company, with an eye toward cashing out by selling it, or taking it public.

The key to this strategy is debt: the PE firms borrow to invest since, just as with your mortgage, the less money you put down, the bigger the potential return on investment. But debt also increases the risk that companies will go bust, so early on, the amount of debt PE firms employed was conservative.

That has changed in the last 10 years. After using debt to buy them, many PE funds now have their portfolio companies borrow even more. They then use that money to pay themselves “special dividends.” This allows them to recoup their initial investment while keeping the same ownership stake.

Before 2000, big special dividends were not common. But between 2003 and 2007, PE funds took more than $70 billion out of their companies. These dividends created no economic value—they just redistributed money from the company to the private-equity investors.

As an example, in 2004, Wasserstein & Company bought the mail-order fruit retailer Harry & David. The following year, Wasserstein and other investors took out more than $100 million in dividends, paid for with borrowed money. In 2011, Harry and David defaulted on its debt and dumped its pension obligations on the US government. And when an investment goes bankrupt, there are more fees, and maybe more tax write-offs for the PE partners.

Taxpayers are left on the hook. Interest payments on that debt are tax-deductible, and when pensions are dumped, a federal agency, the Pension Benefit Guaranty Corporation (PBGC) picks up the company’s pension liability. That means taxpayers are on the hook for those unfunded pensions.

And the money that PE dealmakers earn is taxed at a much lower rate than normal income, thanks to the US tax code’s carried interest loophole, which permits that income to be taxed at capital gains rates.

Most do not know that the single largest source of investment capital in PE funds is government pension funds. According to Preqin, a database company that tracks investment in PE, approximately 30% of capital in US PE funds is contributed by government pension funds. Government pension funds are usually called “public” pension funds, administered by government employees and governed by officials who are directly elected by the public or appointed by elected officials.

A key point about the power and reach of PE. They have more than $3.5 trillion under management. Assuming normal leverage (30% equity) that gives them $11.7 trillion in buying power. That’s about 40% of the value of publicly-traded firms in the US. Think about the political clout they have by investing government pension money. Not only do PE firms own a huge portion of America’s productive businesses, unlike the diffuse ownership of public companies, they control them outright.

So, PE is a government-sponsored enterprise, both via tax subsidy and via funding. We taxpayers are helping them to fabulous paydays, thanks to our Congress Critters.

If PE firms are as good at remaking companies as they claim, they shouldn’t need tax loopholes to make their money. If we capped the deductibility of corporate debt, and closed the carried-interest loophole, it would not prevent PE firms from buying companies or improving corporate performance.

But it would add to our tax revenues, and that might keep a bridge or two from falling into a river during rush hour somewhere in America.

The American Dream: You have to be asleep to believe it.” -George Carlin


Stock Buybacks: Who Benefits?

Bloomberg reported this week that companies in the S&P 500 are poised to spend $914 billion on share buybacks and dividends this year, or about 95% of their corporate earnings. Data compiled by Bloomberg and S&P Dow Jones Indices show that money returned to stock owners exceeded profits in the first quarter and may again in the third quarter of 2014.

The proportion of cash flow used for stock repurchases has almost doubled over the last decade while it’s slipped for capital investments. So, who is benefiting? From Bloomberg: (emphasis by the Wrongologist)

Buybacks have helped fuel one of the strongest rallies of the past 50 years as stocks with the most repurchases gained more than 300% since March 2009. Now, with returns slowing, investors say executives risk snuffing out the bull market unless they start plowing money into their businesses.

The S&P 500 Buyback Index (yes that is a thing) is up 7.5% percent this year through October, compared with the 6.5% advance in the S&P 500. It did better in the past, beating it by an average of 9.5% since 2009. Excluding the two years in which we had a recession (2001 and 2008), dividends and stock buybacks have represented 85% of corporate earnings since 1998. So, there has been little reinvestment in the business going on. Stock repurchases have helped buoy the bull market since 2009 by about $2 trillion.

Consider that corporate revenues have had an average growth rate of 2.6% per quarter in the past two years, while per-share earnings grew at 6.1%, more than twice as fast, says Bloomberg. Since earnings per share (EPS) is the ratio of the total earnings divided by the number of shares outstanding, you can either increase the numerator or decrease the denominator in order to grow EPS.

Corporate America has decided it is easier to reduce shares rather than to grow earnings.

This translates into bad long-term corporate strategy. During the same period, the portion of earnings used for capital spending has fallen to about 40% from more than 50%. This use of cash to fund buybacks has left US-based companies with the oldest plants and equipment in almost 60 years. Bloomberg says that the average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to annual data compiled by the Commerce Department.

Today, shareholders are the most mobile of corporate stakeholders. The days of “buy and hold” investing are over; it is now just for the smallest of investors. For example, high frequency trading (HFT) represents 70+% of trading by volume. The HFT “investors” often hold share ownership for fractions of a second. The HFT firms are in bed with professional fund managers who own large chunks of equity in public companies. Together, these shareholders ONLY want corporate strategies that maximize short-term profits and increasing dividends. Coupled with the growing trend of limited, or little, voting rights for stock ownership by the public, professional managers have a free hand to get wealthy without responsibility for longer term corporate performance. This plays into the hands of CEOs and other C-level managers who derive most of their compensation from increasing value of stock. Equilar, an Executive Compensation firm, reports that about 63% of S&P CEO compensation is in the form of stock.

This is not managing a business, it is liquidating a business. While it may be in the individual executive’s short-term interest (company stock appreciation and bonuses) ultimately, it will kill the US economy. Look for more complaints about the American workers when they are unable to compete, using worn out, or obsolete equipment.

We need different ideas to inform our effort to steer the ship of state to higher GDP growth and full employment. How about tying executive performance to adequate return targets for all STAKEHOLDERS rather than to a maximized return to shareholders who no longer buy and hold shares?

You can only go so far with financial engineering before you actually have to improve your business with real revenue and profit growth. Companies have done about all that they can in terms of maximizing the ability to do these buybacks.

What would be wrong with trying some new ideas?