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02
Sep 10

The Economy at Street Level

While we have examined macroeconomic issues extensively, rarely do we focus on the micro. We need to look at what is happening to real people.  Examining economics at street level is not as scientific or as mathematically precise as our econometric brethren would be.  We would probably fail the basic intro econ course at a prestigious academic institution.  Nevertheless, the timeless philosopher, Yogi Berra, says it well: “you can observe a lot by just watching.”

Walking

The best way to learn what is going on somewhere is to walk, not drive.  I live in a small city, a bedroom community for a larger city.  The median family income is $62,000 and the per capita income $35,000.  The city is racially diverse and attempts to cater to its upscale resident consumers.  Dropping my car for service at the local auto dealer (there are Porsche, Volvo, Mercedes, Lexus, Subaru and Buick dealers within walking distance),  I politely declined the courtesy shuttle and, to observe business conditions, walked home.   Covering about a mile through one part of our retail  and commercial district, I observed the following:

  • Ten retail establishments were vacant.
  • Each of several small office buildings had “space available” signs.
  • Each of the apartment buildings and garden apartment complexes I passed advertised one and two bedroom apartments for rent.
  • An office building which started construction six months ago has not progressed.
  • Almost every retail establishment had sales in progress, and restaurants advertised specials.
  • A major wind and rain storm hit our city in March.  Several damaged city trees have not been removed and badly buckled sidewalks have yet to be repaired.

Listening

The economy continues to impact friends, neighbors and family.  Here is what the Washington beltway political elites are not hearing:

  • One question, I regularly ask: on a percentage basis how much has your income declined from your most recent peak earnings year?  Other than one medical specialist who said his income has not declined, the response is a decline of 25-50%.
  • For an over-fifty executive, attorney, senior information technologist or finance specialist the job prospects are almost nil.   These are highly trained, experienced competent individuals who have been out of work from one to two years.  Unarticulated age discrimination is endemic in our system.  This type of candidate probably has a better chance of getting hit by a meteorite than getting a full time position with a firm.
  • Sending a high school senior to the state university has come back in vogue.  In the past, State U lacked the cache of the Ivy League or better private schools.  Suddenly this option has gained new luster.
  • Instead of the direct path to graduate school, new college graduates, even Ivy League grads, are scrambling for jobs.  Many new alumni of prestigious universities are interning with no pay or $10 per day stipends.  The entire economic value of graduate and even undergraduate degrees is under question.
  • Overseas vacations are out and domestic, and automobile vacations are in.  And we’ve all recently heard a new word:  staycation.
  • Since the banks have tightened lending requirements, the re-sale house market is virtually dead.  Sellers cannot find qualified buyers.
  • Small business owners and professionals have had their credit lines reduced, which de facto has cut back on business expansion.
  • Friends who are doctors and dentists are finding that they cannot fill their weekly schedules and are going to 3 and 4 day workweeks. Even in large firms, attorneys are having difficulty generating billable hours.
  • Home equity lines have been slashed, further undercutting spending plans.  I question why some of my high earning friends were using these lines for luxury expenditures in the first place.

It May Not Be Science but It Is Real Life

Again I have presented “street level” anecdotal information on the real economy.  I believe this anecdotal information more accurately presents the state of the economy, compared to the endless cheerleading from financial media and the Administration.

Perhaps some of the elite should bring their own cars in for service, avoid the courtesy shuttles, and walk home.    Rather than this cheerleading, what Yogi might say about our current recession is the real truth for many people: “it ain’t over until it’s over.”

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30
Aug 10

Memes of the Rich and Famous

Memes (as in “creams”) are cultural ideas that are transmitted through media.  Memes are the cultural analog of genes.  We have numerous transmitters: social networking sites, television, blogs, and print media.  Our focus on the rich and their separation from the rest of American society is a growing meme.  Recent articles have raised the question of whether or not America is becoming two societies, the rich and everyone else:

Voyeuristic focus on the rich has always been an American obsession.  “Lifestyles of the Rich and Famous” obsessively peered into the lifestyles of wealthy athletes, entertainers and business people.  The show ran for eleven years.   The rich are now objects of scorn: hedge fund managers making money from the housing collapse; bankers, on the brink of bankruptcy, awarding themselves huge bonuses thanks to government loans and guarantees; and corporate executives receiving gigantic severance packages after corporate wrongdoing. See, e.g. Following the Hurd

We have moved beyond voyeurism and scorn.  Our anger at the rich suggests economic and political upheaval.

The Rich Separate from Us

Michael Lind’s article in Salon, Are the American People Obsolete? appears to be the genesis of this meme:

Have the American people outlived their usefulness to the rich minority in the United States? A number of trends suggest that the answer may be yes.

In every industrial democracy since the end of World War II, there has been a social contract between the few and the many. In return for receiving a disproportionate amount of the gains from economic growth in a capitalist economy, the rich paid a disproportionate percentage of the taxes needed for public goods and a safety net for the majority. See Are the American People Obsolete?

We have always needed ordinary people as consumers and soldiers.  But now globalization has undercut the first part of this bargain at the nation-state level.  The middle classes in China and India are more intriguing customers than debt-ridden, unemployed Americans. They are also cheap and productive producers.  For the second part, a volunteer professional military undercuts the bargain even further.

Lind points out the economic and political consequences of this new social contract:

If the American rich increasingly do not depend for their wealth on American workers and American consumers or for their safety on American soldiers or police officers, then it is hardly surprising that so many of them should be so hostile to paying taxes to support the infrastructure and the social programs that help the majority of the American people. The rich don’t need the rest anymore.  See Are the American People Obsolete?

Bring Back the Robber Barons

Previously, we discussed the role of the nineteenth and twentieth century American entrepreneur in Bring Back the Robber Barons.   Lind focuses on the same point:

As bad as they were, the robber barons depended on the continental U.S. market for their incomes. The financier J.P. Morgan was not so much an international banker as a kind of industrial capitalist, organizing American industrial corporations that depended on predominantly domestic markets. He didn’t make most of his money from investing in other countries. See Are the American People Obsolete?

The robber barons were integrated into American society, not living in privileged enclaves like Greenwich, Princeton or Palo Alto or foreign equivalents of London, Hong Kong or Singapore.  Thus, it was natural for the robber barons to focus their philanthropy in America.  Our new citizens of the world have a different mindset:

…philanthropists may be inclined to devote most of their charity to the desperate and destitute of other countries rather than to their fellow Americans.  See Are the American People Obsolete?

Implications

Richistan, A Journey Through the New American Wealth Boom and the Lives of the New Rich, describes the rich becoming their own virtual country.  The new rich feel no civic obligation or shared sense of sacrifice.  They can default on mortgages and avoid military service for their children.  We have written about a different time in America where even the scions of the rich and powerful felt obligated to join the war effort to defend the nation. See e.g. A Reputation as Good as Goldman Part II.   Now we hear whining and threats: “if the Bush tax cuts are repealed we will leave the country.”

Unwittingly, the Obama Administration has enabled the petulance of the rich by supporting the banks and Wall Street to the detriment of Main Street.  Faced with threats of emigration, it remains to be seen whether the Administration has the gumption to let the Bush tax cuts expire.  Apparently, the rich are ready to depart the United States if marginal tax rates rise from 35% to 39.6%.  We are not exactly talking about conscientious objectors to the Vietnam War fleeing to Canada.

We have learned much about the new rich, and it is not all to the good. Paraphrasing Sir Winston Churchill, we have already established their virtue; we are only haggling about their price.

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26
Aug 10

Artificial Sweeteners Turn Sour

Last week in Artificial Sweeteners we discussed how government intervention has distorted the economy, the stock market and the housing market.  The basic thesis:

Excessive economic stimulus and a misguided zero interest rate policy has created false bottoms in the housing and stock markets.   See Artificial Sweeteners

Dour economic statistics released this past week only confirm that thesis.  While extrapolating from one month’s statistics is dangerous, nevertheless the numerosity and interrelated nature of recent reports raises questions whether there ever was an economic recovery.

Scanning the Headlines

The past week we have been bombarded by negative economic reports from housing to employment to durable goods.  A quick look at the headlines:

The Super Sweetener

The Congressional Budget Office calculates that stimulus added 4.5% to GDP.  Further, these programs created up to 3.3m jobs.   One estimate is that without stimulus, GDP would have been negative 3.5%.   What happens next?

So now that the stimulus is tapering off, America has the following rather unpleasant things to look forward to: a 4.5% reduction in run rate GDP as the direct economic boost disappears, the gradual loss of 1.4 to 3.3 million jobs, and the eventual realization that non-recurring, one time items can not be projected into perpetuity, despite what Keynesian dogma may preach. See CBO Estimates that Stimulus Boosted Q2 GDP by 4.5%, Standalone Number is likely under around -3.5%

Shoveling Money to No Avail

Morton Zuckerman captures the folly of current economic policy:

Tons of money have been shoveled in to rescue reckless banks and fill the huge hole in the economy, but nothing is working the way it normally had in all our previous crises. See End of American Optimism

All we have created is a “new normal” of slow or little growth. Compared to sales growth of 4% in past recessions, sales are increasing at a little over 1%.

…there are at least 14.5 million Americans still searching for work: 1.4 million of them have been jobless for more than 99 weeks, 6.5 million have been jobless for over 27 weeks. This is a stunning reflection of the longer-term unemployment we are coping with.

The unemployment numbers are worse than reported. Last year the Labor Department admitted it over-counted the number of jobs by 1.4 million….

Since April, the Labor Department has counted 550,000 nonexistent jobs under this so-called birth/death series. Without these phantom jobs, the economy this year created virtually no jobs—certainly not the 600,000 the administration has been touting.

The Obama administration projects the unemployment rate will drop to 8.7% by the end of next year and 6.8% by 2013. That is totally unrealistic. See The End of American Optimism.

A policy of artificial sweeteners has misled the American public and merely put off the day of reckoning.  Trillions of stimulus dollars have masked underlying weakness in the American economy.  Instead of these sweeteners, banks should have been forced to write off bad debt, insolvent firms should have gone bankrupt, government interference in the economy should have dwindled,  and programs increasing employment costs should have stopped.

If the economy were permitted to self correct, we would be on our way to recovery rather than be suffering the sour aftertaste of artificial sweeteners.

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23
Aug 10

Magical Thinking

“Just as in the late stages of the Roman Empire, magical thinking abounds. This is America, the capital of can-do! We are audaciously hopeful because we always arise, newly envigorated by the unquenchable spring of American innovation….” Nothing has Changed, Charles Hughes Smith

How ironic that we live in an age of magical thinking.  We have never had more information and commentary a mere computer keystroke away.   With all this information, one would think that we could easily accept reality and think critically.   Perhaps reality is so discouraging and the consequences of our current path of behavior so awful to contemplate that we prefer magical thinking, hoping against hope that a solution will appear.

Nowhere is magical thinking more evident than in our current economic plight.

The Land of Endless Deficits

Paul Krugman, Professor of Economics, influential Democrat and New York Times columnist, is the high priest of deficit spending.  His philosophy in short:

Spend now, while the economy remains depressed; save later, once it has recovered.  How hard is that to understand? See Now and Later

First, we never save later, as Congress would rather keep spending to buy votes than be fiscally prudent.   Second, the US is absorbing a large portion of the world’s savings to fund the ongoing $1.3 trillion dollar per year deficit.  Third, even Krugman realized that our debts are growing exponentially.  His view is that with high unemployment this is the not the right time to become fiscally prudent.  Fourth, taxpayers have paid $3.7 trillion over the last year to achieve a modest economic recovery which is currently fading.   In the 1950′s one dollar of debt added a dollar to GDP;  recently it took $5.57 to add a dollar to GDP.  Source Contrary Investor. We have reached the point of debt saturation.

Why Not Cut Taxes?

Republicans have an equally magical mantra:  “just cut taxes.”   Back to the Reagan era, Republicans have been enthralled by the Laffer Curve:

Economist Arthur Laffer made a very interesting supposition: If tax rates are high enough, then cutting taxes might actually generate more revenue for the government, or at least pay for themselves. (In one of life’s great coincidences, he first sketched a graph of this idea on Dick Cheney’s cocktail napkin.) If the government cuts taxes, then Uncle Sam gets a smaller cut of all economic activity — but reducing taxes also generates new economic activity. Laffer reasoned that, under some circumstances, a tax cut would stimulate so much new economic activity that the government would end up with more in its coffers — by taking a smaller slice of a much larger pie.  See Debunking One of the Worst Ideas in Economics

If the US had a 99% marginal tax rate,the rate paid on the last dollar of taxable income, Laffer’s theory might work.  But, we do not:

We don’t have a 99 percent marginal tax rate. Or 70 percent. Or even 50 percent. We start with low marginal tax rates relative to the rest of the developed world. (Yes, I understand that it may not feel that way after the check you wrote last month.)

So cutting the tax rate from 36 percent to 33 percent is not going to give you the same kind of economic jolt as slashing a tax rate from 90 percent to 50 percent. There’s no huge black market to be shut down, no big supply of skilled workers to be lured back into the labor market, and so on.  See Debunking One of the Worst Ideas in Economics

The ultimate problem is that even if the economy grows, government revenues shrink, government spending continues and deficits widen.

Bring in the Grown Ups

Former Reagan budget director David Stockman recognizes that, if honestly measured, the budget deficit would be a Greek-like 120% of GDP by 2015.  Stockman excoriates the Republicans for cutting taxes and failing to balance the budget.

…the new catechism, as practiced by Republican policymakers for decades now, has amounted to little more than money printing and deficit finance — vulgar Keynesianism robed in the ideological vestments of the prosperous classes.

This approach has not simply made a mockery of traditional party ideals. It has also led to the serial financial bubbles and Wall Street depredations that have crippled our economy. See Four Deformations of the Apocalypse

His prescription is both simple and logical: “…balanced budgets, sound money and financial discipline — is needed more than ever.”

Without Keynes, Laffer or Friedman

Keynes’ “pump priming” through endless deficit spending and Milton Friedman’s monetarism call for expansion of money supply to ward off deflation.  These flawed strategies have captured our Treasury Secretaries from Republican Henry Paulson to Democrat Timothy Geithner.  Reviving Laffer’s arguments, and ignoring widening deficits, Congressional Republicans argue for extension of the Bush tax cuts.  Unfortunately, these theories have not extricated us from the current economic morass.

Faced with reality, the political elite would rather delude themselves with hope and magical thinking than confront the harder realities of austerity and living within our means.  We appear doomed to repeat these failed policies until it is too late.  Perhaps an economically rational adult will arrive to break the magic spell.

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19
Aug 10

Artificial Sweeteners

Artificial sweeteners have been the subject of health concerns.  Aspartame, for example, has been found to be a migraine headache trigger.  Products containing it carry a health warning for PKU, a rare hereditary disease.  Today we learn that diet sodas markedly increase the risk of pre-term deliveries.  See Add Diet Soda to the List of Things to Avoid While Pregnant.

Similarly, the Federal Reserve and the Administration have not trusted that the economy can heal through natural market forces.  Instead we have been served up the economic equivalent of artificial sweeteners.  Concerned by slow growth, not even negative growth, the government again is firing up the machinery for money printing and stimulus.

In each instance, the government is intervening, distorting, and artificially “sweetening”  the bond market, the housing market and, indirectly, the stock market.  What are the consequences?

There is No Free Lunch

Martin Hutchinson in The Peril of False Bottoms targets faulty government policy as the reason for our anemic economic recovery.  Excessive economic stimulus and a misguided zero interest rate policy has created false bottoms in the housing and stock markets.    A false bottom is defined as a stabilized “price far above the likely long-run price equilibrium of the assets concerned.”

Bernanke has precedent for providing excessive liquidity and holding interest rates too low for too long.  Greenspan reacted to the internet stock market crash by flooding the market with liquidity.  Doing this drove the market to over 14,000 on the Dow Jones Index and created a housing boom.   In the 2008-2009 real estate and stock market crash we learned  how flawed this policy was.

More on False Bottoms

Hutchinson points out federally inspired housing market distortions:

House prices are currently 47% above their level in January 2000, according to the S&P Case-Shiller 20-city index, compared to a 49% rise in prices since that time – in other words, they are in real terms at the same level as at the top of an immense speculative boom.During the recent contortions, the U.S. monetary and fiscal authorities have established false bottoms in two markets. The first is housing, where subsidies to first-time buyers, ultra-low mortgage rates, government guarantees on $700,000 home mortgages and foreclosure-avoidance schemes have prevented the housing market from falling even to its average level where the average house price is about 3.4 times average earnings. The Peril of False Bottoms

These misguided policies have consequences:

…with additional buyers having been sucked into the market, it is now likely that house prices will fall further than this. Indeed, if the appalling suggestion put forward last week that the government through Fannie Mae and Freddie Mac forgive $1 trillion of defaulted home mortgages is put into effect, they will undoubtedly do so. Nothing could be more designed to destroy confidence in the housing market than a massive subsidy to the most foolish and improvident home buyers, at the expense of the thrifty and careful renters who are the major source of potential new demand for housing.

If the buyer pool is attacked in this way, or forced into unnecessary losses by being made to buy too soon, house prices may not bottom out at the market-clearing level … but may continue falling.  The Peril of False Bottoms

Wither the Stock Market?

The stock market is the second false bottom:

Currently at 10,650 as I write, the market is 35% above its appropriate “middling” target. The “trailing” P/E ratio of 20.4 on the Standard and Poors 500 is also above its historic average, even though corporate and bank earnings are currently inflated by ultra-low financing costs and a steep yield curve. Thus at some point we can expect reality to intrude, and the market to drop to its likely cycle low in the region of 5,000 on the Dow Jones index.

Again market prices are too high for any intelligent buyer.  And worse, buyers will then be unavailable to buy stocks at the bottom. The Perils of a False Bottom

Politics v. Economics

Politicians are worried about the next election.  Thus, we see the desperation of the Administration to throw economic caution to the wind.   Zero interest rates, forgiveness of imprudent debt, subsidies to overpaid public sector workers (with no corollary “give backs”) are all hallmarks of erratic and misguided government policy.  They also sacrifice long-term prudence for the feel good of short term stimulus.

Who will pay this price?  Unfortunately, it will be stock market investors, pension plans, life insurance companies and homeowners.  Directly or indirectly, that is virtually all of us.  We need to beware politicians handing out artificially sweetened candy. Just like aspartame and our physical health, artificial economic sweeteners can be harmful to our financial health.

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16
Aug 10

Bring Back the Robber Barons

Bill Gates and Warren Buffet have encouraged wealthy families to give half their wealth to charities, and many have done so.  One year into the effort, Buffet announced that forty families have agreed to pledge more than half their wealth to charity.   Emblematic of our current age, most of these families have made their money in the finance industry.

A Different Time in America

Once upon a time in America there was an entrepreneurial class that did more than shuffle pieces of paper.  They produced real things.  Historians originally referred to this group as “Robber Barons” because the large fortunes they amassed involved ruthless and sometimes uncompetitive business practices.  While some made their fortunes in finance, the overwhelming majority laid the foundation for America’s 20th century industrial dominance:

  • John Jacob Astor  (real estate, fur)
  • Andrew Carnegie (steel)
  • Jay Cooke (finance)
  • Charles Crocker (railroads)
  • Daniel Drew (finance)
  • James Buchanan Duke (tobacco)
  • James Fisk (finance)
  • Henry Morrison Flagler (railroads, oil, the Standard Oil company)
  • Henry Clay Frick (steel)
  • John Warne Gates (steel)
  • Jay Gould (railroads)
  • Edward Henry Harriman (railroads)
  • Milton S. Hershey (chocolate)
  • Mark Hopkins (railroads)
  • J.P.Morgan (banking, finance, steel, industrial consolidation)
  • Henry B. Plant (railroads)
  • John D. Rockefeller (Standard Oil)
  • John D. Spreckels (San Diego transportation, water, media)
  • Leland Stanford (railroads)
  • Cornelius Vanderbilt (railroads)

These individuals were also the backbone of American philanthropy.  For example, think of:  Carnegie (libraries); Rockefeller (University of Chicago, the Rockefeller Foundation) and Leland Stanford (Stanford University).  The Robber Barons not only focused on industrial wealth creation.  They were equally concrete and focused in charitable giving that provided tangible benefit to American institutions and society.

In contrast, the Gates Foundation focuses on world health concerns, a worthy but certainly more amorphous goal.  As an aside, the Gates-funded vaccination and AIDS treatment programs have received criticism for singular focus on certain diseases to the derogation of comprehensive health care and diversion of important medical resources.  Few of the Gates Foundation initiatives benefit Americans.

The Over Financialized Economy

The wealthy donors signing on to the pledge are one more reminder of the over financialized American economy.   See The Mirage of a Financialized Economy; The People v. Wall Street.  Today’s fortunes were earned at the expense of the industrial economy, rather than in pursuit of its success.   Two recent commentaries support the deleterious effect of an economy over-focused on the financial:

Boston-based asset manager Jeremy Grantham in Summer Essays criticizes his own profession:

“In 1965, 3% of GDP that was made up of financial services [and that] was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%.

This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.”

Professor Steve Keen, an Australian economist and author of Debtwatch believes that the percentage of GDP going to the financial sector should be even lower:

Because of that debt level, bank profits have gone through the roof as a share of GDP. Back before we had a financial crisis—when debt levels were far lower than today—so too were bank profits as a share of GDP. A sustainable level of bank profits appears to be about 1% of GDP.  See Bank Profits a sign of economic weakness, not health

Bring Back the Robber Barons

We need a political and economic re-set button.  The Obama and Bush Administrations have attempted to uncritically favor the financial sector through loan guarantees, TARPs and other artifices.  No one has asked the critical question of why we are favoring this sector that has absorbed a disproportional share of GDP at the expense of a productive reality-based economy that makes real things and employs real people.

No wonder unemployment has remained stubbornly high, and the economy is poised to enter a “double dip” recession.  Perhaps we need a new class of wealthy people focused on creating real wealth and jobs in America.   Maybe it is time for some twenty-first century Robber Barons.

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12
Aug 10

Hurd Roundup

DS, a Human Resources Vice President and former colleague, is an expert on organizational behavior, leadership training and executive development.  After reading Following the Hurd,  he provided these comments:

Another aspect of these cases that still continues to amaze me – as a former leadership development guy – is that all of our efforts (and expense) to instill and develop in leaders the decisions, actions and behaviors associated with good and moral leadership is largely ineffective and neutralized in the presence of the self-affirming/aggrandizing bubble (as you describe) that surrounds characters such as Hurd.

The other element at play I believe has to do with emotional age when assuming the top position and tenure in the job.  Back in the day, executives didn’t get tapped for these jobs until they were pushing 60 or so and maybe they would have a run of five years.  Early in their tenure, the leader almost always navigated the first crisis (usually a business crisis, but sometimes personal).   Given their five year window, back then, they almost never had to deal with a second crisis of major magnitude – they went off into retirement, revered.  The next guy then came in and repeated the same process.

But today, executives are quite a bit younger at appointment, imbued with certainty, looking to prove their virility and more easily seduced by power.  Their anticipated tenure could easily exceed ten years.  Likewise, the top jobs are now of such staggering complexity (cognitive, physical and psychological), that few air-breathing humans can actually perform them well, by themselves – thus the trend toward Office of the Chairman, Executive Leader Council and other rickety power-sharing, “star-chamber” arrangements.  The business environment and the operational tempo today almost guarantees that they will experience a major crisis (business or personal) every 18-24 months.  Like their forebears, they’ll handle the first one just fine, for a variety of reasons they will be unable to navigate the second crisis.  The odds and time itself are against them and they are ill-equipped (on many levels) to prevail.

Add that to the dirty water they are swimming in inside the “bubble” and you have a predictable (maybe unavoidable, though I’d hate to concede that) outcome.

Surviving a Crisis

DS’ additional thoughts on CEO crisis management:

The reasons why they handle the first crisis well are at least twofold -

Early in their tenure their sense-making skills are at their peak – primarily because of the novelty of a new job/environment, they are listening to many sources of input, they are open to new ideas and haven’t wall themselves off in the star-chamber and surrounded themselves with sycophants.  Ironically, the fact that they are short on “experience” in the new situation works to their benefit because they avoid the traps that come with believing they are “familiar” with what is going on.  Big ears trump experience!

Second, they make quicker and more confident decisions early on vs. later when their decision-making slows and they become more risk averse.

With the passage of time on the job, the factors reverse themselves – they stop listening and their reaction and decision-making time slows down.  This is ironic since they have had the opportunity to accumulate helpful experience.

Voila!  Train wreck!

Unfortunately, the Mark Hurd saga is not an isolated instance.  American business has seen a spate of ethical lapses and high level departures. See Ethical Lapses Felled Long List of Company Executives.

Final Thoughts

Hurd’s departure has left a void and recriminations.   The acting CEO is desperately trying to reassure customers, Wall Street and employees that all is well and it is business as usual.   The Board is commencing a search for a new CEO.  Given the fast moving nature of the technology industry, Wall Street is openly worried about a delay in finding a successor.  Finally, the Board is miffed that Hurd did no depart quietly, but sought to vindicate his actions and preserve his reputation. See Digits Live Show: Mark Hurd Isn’t Leaving H-P Quietly

Perhaps the Board should spend less time searching for a cost cutting guru or the next creative Steve Job-like creative genius, and more time and thought on the moral character of Mr. Hurd’s successor.

If my colleague is correct, Mr. Hurd will not be the last CEO to exit in an ignominious fashion.

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11
Aug 10

Awash in Legacy Costs

Legacy costs have strangled many American iconic and venerable American industrial firms.  The automobile and steel companies are recent victims of this growing scenario:  diminishing work force and profits supporting large and growing pension and retiree medical costs.  In many instances bankruptcy has been the corporation’s only way out.

The Financial Dictionary defines legacy costs in the private sector as follows:

Ongoing costs to a company that come from funding activities that, by definition, do not increase revenue. Perhaps the most prominent example of legacy costs is the funding of pension plans. Legacy costs often accrue when a company takes on too many responsibilities in times of strong performance or when it takes on an appropriate level of responsibility and then its priorities change.

Legacy costs also include retiree medical, life insurance and other promised benefits.

The recent turmoil in the financial markets has revealed a potentially larger legacy problem.  Not only is private industry suffering this stranglehold; legacy costs are also drowning state budgets in red ink. Like private business, the public sector is also saddled with pension, retiree medical and life insurance benefits.   Completing the analogy, many of these costs were taken on when state tax revenues (think profits) were high.  Politicians avoided confronting public employees and unions and chose the path of least resistance; that is, they capitulated to exorbitant demands.  Then they compounded the problem:  instead of direct layoffs, states resorted to early retirement pension sweeteners, which depleted pension assets.

The Current Status of Public Pension Plans and Other Benefits

On August 6th, the New York Times reported the massive underfunding of public pensions.  See Battle Looms over Huge Cost of Public Pensions. The Times discovered a February Pew Center for States study showing a $1 trillion pension underfunding. (We could have a whole different post as to why it took until August for the Times to report a study published in February.)   Worse yet, the Pew study may have been overly optimistic.  In other words, their methodology understated the liability and the deficit.  In contrast, the National Center for Policy Analysis’ Unfunded Liabilities of State and Government Employee Retirement Benefit Plans found that states were using too high a discount rate to determine employee liabilities.  Under the National Center for Policy Analysis deficits are far more alarming:

  • Unfunded liabilities for health and other benefits are
    $558 billion, compared to the reported $537 billion.
  • Thus, total unfunded liabilities for all benefit plans are an
    estimated $
  • Unfunded pension liabilities are approximately $2.5
    trillion, compared to the reported amount of $493 billion.
  • 3.1 trillion — nearly three times higher than
    the plans report. See Reality Beckons (Government Pensions)

While pensions are funded, other benefits like retiree medical, vision and dental have no assets side aside to fund them.  Moreover, based on current trends, medical costs are growing exponentially.

The New Battle Ground

Colorado undertook modest changes to its pension plans to lower future pension payments. The state legislature reduced its cost of living adjustment cap from 3.5% to 2%. The result was an immediate lawsuit from public employees:

Earlier this year, in an act of rare political courage, a bipartisan coalition of state legislators passed a pension overhaul bill. Among other things, the bill reduced the raise that people who are already retired get in their pension checks each year.

This sort of thing just isn’t done. States have asked current workers to contribute more, tweaked the formula for future hires or banned them from the pension plan altogether. But this was apparently the first time that state legislators had forced current retirees to share the pain.

Sharing the burden seems to be the obvious solution so we don’t continue to kick the problem into the future. See Battle Looms over Huge Cost of Public Pensions

Employees view their pensions as inviolable contracts, while the state is invoking changes as actuarial necessities.

Who Thinks About the Taxpayers?

Taxpayers are facing unemployment, the risk of losing their jobs and increasing costs of education, medical and energy.   Public employees are well paid, largely insulated against layoffs, and receive top of the line current and retiree benefit packages.  Barron’s points out that: “[m]ost public employees, if they hang around to retirement, can count on pensions equal to 75% to 90% of their pay in their highest-earning years.”  The $2 Trillion Hole.  Frequently, supervisors and employees collude to inflate final pay with shift and overtime pay in the last year of work.  Current and retiree medical benefits require minimum or no contribution.

In contrast, private sector benefit plans pale in generosity to public benefit plans.  I worked for a company for 32 years and my pension is a little more than 40% of my last five years of pay.  Retiree medical requires a 20% contribution.   Our plans had no cost of living adjustments.   My company’s plans were probably in the top 5% of benefit plans in America.   Most companies offer little more than a basic medical plan and no retiree benefits.

The federal government will soon run out of borrowing capacity.  In addition, there are questions of federalism; that is, the states are supposed to be responsible for their own finances.   Federal and state legislators and public unions  have to be far more realistic than they have been.  If they are not,  some of our largest states (think New York, New Jersey, California, Illinois) will suffer as did  GM and  Greece:  drowning in legacy costs.

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American Society / Corporate Behavior / Media / Political / law — 0 Comments
09
Aug 10

Following the Hurd

On Friday, the stock market shook with the news of the announced resignation of Mark Hurd, CEO of Hewlett Packard. The man credited with reinvigorating Hewlett Packard resigned as chief executive of the technology giant after an investigation of his relationship with a female contractor.  That investigation revealed that he violated the company’s business standards.

On Friday, HP expanded that Mr. Hurd, 53 years old, didn’t violate the company’s policy regarding sexual harassment.  He  had however, submitted inaccurate expense reports intended to conceal what the company said was a “close personal relationship” with a female consultant.  See H-P Chief Quits in Scandal

In a memo to all HP employees, acting CEO Cathie Lesjak provided more detail:

“Mark had failed to disclose a close personal relationship he had with the contractor that constituted a conflict of interest, failed to maintain accurate expense reports, and misused company assets.” See H-P’s Hurd Reaches Settlement with Contractor

The Wall Street Journal later learned that Mr. Hurd and the contractor reached a settlement on the sex harassment claim.

Some Thoughts on Corporate Culture

A mystique surrounds CEOs of large, publicly traded corporations.  The CEO of such a corporation is as close to a feudal lord as one can get in 21st century America.  A CEO is surrounded by a myth making machine.   A VP of Public Affairs burnishes the image of the CEO as powerful and successful, minimizes setbacks and trumpets the smallest of victories.  The CEO can access airplanes and limousines, play golf at the best clubs, dine and stay where he or she chooses with little or no oversight.   Backed by corporate political action committee contribution funds, he or she has instant access to Senators, Congressmen and even the White House.   A fawning and largely uncritical cadre of financial media pundits and Wall Street analysts clamor for opportunities to meet and interview a CEO.

Since corporations are a hierarchy and a CEO sits atop the organizational pyramid, subordinates are generally fawning.  Fearing unemployment, few want to tell the CEO (the emperor?) he or she is wearing no clothes, or should be staying clothed at critical moments.

Absolute Power Corrupts

“Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men.”  Lord Acton

With few to hold up a critical mirror, CEOs eventually start to believe their own press clippings and may even succumb to believing in their own infallibility.   Forgetting that it is often the office and rank that is being saluted, not necessarily the occupant, the tendency is for the CEO to believe they can do no wrong.

Blind spots eventually develop.  As with CEO’s, we have seen it with our more notorious Congressmen who believe that the tax laws do not apply to them, it is alright to have sex with subordinates, or obtain below rate mortgages.  Eventually comes the belief that the “rules do not apply to me.”  To their dismay, they find out often publicly and harshly that rules do apply.

Some Final Thoughts

I am always amazed when stories like Mr. Hurd’s reach headline status:

-          Why do CEOs risk so much for so little?  Mr. Hurd made $24.2 million dollars in 2009 and was slated to make $100m over the next three years.   How much could the dinners and trips have cost Mr. Hurd if he had paid from his own pocket?

-          Companies have strict policies on sex harassment and expense reporting.  Numerous high level executives have been publicly disgraced and lost their positions for such violations.  Mr. Hurd is a very smart man. Why did he not learn from others’ experience?

-          I have lectured on the EEOC Sex Harassment Guidelines.  The best defense in the workplace is to avoid dating any subordinate or contractor.  Once any personal relationship develops and then breaks off, it is difficult to prove that no harassment occurred in this unequal power relationship.

-          Why did HP’s internal audit function not find the expense report abuses and report them? Why did it take the complaint of the contractor for the Board to order an investigation?

-          Why did Mr. Hurd receive over $12m in severance pay when the Board found expense reporting improprieties?  Isn’t that behavior a “for cause” termination? (Note –if Mr. Hurd had a contractual right to severance regardless of this behavior, that itself is problematic.)

Not all CEOs behave like Mr. Hurd.  Certainly, and in my experience, many are ethical and hardworking.  But unfortunately, Mr. Hurd’s tale occurs far too frequently in corporate America.

Outside corporate governance groups have mindlessly over focused on pay practices, staggered voting and other relatively minor issues.   Focus should be on close corporate Board of Director supervision of CEO and senior executive behavior.   Aside from all the logical and obvious reasons for eliminating this behavior is the other external one as well:  the market generally reacts swiftly to this chicanery.  On Friday, HP stock was down a significant 9.7 %.  Following the Hurd can be quite costly.

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Economics / Financial / Political — 0 Comments
05
Aug 10

Zero Interest Rates Equals Zero Jobs

Following World War II, typical economic downturns and recoveries have been “V” shaped.  That is, a sharp downturn in Gross Domestic Product and rising unemployment followed a quick turnaround in both economic activity and employment numbers.   This time is different.  We are witnessing zero or negative job growth and an anemic recovery.

Today’s situation is a different animal: a balance sheet recession.  Both businesses and individuals took on too much debt. And that debt was unsupported by income.  We are now saving to pay down that debt (the most recent savings rate increased to 6.4%), or defaulting on obligations (in May home foreclosures rose 44% to a new record).

Paradoxically, second quarter earnings demonstrate that corporations are beating earnings estimates and reporting healthy profits.   Gluskin, Sheff reports that

…78% of the companies reporting have beaten estimates and earnings per share are up 42% year over year versus initial expectations of 27%.

Companies have focused on tight cost controls to achieve these results.  The most recent durable goods report provides a clue to how costs are being controlled.

Orders for non-military capital equipment excluding aircraft climbed 0.6 percent last month after jumping 4.6 percent in May, more than previously reported, figures from the Commerce Department showed in Washington. See Second Quarter Earnings: Companies Beat But Investors Shrug

Looking further, we see we are in a jobs depression. Karl Denninger slices through the obfuscatory government data and finds that from July 2009 to July 2010 unemployment is 17% worse. See Watch the Birdie (Jobless Claims). After trillions of dollars of stimulus and guarantees and a zero interest rate policy, all we have to show for the effort is zero, or negative, job growth.

My strong suspicion is that management is substituting capital for labor.

A Brief Anecdote

One of my friends is the cost cutting guru for his company.  Always on the lookout for new labor saving technology, he found a type of packaging machine that could replace five employees currently performing the function manually.  His view is that labor saving technologies are the only thing preventing the economy from crashing.  By laying off those five employees, the machine pays for itself in two years or less.

On the other hand, employees unionize, get sick, go on vacation, file worker’s compensation and discrimination claims, and go out on pregnancy and family medical leave.  As an employer, machines suffer none of these disabilities.  Substituting capital for labor is firmly rooted in all corporate cost cutting strategies.

Unintended Consequences

With Obama, Bernanke, Geithner and Summers setting economic policy, I always feel it is improvisation night.   This team seems to bounce from one economic policy to the next with little thought given to unintended consequences.

-          Zero Interest Rates – I have written about the pernicious effect of zero interest rates on savings, especially for senior citizens.  See e.g. Is the Administration Determined to Make the Elderly Poor? Nothing from Nothing.  However, the upside is that low interest rates encourage the creditworthy to borrow for capital investment.  For example, IBM was able to borrow at 1% for 3 years.  If you can purchase labor saving machines with low interest rate loans and tax depreciation savings, why not?

-          Expensive Social Programs – Ignoring high levels of unemployment and economic stagnation the Obama Administration pushed ahead to pass health care reform.  The law does not apply to businesses with less than 50 employees.  The perverse effect is obvious:

…potential tax penalties for employers with more than 50 workers could cause many smaller businesses to rethink any hiring or expansion plans.

“It could have a negative effect on hiring as businesses figure out just how much the new law and offering health benefits will actually cost them,” many … small business clients have kept their staffs below 50 workers to avoid the complicated compliance requirements of laws such as the Family and Medical Leave Act.

“The new tax penalties for businesses with more than 50 employees will certainly make many business owners think twice about expanding and hiring more people….”  See Small Businesses Ponder Impact of Health Care Reform

Add in the threatened expansion of unions through the Employee Free Choice Act and no wonder large and small businesses are reluctant to hire.

Machines Make Better Employees

At its core, the Democratic Administration has failed in its campaign promises to reduce unemployment and get the economy back on track.  Through its zero interest rate policy the Federal Reserve and the Administration have “manufactured” our current high unemployment rate.  Today’s jump in new unemployment claims, to a weekly rate of only emphasizes the point. See Weekly Initial Unemployment Claims Increase to 479,000

The net effect is that machines provide better value than employees.  The labor market has structurally changed and not for the better.  Zero interest rates coupled with zero forethought is harming the working population.

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