Whither Economic Policy? Whither Investments?

President Obama has returned to Washington, D. C. We are told that he plans upon his return to focus on domestic economic issues.

The president has had two weeks that have not necessarily been the best of his administration. The mid-term election did not go the way he wanted and his sojourn into the international waters of the East did not go swimmingly.

Now, where is he going to go on the economic front?

His economic team is crumbling before his eyes and Ben and Tim are not getting the best critical reviews.

The economic news is not exactly what he would like to hear. It seems as if the results the economy is posting are exactly the opposite of what he has tried to do.

The front page of the Wall Street Journal trumpets: “Paychecks for CEOs Climb”. Here are the opening words:

“The chief executives of the largest U.S. public companies enjoyed bigger paydays in their latest fiscal year, as share prices recovered and profits soared amid the country's slow emergence from recession.

At these 456 companies, the median pretax value of CEO salaries, bonuses and long-term incentives, such as grants of stock and stock options, rose by 3% to $7.23 million, according to an analysis of their latest proxy filings for The Wall Street Journal by consulting firm Hay Group.

The Journal usually tracks executive compensation each spring. To provide a fuller post-recession picture, it followed up this year by analyzing pretax CEO pay at every U.S. public company with at least $4 billion in annual revenue that filed proxy statements between Oct. 1, 2009, and Sept. 30, 2010.

The results differ markedly from the April analysis, which covered 200 such companies and found median total direct compensation had dropped 0.9%.” (http://professional.wsj.com/article/SB10001424052748704756804575608434290068118.html?mod=wsjproe_hps_MIDDLESecondNews.)

The largest companies in the United States and their chief executives seem to be doing just fine, thank you. Plus, these companies are able to raise debt at record low interest rates and they seem to be piling up cash as fast as they can.

Recent headlines also reported that the income distribution in the United States again has moved more and more toward the wealthier end of the spectrum.

And, what do the policymakers and economists supporting the administration recommend? More spending because the administration has been too timid. More liquidity for the financial markets because we are in a liquidity trap.

Will this continue to be the economic policy of the Obama administration going forward?

I see no indication that it’s economic policy will change. And, if this is the case then this environment should drive investment decisions going forward.

The foundation of these investment decisions, I believe, is that the “largest U. S. public companies” will continue to prosper. The economic policies being proposed have little or nothing to do with resolving the underlying economic imbalances that exist in the United States and that is why the recovery, as it continues, will be skewed toward the larger companies.

Of course, not all of the largest U. S. public companies are going to thrive, but I believe that this is where a lot of the action will be. The action will be in the following companies: companies that will be bought by the large companies building up the large piles of cash; the companies that are engaged in “bubble” assets like commodities, emerging market financial instruments, and bond markets; and a select few companies that are doing the buying of the smaller companies.

I don’t immediately like companies that are doing the acquiring because mergers and acquisitions don’t always work out. In fact, my research indicates that at least two-thirds of the corporate combinations don’t work out. First off, those that move earlier tend to fare better because the acquisition prices don’t get inflated until the merger frenzy progresses: followers get killed. Second, I don’t trust a lot of executives in making mergers work. So many get caught up in “ego” problems that they either overpay for the target or move to make mergers without the culture or the expertise to pull off the acquisitions.

This makes the potential targets for takeover extremely attractive. Why? Because the targets in this instance will be those companies that are not performing well due to the recession and the tepid recovery and the price of their stocks will be relatively low with few prospects, except for being acquired, for they are still basically struggling companies.

To me the pieces are in place for a substantial consolidation of companies in the United States. The largest companies have cash and will have the ability to garner much more as they need it. Note: this just came across the net: Caterpillar Strikes $7.6 Billion Deal for Bucyrus. Caterpillar is offering $92 a share in cash for Bucyrus, a 32 percent premium, as the heavy equipment colossus makes a big push into mining equipment.

Alright!

The executives of these companies stand to make lots and lots of money by making their companies bigger, whether or not they make them bigger successfully. Given the information presented above, this seems to have already started. Continuing the government’s existing
economic policy will see this environment lasting for quite some time.

Companies dealing in “bubble” assets can obviously benefit from “going to the dance.” The downside is “staying too long at the dance.” But, the Treasury and the Fed have signaled that their current policies will continue for “an extended time.” Let the music play on.

The results of this? The income distribution will continue to skew toward the wealthy end. Big businesses will get bigger. Small businesses will do alright, but they will be on the periphery not at the center and will be devoted more to upper income tastes. Employment will continue to be weak because mergers and acquisitions tend to result in layoffs and a shrinking workforce rather than an increasing one. Capital investment will not be too lively because mergers and acquisitions, at first, result in the scrapping of old physical plant and equipment and not the expansion of it.

Basically, the scenario I have described translates in the following way: the stimulus is going to be paper, and, therefore, the profits and wealth that are going to be created are going to be primarily paper.

Money will be made in this environment…lots of it! Just don’t remain too long at the dance!

The Basics of Turnarounds: the United States Situation

A part of my life has been connected with company turnarounds, bank turnarounds to be more precise. I would suggest that the United States is in a turnaround situation right now but its leaders claim that the economic model it is using is still relevant and that all that is needed is a little more time and a little more co-operation from others and everything will turn out alright.

My experience has led me to some conclusions about what is needed in a turnaround situation. (By-the-way, all my turnarounds were successful and I can say that now because I am not doing turnarounds any more.) We don’t have much space to discuss these things so let me just summarize what I believe to be the four most important factors in achieving a turnaround: the business model; information coming from the market place; the need for transparency and openness; and the existing business culture.

Although these factors relate to a business situation, I believe that they can be applied to any “turnaround” situation, including the “turnaround” of a government.

First, and foremost, an organization gets into trouble because its business model, or economic model, is not working. But, because a leader or a management team believes that the organization has gotten where it is because of that business model, they tend to stick with the model and apply the model even more forcefully.

In some cases, the success of the model has come because of the timing of the model’s use and not because of any inherent characteristics of the model are correct. To justify this statement I refer the reader to the book “Fooled By Randomness,” by Nassim Nicholas Taleb.

In terms of the economic model that the United States government is applying, and has been applying for a very long time, there is no real evidence that it works. I am, of course, speaking of the Keynesian macro-economic model.

Ever since the 1930s when the model was first presented, all I have ever heard in times of difficulty is that the reason the Keynesian model falls short is that not enough stimulus has been forthcoming. Keynesian economists contend that the Great Depression continued on for as long as it did because governments did not create sufficient budget deficits. Only the war effort, World War II, got the US out.

This criticism has been applied over and over again during the last fifty years. All we have been hearing from the fundamentalist preacher Paul Krugman is that the Obama stimulus package must be greater. He has been consistent in applying this remedy since early on in the Great Recession. More spending, more, more!

Maybe the economic model the government is using is wrong!
The application of this model over the past fifty years has produced falling capacity utilization, rising under-employment, and greater income inequality.

Maybe the economic model has not been applied correctly!

Defensive comments like these are heard over and over again within a company that is in decline.

Second, it seems that others recognize the decline in the company even though the leaders and management of the organization do not. That is, the market recognizes that the model of the organization is not working and that the organization is in decline.

And, what is the response of the leaders or managements of the targeted organization. The response is “The market doesn’t understand us!” I don’t know how many CEOs I have heard express this sentiment in the face of a falling stock price.

The thing is, the market does understand the company and the fact that the company is applying an inappropriate business model.

The market response to the economic policy of the United States? Well, the behavior of the United States government in the 1960s resulted in the need for the United States to go off the gold standard. Since the United States has been off the gold standard, the value of the United States dollar has declined almost constantly (with the two exceptions, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve system and during the 1990s when Robert Rubin was the Secretary of the Treasury).

Obviously, for the value of the United States dollar to substantially fall, almost continuously, over a fifty year period, indicates that something must be wrong with the economic model the government is using. During the past fifty years, the government has relied on a credit inflation whose foundation is a federal deficit that has resulted in the federal debt increasing at an annual compound rate of growth of more than 9% over this time period. The government has created other avenues of credit inflation through programs like those built for housing and home ownership. The whole economic model was based upon inflating the economy causing people to constantly “leverage up” and take on more and more risk.

Third, transparency and openness goes by the wayside as organizations experience decline. Cover ups abound! President Obama came into office declaring that he was going to change the way things are done in Washington. Yet, his administration is now charged with opaqueness and obfuscation like every other presidential administration. Even little bits of information, like the recent report by the special inspector of the TARP program, only adds to the accusation that this administration is hiding things. This was in all the papers this morning. (See “Treasury Hid A. I. G. Loss, Report Says,” http://www.nytimes.com/2010/10/26/business/26tarp.html?ref=business.) This does not help!

Fourth, the culture of an organization begins at the top. In a turnaround situation, a new culture
must be implemented and that culture must begin with Number One. The new leader that takes on a turnaround situation must change the way things are done and introduce a new business or economic model into the organization.

However, this new business model cannot be introduced or implemented if the (new) leader assumes that little or nothing needs to be changed. And, this implementation cannot be carried off unless the members of his or her team are all on board.

In my view, things need to be changed in Washington, D. C. The evidence in the market place is hard to ignore, although Washington has done its best to shift attention to others. But, the weakness of the United States position has been observed and others (China, Brazil, and India, and others) have moved into the void to take advantage of it. (See my post http://seekingalpha.com/article/229112-the-imf-bowl-u-s-vs-china.)

Even if the philosophy of economic policy used by the United States government was appropriate forty or fifty years ago, things have changed since then. (See my post http://seekingalpha.com/article/232044-maybe-things-have-changed.) The United States needs to be “turned around”. But, to do a turnaround, those that are in leadership positions must accept the fact that a turnaround is necessary. I don’t see this happening any time soon.

What Should the Fed (and the Federal Government) Do Next?

This morning there is a series of articles in the opinion section of the Wall Street Journal titled “What Should the Federal Reserve Do Next?”. It consists of several short pieces written by well known economists. I recommend that you read them.

I would especially recommend the opinion piece written by Allan Meltzer, a professor of economics at Carnegie Mellon University and the author of “A History of the Federal Reserve”. The following quote is, I believe, especially important for the monetary policy of the Federal Reserve…and for the fiscal policy of the federal government.

“In ‘A History of the Federal Reserve,’ I concluded that the principal mistakes the Fed has made have resulted from giving excessive attention to current events and forecasts of highly uncertain near-term developments. By focusing on the short-term, the Fed neglects the longer-term consequences of its actions. The transcripts of FOMC show that the members are paying little attention to medium- and longer-term consequences.” (http://professional.wsj.com/article/SB10001424052748704358904575477580959771188.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj.)

Unfortunately, we are in a short-term world. Everyone focuses on “current events and forecasts of highly uncertain near-term developments.” As a consequence, there is a tendency to over-react to situations and, in doing so, set the stage for further difficulties down-the-road.

The policy-cycle has gotten shorter and shorter. Richard Nixon believed that he lost the 1960 election to John Kennedy because the economy was not performing well. Thus, when Nixon became president he focused on making sure the economy would be expanding during the 1972 election. He froze wages and prices and took the United States off of gold in August 1971 because he believed it was necessary to contain the inflation begun in the Kennedy-Johnson years so that he, Nixon, could re-stimulate the economy so that he would be re-elected.

This four year cycle became the “thing” for Presidents. Slow down the economy immediately after getting elected so that the economy could be re-started in time to get re-elected.

In the 1992 election, “It’s the economy, stupid!” became the mantra of the Clinton campaign. And this approach appeared to be was in Clinton’s election.

But, then a funny thing happened: the cycle shortened. The mid-term elections became the thing. Whereas the Democrats controlled both houses of Congress when Clinton took office, the 1994 congressional elections turned the tide and resulted in the President facing a hostile legislature for the rest of his tenure. Focus was placed on mid-term elections as well as presidential elections.

Bush (43) experienced a similar turn-around in the 2006 election where the Democrats once-again established their control in Congress.

Now presidents must get re-elected, but also get “their” Congress re-elected.

Current economic policy making in the United States is on a very short string…not that it hasn’t been for a long time.

The problem this creates is that the economy is never allowed to fully adjust to the economic dislocations that appear over time. The efforts to re-stimulate the economy are over-whelmingly aimed at putting people back to work in the jobs and industries that existed before the previous recession. As a consequence, the economy never fully adjusts as it needs to.

Several things can happen. Human capital does not evolve as it should to meet the changes in technology taking place. The result is that unemployment rises, but even more important under employment rises. America now faces the problem that about one out of every four individuals of working age is either unemployed or underemployed. Income inequality is highest in sixty years.

The capacity utilization in the United States has dropped continuously since the 1960s and still rests substantially below the previous levels attained. It is expected that the near-term peak in this measure will be well below the previous peak. This, I contend, is a result of the government’s efforts to force resources back into “legacy” physical capital. (See my post http://seekingalpha.com/article/213163-jobs-and-skills-the-current-mismatch.)

Another area of major concern is the debt burden taken on by individuals, businesses, and governments. In the past fifty years, the federal government has created deficits and excessive monetary growth to combat unemployment and income inequality and sustain as much economic growth as it could. This has been the perfect environment for people to take on more and more debt…and that is exactly what they have done.

However, history shows over and over again that debt levels can eventually reach heights that are unsustainable. And, when this happens, the debt loads have to be worked off. The relevant question is, have we reached that stage where people must de-leverage and work with lower debt levels? If this is the case, working off current debt loads will not be easy.

It takes time for economies to re-adjust and re-structure. Debt loads have to be worked down. Labor must be re-trained. Legacy capital must be replaced with physical capital more attuned to the age. And, continued monetary and fiscal pressure only delays such adjustment and makes American commerce less competitive. (See “U. S. Falls in Ranks of World Economy,” http://professional.wsj.com/article/SB10001424052748704362404575480023901940654.html?mod=ITP_pageone_4&mg=reno-wsj.)

Furthermore, the existing panic in United States policy making, both monetary and fiscal, is creating a world exactly the opposite of what policy makers seem to be attempting to achieve. For example, the Fed’s low interest rate policy is subsidizing the largest financial institutions and creating a world where more and more of the banking assets in America will be controlled by the largest banks. Currently, the largest 25 domestic commercial banks control 67% of the assets of the banking system. Analysts believe that this will go to 75% or 80% in the next five years.

In addition, the ranks of the middle class are dwindling. The low interest rate policy of the Fed has encouraged big companies, big banks, and the wealthy to borrow but these borrowers are just sitting on the cash waiting to engage in an acquisition binge once the economy starts to pick up steam. The middle class? Well, the middle class, those that have paid their bills, who have stay married and worked hard throughout their lives and have saved: this middle class is facing the fact that they will earn next to nothing on their savings. (See “Falling Rates Aid Debtors, but Hurt Savers,” http://www.nytimes.com/2010/09/09/business/economy/09rates.html?_r=1&hp.)

United States policy makers, in an attempt to stay in office, have advocated monetary and fiscal policies aimed at putting people back to work and making it easy for these people to buy “things”, especially houses. They continue to follow such “populist” policies in order to get re-elected and maintain their power. Both parties are guilty. (See my “Wall Street Greed vs. Washington Greed,” http://seekingalpha.com/article/219804-wall-street-greed-vs-washington-greed.)
The speech given recently by President Obama offering $350 billion in new economic stimulus, even though some of this is aimed at “longer term” projects, appears to be an example of just another politician experiencing the panic that comes with an upcoming election.