Category Archives: Finance

Social Value

James Montier has a good post over at GMO, The World’s Dumbest Idea, in which he tries to diagnose what has gone wrong with American capitalism. This is now a popular debate. Montier is a superb market analyst, and he adds to the debate by showing, quantitatively, what has happened to American companies over the past forty years. Jeremiah’s readers will recall that America started going to hell in the 1970s.

Before 1976, professional managers were in charge of performance in the real market and were paid for performance in that real market.

Montier lays the blame on Milton Friedman and a management fad called shareholder value maximization (SVM). He makes observations about corporate short termism, executive compensation, and social responsibility. Montier distinguishes the SVM period from an earlier (and better) “era of managerialism.” Here is his chart showing how SVM has shortened the lives of successful American companies.


To some extent, this is a semantic argument about the meaning of “shareholder value.” Obviously, if myopic (and overpaid) executives are destroying big companies, that is no one’s idea of value.

Writing in 1970, Friedman had probably the same idea of value as did most professional managers, i.e., “if we take care of the customer, then the profits will take care of themselves.” Those were the days of investing for the long term, for retirement. The leading newsletter was called Value Line. Montier, himself, is a “value” investor. The idea that executives could use leverage to juice their options hadn’t been invented yet.

If [a sole proprietor] acts to reduce the returns of his enterprise in order to exercise his “social responsibility,” he is spending his own money, not someone else’s.

Friedman’s point was that executives are not hired to spend the shareholders’ money on social projects. They should focus on making a profit, and then the shareholders can – individually – support social projects as they desire.

A confirmed free marketer, Friedman believed that a company serves society best by creating products that people want to buy, and jobs that people want to hold. This is not too different from the oft cited mission statements of companies like P&G and J&J.

Friedman never actually said “shareholder value maximization.” He talked about increasing profits, which – in the old days – was understood to depend on those other values.

We will provide branded products and services of superior quality and value that improve the lives of the world’s consumers, now and for generations to come.

In the old days, people didn’t expect to get rich quick on their investments. In a market based on value, that is not realistic. The way to get rich quick is to pillage the value built up by more responsible managers.

Montier cites the case of IBM, and their plan to double EPS in five years. Seriously, double EPS in five years? Any cogent director would have to ask how the new CEO plans to do that. Is there a magic elixir to double our sales? Or, is he planning to slash R&D, cut staff, and load up on debt? You would hope that someone whose family name is on the building defenestrates him at that point – Montier supplies a comparison with privately held firms.

The real problem is not Friedman and not, strictly speaking, SVM. The real problem is that mechanisms have been invented whereby executives can pump their share prices, and their compensation, while actually destroying value. Studies and samples vary, but corporate debt in America has gone from something like two times earnings, in the old days, to four times earnings today.

For the last 35 years, stock-based compensation has been tried. It had the opposite effect of what was intended.

Montier’s article is filled with facts about the perverse consequences of stock based compensation, but he doesn’t make any serious recommendations for public policy. He leaves us hanging with a vague notion of “stakeholder capitalism,” and an apology for sounding socialist. Of course, this is where a socialist would say that government should run all the companies, because “the government doesn’t have to make a profit.”

That is actually the world’s dumbest idea. It would merely exchange one set of rapacious managers for another, probably worse. It is also a case of freeze-frame economics. Socialists always want to take over the existing companies, with no provision for entrepreneurial new ones.

So, what about policy? The Forbes article quoted here contains specific legal reforms, like getting rid of forward guidance. Another obvious reform would be to hike interest rates. The Fed is ostensibly “independent” so that they can choke off asset price inflation, financialization, and structural traps. It doesn’t take independence to be the stooge of Wall Street.

See also: The Dumbest Idea in the World: Maximizing Shareholder Value


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Attack of the Zombies

There are many layers to the debate over derivatives trading, which is why we find David Stockman on the same side as Sen. Elizabeth Warren (D-MA). This, by itself, is remarkable. Stockman has a book and a blog wherein he bemoans the corruption of American capitalism, and Warren is an anti business populist – not to say “socialist.” Both hate investment banks. Here’s Stockman:

Banks are not free enterprise institutions; they … would not even remotely exist in their current Wall Street incarnation without state subsidies and safety nets … and deposit insurance

The debate is about the “swaps push out” provision of the Dodd-Frank reform act, which was postponed as part of last week’s crunch budget bill. This provision would have required Citigroup, notably, to move its swaps trading operation into a holding company separate from the FDIC insured bank. We mention Citi, as Sen. Warren does, because they have lobbied hardest against the provision.

[Dodd-Frank] required banks with access to deposit insurance … to move their derivatives business to separately capitalized affiliates.

Jeremiah is not among those who consider all derivatives to be “weapons of mass financial destruction.” Dodd-Frank makes an exception for traditional swaps trading, which is used to reduce risk. Swaps, like futures and options, grew out of the need to hedge things like currency risk. The textbook example of using an option to reduce risk is – buying a put temporarily to protect a long term investment.

Banks can keep what many consider more “traditional” swaps activity, including interest-rate and foreign-exchange swaps. A bank also can continue to engage in swaps to directly hedge its own risks.

Citi’s assertion that the push out provision would materially harm traditional hedging is a lie, because that’s exempt. The provision is meant to address dealers and market makers. Depending on how you feel about banks, here is a choice of policy approaches:

  • Outlaw swaps trading entirely
  • Outlaw swaps trading for FDIC insured banks
  • Outlaw all investment banking for FDIC insured banks
  • Get rid of deposit insurance entirely

Here, we are focusing on deposit insurance because that’s the most obvious source of risk to the taxpayer. The other form of federal assistance given to big banks is access to the Fed’s discount window. Once upon a time, the Fed provided liquidity “for good collateral, at a penalty rate,” but – with rates near zero and lax collateral standards – it’s a lot like free cash.

Note that, while neither the Fed nor the FDIC is funded by tax receipts, both are considered federal assistance by Dodd-Frank. The drafters considered, correctly, that market making in derivatives entails more risk than the FDIC can bear. That’s why the push out provision says swaps must be in a separate, non-deposit holding entity.

Alternatively, to compensate for the risk, swaps entities could be assessed higher FDIC premiums. That would be a free market solution. If you try to imagine what the market rate for deposit insurance might be, you get a good idea why it’s considered “federal assistance.” Deposit insurance is a subsidy to the banks, allowing them to pay less interest than they could in a free market.

FDICIn a free market, banks would display their capital ratios instead of the familiar FDIC plaque. Below are the Tier 1 capital ratios from selected banks’ most recent resolution filings:

  • Goldman Sachs: 16.7%
  • Morgan Stanley: 15.6%
  • J.P. Morgan Chase: 11.9%
  • Bank of America: 11.9%
  • Citigroup: 11.1%

These are the consolidated entities. As a depositor, you would want to look at your consumer banking entity – and you would want to know that it’s not funding the swaps entity. You would also want to look at how much capital your bank is projected to have in an “adverse scenario,” a.k.a. the Fed stress test. Note that Citigroup places last and, indeed, had failed the stress test.

The Fed has consistently raised the standards of its annual stress tests, leading some bankers to grumble that the regulators’ efforts … may be choking off credit to the broader economy.

This is the devil’s bargain we made with our banks. We need lots of credit to support our lifestyle, and the banks can’t survive in a free market. Instead, we pamper them with guarantees and smother them with regulation. We also worry about competition from similarly subsidized foreign banks.

Sound familiar? Regular readers will recognize this dynamic from industrial protectionism, which always cuts two ways. Protect the American steel industry, and you tax our car makers. Block cheap imports, and you raise consumer prices.

In the case of banking, we wanted our banks to compete internationally, so President Clinton repealed the Glass Steagall Act. We also want cheap credit for investment and – for you Keynesians – consumption. We pay the price in government guarantees, financial repression, regulation, and compliance.

It is ironic that the supposed heart of capitalism is, as Stockman says, a “ward of the state.” We know that bank protectionism leads to stagnation, because Japan and Europe are already there. We don’t need to join the zombie bank competition.

What we need to do is systematically reduce federal assistance, segregate investment banking, cull the TBTF ranks, and tighten the discount window. In short, we need to expose American banks to market discipline.

Contrary to the hype, our economy does not depend on investment banking. This industry can be overinvested just like any other. This means resources that could be employed better elsewhere – resources like capital, government attention, and bright young kids who should have been engineers.

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Sugar in America

WillyWonkaDespite NAFTA, we have just raised tariffs on Mexican sugar. No one can accuse Mexico of “dumping” with a straight face. Our domestic sugar price is set at the pleasure of the sugar lobby and the 0.2% of American farmers it represents. This is another case of blaming our trading partners for our own problems.

Sugar in America costs 26 cents per pound, wholesale, versus 16 cents on international markets. That is a 40% arbitrage opportunity. If you are selling black market cigarettes, you are in the wrong business.

The advantage of being in Canada is that they can acquire sugar at world sugar pricing, which tends to be 40 to 50 percent lower than what I’m paying.

Jeremiah is not strictly against protectionism. Used properly, trade protection can give a struggling American company time to regroup. The risk is that it becomes a crutch, and taxpayers end up supporting an uncompetitive industry.

In this case, the sugar lobby is screwing not only the taxpayers, but the consumers and downstream producers. They are raising factor costs for Hershey, General Mills, and Coca Cola. The quote above is from America’s last gumball maker.

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Blame Canada

We did a double take when we read about Burger King’s tax inversion to Canada. Canada? Burger King is majority owned by Brazilian private equity, so they’re not exactly “corporate deserters,” to use the president’s phrase. They will also enjoy revenue synergy with Tim Horton. Plenty of financial analysis is on FT, as here. So, when did Canada become a tax haven?

Jeremiah is always coaching you to find the truth behind the news, and this is a great example. America has the world’s highest corporate tax rate, at 35%. If you know this, you also know the headline figure is contested. Many pundits say that, once you back out various credits and deductions, the rate is closer to 23%. If this were true, companies would not be leaving the country. See chart from Bloomberg, below.


The Brazilian capitalists will have done their own tax planning. KPMG reckons that the total tax rate in America is 40%, versus 26% in Canada. To be fair, the tax apologists may be right about certain companies which are able to enjoy the gamut of preferential tax breaks. GE famously paid no tax at all in 2010.

Over the last decade, G.E. has spent tens of millions of dollars to push for changes in tax law, from more generous depreciation schedules on jet engines to “green energy” credits for its wind turbines.

The point is that if you “follow the money,” you can determine which pundits are liars, and which corporations have Washington skills.


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Taxation without Representation

Prior to the Revenue Act of 1913, the federal government was supported pro rata by the states. States are apportioned seats in the House of Representatives according to population, and this was also their share of the federal budget. Congress could levy direct taxes only in proportion to population. It’s easy to see the wisdom in this approach, plus it didn’t require a huge federal agency.

Tax by StateRepresentation was linked to cost sharing. Without this link, there would be a risk that populous states could pass laws shifting the federal tax burden to small, rich ones.

We wanted to see what the House would look like if the original rule were still in effect, so we downloaded the IRS data book and reallocated the seats according to each state’s tax payments.

Federal tax collection, all types, net of refunds, was roughly $2 trillion for 2012. The table shows the current allocation of 435 seats, by population, and our reallocation by net tax.

The third column shows the number of seats by which each state is over (or under) represented relative to the old rule. Another way to think of under-representation is to say that the state is overtaxed relative to its voting power.

Sure enough, richer (though not necessarily smaller) states are underrepresented and poorer ones are overrepresented. Could this result in a legislative bias? Almost certainly.

The top twenty-three states in this list enjoy a voting majority in the House. They have an incentive always to vote for higher income taxes – because the burden will fall disproportionately on other states.

See also: Easy Constitution

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Understanding the Gini Index

Now, you can study the famous Gini index yourself – and not have to rely on Jon Stewart. Here is Jeremiah to show you how. Start by downloading the latest individual income data from the IRS Statistics on Income. Use the AGI line to calculate cumulative income, and the number of returns to calculate cumulative filers.

Jeremiah likes to add back the spouses and dependents, because that brings the total close to 300 million, the actual U.S. population. You don’t need to calculate income per capita, because we are only interested in percentages. Plot the cumulative percentage of income against the cumulative percentage of tax filers. Your chart should look like this:


Individual income for 2012 was roughly $9 trillion, and the tax take was $1.2 trillion. The distribution of income is pretty unequal, as you can see. Twenty percent of income is earned by the top one percent – those earning $200K or more. That’s the IRS wording, “earned income.” Pundits prefer flows to, or “captured by.”

The more of a belly the blue line has, the more unequal the distribution. The red line represents total equality. To get the Gini index, calculate the area under the blue line, subtract it from the area under the red line (50%) and then divide the area of this lens-shaped region by one-half. It would make more sense simply to compare the two integrals, but then we’d have a positive measure of equality.

In our example, the Gini index is 54%, and worse than the official statistics. Those are based on a survey by the census bureau, and here we are working from tax data. The census bureau reckons the index around 45% and they don’t publish their raw figures. There’s a reason we prefer to use IRS data.

Next, let’s look at who pays their fair share of the $1.2 trillion. We run the same figures as before, only this time we calculate the cumulative percentage of the nation’s personal tax burden.


The distribution of tax payments is even more unequal than the distribution of earned income. The Gini index for this chart is 73%. That same one percent, who earn 20% of the income, pay 35% of the tax – and 50% of Americans pay next to nothing.  Inequality is an awful thing. Someone should protest.

See also: Selected Measures of Household Income Dispersion

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Draining the Swamp

Here is a provocative post by Charles Hugh Smith in which he asserts that no fixes are possible, the system must inevitably crash and burn, etc. Charles is part of a cottage industry that has been making this prediction for, in his case, about ten years. Jeremiah recalls hearing the same predictions during the civil rights struggle, then again during the eighties, and – of course – the millennium.

Virtually none of the thousands of emails I receive present a few policy tweaks as credible fixes.

We write “provocative” because, while Jeremiah often feels America has passed the tipping point – his goal is to find solutions. Here are four big ones that all attack the root cause, namely too much money available to too many crooks in Washington.

  • Repeal the federal income tax. The central government should be funded by tax collection at the state level. That’s how America worked for the first hundred years. This would reduce the size and power of the central government.
  • Bring back Glass-Steagall, or something like it, to keep retail banks from speculating. Allow investment banks to go under, if they make bad bets. If they’re “too big to fail,” then break them up under monopoly law. This would avoid a repeat of 2008, and also curb some moral hazards.
  • Speaking of Carter Glass – end the Fed’s dual mandate and restore its original role as a lender of last resort. No “taming the business cycle,” inflation targeting, or other hocus pocus. This would curb moral hazards like hedge fund welfare, and also make it harder to hide bad fiscal policy.
  • Transition Social Security toward a defined contribution system. That way, the account would follow the contributor, and the system wouldn’t depend on a permanently young population. This would deprive Washington of a big slush fund, and also avoid a fiscal crisis.

Charles is correct insofar as no one has the political will to make these changes, but – there’s a difference between lacking ideas and lacking nerve. Our job as voters and activists is to keep the solutions top of mind, and then demand leaders who will implement them.

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