The Case Against the Obama Taxes

Yesterday, President Obama proposed a tax plan.  George Shultz has replied: “rich people and large companies like General Electric Co. are the beneficiaries of a complicated tax system.”

“It’s wealthy people and the GEs of the world that know how to manipulate these preferences and get their tax rates down,” said George Shultz, an economist and former dean of the University of Chicago’s business school. “The average Joe doesn’t have access to those lawyers.”

George Shultz, also former United States Secretary of the Treasury and Secretary of State, made this statement in an interview with Bloomberg press when arguing for a complete change in the tax code to reflect the realities of the 2010s. (http://www.bloomberg.com/news/2011-09-20/shultz-says-it-s-time-to-clean-house-with-u-s-tax-code-to-boost-economy.html)

One could also say the same thing when referring to the ability of “wealthy people and the GEs of the world” to handle the inflationary environment created by governments that are aiming to sustain “high levels of employment” as designated by the full employment objectives of the United States and many other western nations. 

The wealthy and the large corporations can protect themselves or even benefit from inflation.  The “average Joe” cannot do this.  In fact, the “average Joe” ultimately “gets screwed” from inflationary policies aimed at keeping him employed.  Having under-employment rates in the 20 percent plus range is not what was planned as policies of credit inflation dominated the past 50 years. 

Furthermore, credit inflation creates a wonderful stage for financial innovation, shifting jobs from manufacturing and production to financial services and other support industries…like the legal profession.  We can only look at the shift in jobs in the United States over the past fifty years to see the consequences of this development.

The financial innovation of the last fifty years points to another change in the world that not only allowed the financial innovation to take place but provides insight into the world of the future.  The change I am writing about is the advent of the Age of Information.  Financial innovation thrived upon the new technology and the new technology was underwritten by the growth of the financial innovation. 

“Wealthy people and the GEs of the world” (along with the JPMorgan’s, Goldman-Sachs, and others) are able to use this technology “to manipulate” things so as to benefit themselves as much as possible.  They have the tools.  Why did GE come to earn two-thirds of its profits from its finance wing?  And, the same can be said for General Motors and many other “manufacturing” companies. 

And, people are concerned about the fact that over the past fifty years the income/wealth distribution of the United States became so skewed toward the rich.  The credit inflation and social policies of the past fifty years created the conditions for those that could “manipulate” things and get their tax rates down and profit from the inflationary environment that was created by the politicians. 

The “average Joe”? 

The “average Joe” could do little or nothing.  If he “stayed employed”, kept the job at which he was already working, he fell behind.  The “average Joe” needed to become educated, needed to become more technologically savvy, needed to find the “lawyers” and financial advisors to “manipulate” the system.  But, that was not the way the incentives were aligned!

Unfortunately, the objective of the politician does not mesh with that of “the average Joe.”  The objective of the politician is to get elected and then to get re-elected.  Consequently, laws and regulations aimed at keeping “Joe” fully employed in his current job have been crucial.  Empathy with “Joe” was good politics.  The fact that “Joe” was constantly falling behind was not the issue.

The world has changed.  Yet, we can’t seem to get away from the same election strategies that have been followed over the past fifty years.  In my mind, we are going through a cultural shift that is painful and disturbing.  It is a shift that is going to take place, one way or another, and just pursuing the same goals over and over will only exacerbate the pain and the disturbance over time.  And, the constant advancements of information technology will just add to this.  

Shultz is arguing that the “Tax Reform Act of 1986” needs to be revised and reformed, not extended and made more complex.  He argues that “a simplification of the code would allow Congress to lower rates on a ‘revenue-neutral’ basis, while economic expansion would boost tax receipts.

“You’ll get a gusher,” Shultz said. “If you get this kind of stimulative tax policy and other things into effect, there will be a response and revenue will come in.”

 It seems as if “wealthy people and the GEs of the world” will play ball with you when they feel that they are not being singled out and picked on.  Otherwise, out will come the lawyers and the financial advisors and we get results similar to the ones described above.  The problem is that in proposing these changes in the tax codes as Obama has done or creating an environment of inflation, things just don’t stay the same. 

The politician is subject to the same fallacy that is faced by the economist conducting his deductive reasoning.  It is the problem of “ceteris paribus”, the assumption that “all else stays the same.”   When you change the tax code or the inflationary environment, all else does not remain the same.  As a result, you often find yourself facing the problem of “unintended consequences.”  You get results that you didn’t intend to get.  In the case of the economic policy over the past fifty years, you get higher levels of employment and under-employment than you wanted and greater inequality in the distribution of income/wealth. 

The current Obama tax plan is a journey into the past.

Maybe Things Have Changed

During my professional career, three things have seemingly dominated the American culture. First, the labor unions; second, the manufacturing industries; and the third was home ownership.

I spent my formative years in Michigan and nothing dominated the newspapers more than the activity of labor unions and the car industry. That was just a part of the society there. Of course, there was the steel industry and in the case of unions there was the coal industry and so on. Nothing is more vivid to me than the role of manufacturing and labor unions in the culture of my youth.

If anything else came close it was the idea of home ownership and the suburban sprawl. It was especially important to put the returning soldiers into homes and to help them live the “true” American life.

These days are gone, but the role they played in this earlier existence still dominates our national life and our political philosophy. Maybe that needs to change. Maybe we need to re-direct our attention.

The manufacturing industries have become a smaller and smaller part of the United States economic machine…for better or worse. The economy has shifted toward information and “information goods”. An “information good” is broadly defined as anything that can be digitized. Besides the computer industry, three other major subcategories in this area are in financial services, higher education, and government. Finance, colleges and universities, and government deal, primarily, with information and “information goods”.

The “new” structure of commerce in the United States is tilted toward the more educated, the more mobile, and the modern urban community. The “old” structure relied more on physical effort, the stationary, and the suburban life.

That is, the driving forces in this new modern world are not cars, and steel, and manual labor.

The thrust of the labor unions has also changed and it seems as if unions have spread into the area of government as the presence of government has grown in the society over the last fifty years. Back in “the good old days”, unions were connected with industry and hard and dangerous jobs and “national” monopolies. International competition was not a threat at that time.

Today, the presence of unions has radically shifted. In the United States most union members are connected with government. This is also the case in the rest of the western, democratic nations. Labor unions are still important in the automobile industry, but the automobile industry is just not as important any more. I have seen figures that indicate that something like 60% of the membership in American labor unions these days is related to government. This move has completely changed not only the location of labor unions in the United States; it has also changed the focus.

The desire to get Americans into their own homes has been present in the country since the country was started. This was felt to be important not only for individuals themselves, but for the substantial positive externalities that were felt to accompany the growth of home ownership.

Today, we may find that renting may become more prevalent in the faster-moving, more educated, “urban” workforce of the 21st century. And, this mobility is becoming more global than just national.

The economic policies of the government have been built around the above factors which, I contend, are not as prevalent as they once were.

Monetary and fiscal stimulus were more effective in an age of “heavy manufacturing” because these industries relied upon fixed capital, huge plants and machinery, and a “local” labor force. When unemployment happened, labor stayed “at home”, both in terms of location, but also in terms of skills because the workers needed to know little else. Monetary and fiscal stimulus put these workers back to work in their old jobs as sales picked up. New investment also was created as the economy rebounded.

The same is not true in the Information Age. “Information” companies do not have huge plants and large machines to maintain. Downsizing and the shifting of the employees occurs incrementally and more rapidly than in the past. People move and re-train and change. Monetary and fiscal stimulus is not so effective because the companies and have “moved on” and do not re-hire people back into their old jobs as did the manufacturing firms. The employees have also “moved on”. Furthermore, these companies do not have large capital investments to undertake that help the economy to re-start.

The labor union issue is surfacing in another way. Labor unions connected with government workers have become very important in recent years and have been very successful in gaining large settlements related to health benefits and retirement. A recent edition of the Economist magazine has covered some of the issues here. The problem: “One California mayor estimates that the effective cost of employing each police officer and fireman is $180,000 a year. That sum is not their take-home pay. For police and firefighters, the big costs occur when they stop working—retirement at 50, combined with inflation-linking, health benefits and lump sums for unused sick leave…California is also shelling out fortunes to retired state and municipal managers; more than 9,000 have retirement incomes of over $100,000 a year.”

And, these pension promises have been subject to “Alice-in-Wonderland accounting.” The Economist presents figures that pension liabilities are estimated to be around $5.3 trillion, compared with $1.9 trillion of assets. “The total shortfall of $3.4 trillion is the equivalent of a quarter of all federal debt.”

So, when it comes to governmental employees, the fighting is not over peanuts. And, this is a worldwide issue as can be noted in the riots taking place in Greece, Italy, Portugal, Spain and France over their government’s retirement and pension payments. And, yesterday it was revealed that the new austerity budget of the British government contains a reduction of 500,000 public sector jobs. “Today, the fight begins,” states the general secretary of the largest government union in the UK.

The role of labor unions in the 21st century society seems to need to be re-addressed going
forward.

Finally, the pressure of the government to achieve high rates of home ownership must be re-visited. We, in the United States, have paid a major price for the emphasis placed on this goal and the resources that were allocated toward its achievement. Payment is still coming due in the area of foreclosures, commercial real estate bankruptcies, and the resolving of government support of Fannie Mae and Freddie Mac. It is very likely that we, the people of the United States, will be paying for this bailout for many years to come.

The whole point of this post is to argue for a change in some of the assumptions behind the economic policies of the leaders of the United States government. The world has changed. Maybe our leaders need to change their outlook as well.

Or, is that too much to ask?

The Problems of Recovery

Comparisons abound between the Great Depression of the 1930s and the Great Recession of the 2000s. So far, we seem to have avoided the depths that were reached in the earlier experience, but we still have to consider whether or not the breadth of the two might be similar. That is, almost everyone one forecasting the recovery of the United States economy in the 2010s seems to be expecting that it will be a long, slow process.

The comparison I would like to consider in this post is the possibility that both of these periods represent a time in which the United States economy was going through a substantial structural change. Many people that have studied the 1930s period argue that the economy that existed in the United States in the 1950s was substantially different from the one that existed in the 1920s. Huge shifts took place in both manufacturing and agriculture throughout the 1930s and these shifts were just accelerated in the 1940s, a period of world war. The underlying cause of this change: technology had changed and the American economy had to adjust to become a modern nation. However, the mismanagement of the financial crisis in the 1930s just exacerbated the depth of the decline.

The argument can be made that major structural changes had to take place in the United States economy as it entered the 21st century. Changes of the magnitude of the present adjustment did not take place during the shorter, less severe recessions of the post-World War II period because the buildup of technological change takes time in order to build up a sufficient backlog of the new technology to really be disruptive. By the end of the 1990s, the structural change connected with the move from a society based upon manufacturing to an information society was ready to occur.

This buildup was not really a sudden one. It has been occurring throughout the last fifty years or so. I believe that the decline in the figures on capacity utilization for the United States captures this change very well.

Note in the accompanying chart that capacity utilization continues to decline throughout the whole period since the late 1960s. Obviously, cycles in this measure took place that were related to the various recessions occurring during the time span, but each new peak in capacity utilization never exceeds the peak it had reached in the previous cycle.

This, I believe, captures the changing nature of the United States economy and the movement from the foundational base of the Manufacturing Age to the growing impact of information technology and the Information Age. The conclusion that can be drawn from this is that the United States economy is not going back to where it was. But, this will take time.

Let me just point out three important factors that are playing a huge role in this change: evolving technologies, changing structure of the labor market, and the rise of the emerging nations.

First, the core of American commerce is not going to be manufacturing as we have known it. The future belongs to information technology, biotechnology, and knowledge. For the government to attempt to “force” workers back into jobs they held in the manufacturing world is just going to postpone the changes that WILL take place and threatens the stability of the society by re-establishing the inflationary environment of the last fifty years.

Second, the age of the labor union is past: non-public sector labor unions are legacy. There was a time when labor unions were needed to temper the pressures and demands of the industrial age of the large corporation who needed large numbers of physical laborers. These unions now compose less than half the union population in America yet have an over-sized impact on the politics of the country. In the next fifty years, the importance of the labor union is going to decline, economically and politically, as the United States moves from the manufacturing base that has dominated the last fifty years into the Information Age described in the previous paragraph.

Third, the United States, although it will remain the number one economic and military power in the world, is going to see its relative position in the world decline. The reason is that major emerging nations are beginning to feel their power and exert it. The immediate group of nations that come to mind are the BRICs. But, there are others. China, as we well know, is starting to exert its influence throughout the world. We see Brazil directly challenge America in the World Trade Organization concerning tariffs and subsidies. (See “Tax Move by Brazil Risks US Trade War”: http://www.ft.com/cms/s/0/dbf4284c-2afa-11df-886b-00144feabdc0.html.) And, more of this is to come! This is going to provide its own pressure for the economic structure of the United States to change.

These adjustments are going to take time. There will be substantial pain for those of working age who are not trained or educated for the new era. I believe that even the number of underemployed, 16%-17% of the work force, under-estimates the structural problem that exists. Thus, the estimate of 11 million new jobs that are now needed in the economy to get us back to where we were before the Great Recession began also under-states the problem.

Investment-wise, just as in the 1950s, the whole structure of opportunities available is changing from the earlier age. But, one needs to consider the new format of the economy that is evolving out of the manufacturing age in developing ones portfolio strategy. Similar to the 1930s, the 2000s are producing a modernization of the United States that will alter the world as it has been known and will produce a world that we can’t even hardly imagine yet.

Regulation and Information--Part B

In my previous post, “Regulation and Information—Part A” I argued that banking and finance has become nothing more than information, and in this Age of Information, money and finance have just become the movement of 0s and 1s. As a consequence, finance has gotten away from people and physical assets and paper money and other forms of wealth, like gold, and just become bits of information that can be “diced and sliced” every which way and that can be bought and sold worldwide.

This post, as promised, has to do with my ideas about the possibilities for the regulation of banking and financial institutions. I will post a Part C tomorrow.

First, I need to explain a little bit about where I am coming from. I call myself an “Information Libertarian”. I believe that history shows that information spreads and cannot be contained. Its spread can be slowed down for a while, by governments or religious bodies for example, but eventually the spread of information wins out. As an Information Libertarian, I believe that it is my responsibility to help speed along the spread of information and, where this spread is being contested or resisted, help to unlock the doors that is keeping information bottled up.

To me, information must see the light of day so that it can be tested, used, and lead to the discovery of more information. In this way false information, information not allowed to change, and other constraints on the problem solving and decision making capabilities of humans can be seen for what they are and transcended.

Rules and regulations in the past have tended to rely too much on what I would call “the achievement of outcomes” and not enough on the “process of how things are being done.”

Reliance on “outcomes” focuses upon the wrong things and is very expensive for those being regulated as well as for those that are doing the regulating. The reason: if there is sufficient incentive for the regulated to do the thing being regulated, it will get done in one way or another, in spite of the regulation. This was the essence of the quote by John Bogle, the founder and former chief executive officer of the Vanguard Group, in my post of January 19 (see http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations). Bogle stated that “There are few regulations that smart, motivated, targets cannot evade.” This was a part of what I was attempting to say in Part A of my discussion of regulation and information: the means of evading regulations has become sophisticated and easier in this Age of Information.

Also the cost of regulating in such an environment has increased substantially. The talent and skill required, along with the necessary patience and persistence of the regulator has gone up exponentially. In my experience, the regulator is ALWAYS behind the industry in knowing and understanding what is going on. How far behind they are varies from situation to situation and is a constant concern. But, you can rest assured that the regulators are behind the regulated.

As I have written in previous posts, the big banks have once more jumped ahead of the regulators in the past year as these banking giants have gained strength. Nothing has helped them more than the subsidy the Federal Reserve has given them by maintaining short term interest rates at such low levels: the Fed has given them “the gift that keeps on giving.” Not only have these banks regained health, they have moved way ahead of the regulators who have been dealing with all the problem small- and medium-sized banks and the squabbles takikng place in Washington, D. C. over how the banks and other financial institutions should be regulated.

This is the problem of focusing on “outcomes.”

I have argued over and over in earlier posts that banks and other financial institutions need to be subject to greater openness and transparency. This is consistent with my views on the need for information to spread and is consistent with my views on what kind of regulation can achieve some degree of success. It is also consistent with the idea that laws and regulations should focus on “process” and not “outcomes.”

Making banks and other financial institutions open up their books and causing their operations to be more transparent is the only way that I can see, in this Age of Information, to effectively have some impact on the behavior of these organizations. Having to report accurately and often to not only the regulators but also to shareholders as well as the public in general is the only way to be able to have some impact on them over time. The idea is that if they can’t hide what they are doing they will be a little more careful about what actions they take.

I cannot buy the argument that financial institutions need to keep their information on customers or what they are doing proprietary for if they don’t their spreads will go away. We saw what a disaster this was in terms of Long Term Capital Management. To me, the running of a financial institution is like coaching a football team: everyone knows the plays; the winning team is usually the one that executes the best or is the luckiest. Everyone knew what Long Term Capital Management was doing and others mimicked them. When things went the wrong way everyone tried to exit at the same time. Sounds like the subprime mortgage market doesn’t it?

I have also been a constant proponent of “mark-to-market” accounting. Let me describe to you how I see this tool. Banks, and other financial institutions, take risks. In order to achieve a few more basis points return over competitors, executives have either taken on assets that are a little riskier than they did before, or, mismatch the maturities of assets and liabilities a little more than they did. Shouldn’t we the regulators, the investors, the depositors, the analysts know this?

They, the bankers, have taken the interest rate risk and the credit risk and should be held accountable. To me it is childish for the bankers to “cry foul” when the market goes against them saying that it is unfair to force them to recognize the mismatched position they have taken. They are the ones that took the risk, they should be held accountable for doing so. They get the credit when things go well. Shouldn’t they be called on the carpet when things go the other way? If you know you might get caught, should you go ahead and do something?

In this case, maybe the bankers need to present two sets of books. One set to show what the value of the assets are if they (the assets) are held to maturity. Another set of books to reflect actual market values. The crucial thing is that the current real position of the bank needs to be “owned” by those running the bank.

The point is that if a management doesn’t want the public and the regulators to know that they have taken excessive risks, then they shouldn’t take the excessive risks.

In the Age of Information, the probability that people will find out what you are doing, particularly if you have some prominence, is higher than before and is increasing every day. We have just seen what can happen when some prominent person lives a life all out of character with who people thought he was. And, the fall has been pretty substantial.

Again, if this person didn’t want us to find out about his extra-curricular activities, he shouldn’t have pursued them. Simple as that!

The objective in requiring openness and transparency in reporting financial data is to say to people “before the fact”: if you take on too much risk or run your business in a careless manner, we will call you out on it. The “we” stands for investors, depositors, or regulators. The financial position of a bank or a financial institution should be “out-in-the-open” in great detail and the analysis of investors and regulators should be shared. If the bankers know they may be exposed then maybe the banks will attack their problems sooner rather than later.

The Special Case of Financial Institutions

In my last post, “Good Management Never Goes Out of Style”, I discussed what I believe to lie at the foundation of good management. The primary emphasis of this argument is that good management focuses upon what helped to create any competitive advantage it might have and maintains that focus over the longer run. In order to do this, good management must obtain good talent and then give the good talent the room and authority to put that talent to work. Good management facilitates good talent by creating a culture of high performance while keeping the focus of the business on what can sustain the competitive advantage of the firm.

Competitive advantage produces exceptional returns but these returns are difficult to sustain because potential competitors, seeing the exceptional returns, attempt to duplicate the results and aggressive market response reduces the firms’ advantage and drives down returns. In some instances, the firm with the competitive advantage may be able to sustain competitive advantage. However, the company may not be able to sustain the competitive advantage…in many cases, it is just not possible. In such cases the only really effective action management can take is to become very efficient and reduce expense ratios.

One recognizes when these foundational principles are being neglected when firms resort to gimmicks to achieve performance. In the last post I mentioned two such gimmicks: increased leverage and the mismatching of maturities. There are many other gimmicks that can be used such as assuming additional risk, accounting tricks (hello Enron), attempts at diversification, and secrecy. As I argued, these efforts generally represent an attempt to force results and come about either from greed or hubris or both. Because they are forced and are not related to basic underlying market realities they eventually fail, often at great cost. Arguing that the world has changed and that this world-change requires new standards only lasts for so long. Losing or changing focus may produce results in the short run but it never succeeds in the longer run.

Financial institutions represent a special case that needs to be discussed separately. The reason for this is that financial institutions are generally intermediaries and therefore depend upon the two ends of the market that they intermediate. The commercial bank is the prime example of an intermediary for historically a commercial bank took small deposits from relatively small economic units that didn’t have any alternatives to depositing it’s funds in the bank, and made large loans to larger economic units that needed the funds to run their businesses. As a consequence of the nature of the business, a commercial bank was grounded in its local or regional economy. Only a few borrowers had a national presence.

This dependency started to break up in the 1960s. Bank borrowers got larger and larger and demanded larger and larger loans. Financial markets developed so that these larger borrowers found that they had more sources of funds than before. In order to support these borrowers, commercial banks had to create new instruments to raise the funds they needed to meet the changing conditions. Commercial banks began to innovate and the result was the large negotiable Certificate of Deposit and the Eurodollar markets. These markets were large and deep, sufficiently so that commercial banks could buy or sell all the funds they wanted to at the going market interest rate. (In the terms of the economist, the supply curve of funds became perfectly elastic.) “Liability Management” was created! Now banks were only limited in their size by their capital base. And, commercial banks could become truly international!

The large customers of the banks found that their sources of funds became more elastically supplied and hence their demand for funds from their commercial banks became more elastic. Bank spreads declined!

Competition worked! Now the race was on! The rest is history!

The problem with innovation in financial markets is that finance is just about information…and the marginal cost of creating more and more information is very, very low. (For an example of this idea see “Information Markets: What Businesses Can Learn from Financial Innovation” by Wilhelm and Downing, Harvard Business School Press, 2001.) Consequently, information can be cut up in many, many different ways. The primary example of this is the Mortgage Backed Security that allows mortgages to be cut up into tranches, including toxic waste, into interest only securities, principal only securities, or any other way that might be thought of and sold.

Thus, financial innovation in making financial more efficient narrows spreads as the supplies of funds becomes more and more elastic…people can buy and sell as much as they want without affecting the price of the funds they are buying or selling. But, in such markets, leverage can become infinite! And, how do people then make money? Well, they must find mismatches…mismatches in risk, mismatches in maturities, mismatches in information, mismatches in timing. There becomes no limit to gimmicks.

We have seen two types of responses to this. First, there was an increase in secrecy. With spreads narrowing it becomes imperative that others not know what you are doing. Long Term Capital Management was noted for its attempts to keep secret what it was doing. The reason…if others know what you are doing the spreads narrow even more. (Three cheers for competition!) Another way to increase secrecy was to put things “off-balance sheet”. In this way institutions could get away with smaller capital bases and riskier business than if they kept these assets “on” the balance sheet.

The second type of response is to review your business model. This is an appropriate thing to do, but in changing ones business model one must be careful about whether or not the change really builds a different business model or not. Financial institutions responded to declining interest rate spreads by cultivating the “fee-based” business model. It can be argued that this effort really did not change the nature of the business but just shifted business. If I create the mortgage, I can then sell the mortgage for a fee. Another institution can package mortgages and get a fee for that. And, another organization can service the mortgages and get a fee for that. And, another institution can…. And, so on and so on.

In this example, the financial business has not changed…just different pieces of the package have been shifted around…and risk is located somewhere else out in the world, someplace no one knows where.

A business model can be changed in a way that can create value. This is what I think the financial services industry is going to have to do. The financial institutions industry is not the only industry that is facing massive changes in this Information Age. When it becomes nearly costless to create information, the old business loses relevance and must find a new way to create value. The question for management becomes, “What is it about what I do that I can, at least initially, create a competitive advantage?”

The follow up question becomes, “After I create the initial competitive advantage, what do I do next?” We see in the case of Information Goods that time pacing becomes extremely important. I tell the young IT entrepreneurs that I work with, “It is all fine and good that you have captured a niche in the market but you must already be planning the next generation of the product or the new, new product that you will bring to market.” Modern technology produces such an environment.

What does this mean for the management of financial institutions? That is for the future to determine. I have my own ideas. But, another question is…and this is just as important…what does this mean for the regulation of financial institutions? In building new financial regulation in this Information Age we cannot just fight the past wars…especially the wars we are now engaged in. That, of course, is the hardest thing for the Government…both the President and Congress…to do! It is going to be an interesting ride.