The Leveraging Strategy: Understanding the trends of the past 30 years

I was trying to close out some browser tabs I’ve had sitting around waiting to be read and got to this one:

http://slackwire.blogspot.com/2011/10/disgorge-cash.html

I’m not sure what linked me to that item, but it’s a good one. Basically, the writer provides a chart and sources that explain how, beginning around 1980, there was a shift in how corporate profits were distributed – from much of them being retained and re-invested, to being paid out or used for share buy-backs. The sources indicate that this occurred as a paradigm shift in the business environment away from CEOs and managers that were primarily interested in the business of the firm to those whose primary interest was providing “shareholder value.” How did this leadership vision change occur? Well, it coincides with the rise in CEO/executive pay (and the sources back this up). Basically, executives have been paid ever-more-generously to redirect profits and the leverage capacity of the firm to shareholders.

But aren’t we all shareholders, via 401k’s, etc? Yes – but remember that executives and board members receive most of their pay in the form of stock (for my company, the CEO’s annual income has been about 95% from the stock, 5% from salary). Golden parachutes are provided in stock. The largest portion of the “1%” is executives and managers. So this isn’t a case of benevolent redistribution – this change actually goes a long way in explaining the change in income growth trends (the 1% has received most of the real change in income since 1980, coincidentally enough, while the rest of earners have seen their income growth flattened).

Interestingly, the new trend indicates that firms are paying out more than 100% of profits (ie, firms are taking on debt and then using some of that to buy back shares and/or pay out dividends). Thus, when you see a chart indicating that the US experienced a debt-bubble (that we are now deleveraging from), it wasn’t just consumers using the equity balloon they saw in their house-value as an ATM (but, note that the house-valuation bubble was fueled by the debt bubble). No, the debt bubble may have actually started with businesses. And how did it then spread to consumers? The lower quintiles of earners don’t financial engineer their assets – they simply take what debt structures are available to them. The consumer debt bubble actually started via the 1%’ers applying their firm-leveraging strategy to their personal asset strategy as a tax-avoidance scheme. For instance, people who own millions in stock can avoid paying tax on their income from that stock by taking out loans against the asset value, selling only enough stock so as to service the debt. Thus, you see an increase in “consumer debt” – but an enormous fraction of the increase isn’t consumers buying 5x larger houses – rather, it arises via leverage strategies amongst the wealthiest.

Note that these leveraged piles of stock or other assets can be taxed at death. So what does the wealthy class call for? An elimination of “the death tax” – and they talk about million-dollar farms and widows to make their case, not billionaires and their children.

But there’s another dynamic here that this writer didn’t even remotely touch on. The coincidence of the negative trend in the US budget deficit – which essentially has been caused by the trade deficit – or in more straight-forward terms, the willingness of nations to push more of their capital into the US than goods and instruments they receive. This capital made leveraging strategies more “cheap” – and so the US govt decided it was a preferable “investment strategy” to spend more than its revenues because it could borrow cheaply – at least relative to the political benefits politicians received.

There are several factors for how this occurred. Possibly the largest was the stabilization of the dollar thanks to Paul Volker’s FED strategy for killing stagflation. The low-inflation FED policies that followed and the stability of the US economy and government allowed the dollar to resume its “reserve currency” status following the relative disruption of the 70’s.

All of this contributed to giving firms an ability to take on relatively cheap debt, too. But as the leverage ratios of firms increased, the stability of the firm came into question anytime the firm experienced market turbulence, whether the turbulence was the fault of the firm’s leadership or not. This increased instability encouraged the “mergers and acquisitions” environment that coincided – a larger firm tends to be more stable than two firms of half the size, even if it the larger firm retains all the same debt and structures. In practice, of course, larger firms are able to cut jobs in redundant divisions. The end result is that markets of 10 or 20 competitive firms employing many redundant employees became consolidated into 3-5 mega-firms that employed significantly fewer people to accomplish the same work – because competition was decreased. These larger firms have more capital resources than smaller firms, too, so are better able to engage in “globalization” strategies as well as replacing employees with automated systems (“technological unemployment,” which leads to forms of “Skill Biased Technological Change,” rising “wage inequality,” and a resulting dramatic difference in the unemployment rates between those with different levels of education (which has been one of the largest trends in the US economy over the past 15 years). Also, larger firms increase barriers-to-entry in markets, further decreasing innovation, competition, and opportunities for startups. Some will debate these points – but just ask yourself – are you more likely to achieve success opening your own restaurant in an area with established restaurants or opening a chain restaurant? Most people will go with aligning with the chain – and even that is very risky unless the new restaurant is sufficiently distinct from the existing ones.

And all of that can be seen as the result of decisions made by the 1% (or the “rentier class” – take your pick), from the way they manage firms, to the way they (as shareholders) demand firms behave, to the way they influence politics, banking policies, and financial products.

Does the fact that China’s willingness to buy US dollars and treasuries helps to enable this behavior let the 1%/rentier off the hook for their choices? No. It just helps shed light on the factors that influence these decisions. I would guess that the slightly lower borrowing rates for US firms that the dollar-as-a-reserve-currency allows is not the only factor that allows the leveraging strategy to work, since the strategy is executed in Europe and other nations as well. That said, it is hard not to wonder what Nixon was really doing in China while, at the same time, he was taking the dollar off the last remains of the gold standard. I can’t help but think that the larger plan, beyond just pushing countries like China toward market reforms, was to encourage the 3rd world to setup unbalanced trade with the US so as to offset any weakness of the dollar in a post-gold world. This is not to say that the move to close the gold window was a bad one – and, of course, the aftershocks of the move took a decade of painful intellectual and market adjustment. But if this pre-1980 part of the story is accurate, the leveraging strategy actually can be seen to have started as far back as 1970, with the Nixon administration executing it. I’ve tried to make the case that this matters – that the leveraging strategy is “bad” – in that it’s a kind of short-term-ism, leads to short-term-ism, and benefits the wealthy and rentier classes at the expense of the lower classes. So it is interesting if the Nixon administration truly engineered the initial aspects of it.

And that leads to the larger factor that probably explains why this shift happened. The leveraging strategy makes more sense in a culture with large income inequality. The more you have a wealthy, rentier class – and the more unencumbered by offsetting structures it is (unions, campaign finance rules, de-progressive taxation, free-market/low-tariff policies, tax shelter/tax-avoidance technologies, a robust financial sector, and, finally, popular movies and literature that preach self-interest and “greed is good” [ie: an in-group/out-group anti-communist culture]) – the more the leveraging strategy tempts otherwise “good” people. By “good” I mean people that are more interested in devoting their life’s work toward benefiting others rather than benefitting themselves. Even if you invent the iWhatever – no matter how beneficial the iWhatever is to the common man – if your pricing and compensation structures are such that the benefit you bring to society results in your own wealth rising to 10,000x that of even the average people living down the street from you, or the people who work with you in making the iWhatever – then the “good” you gave to others was outweighed by the “good” you were doing for yourself – and your net contribution to society is a negative, not a positive.

Wrapping it up. There’s an interesting confluence of preferences here. The Leverage Strategy can be seen to be in favor of all of these:

–          Low taxes

–          Free markets

–          Limited government

–          Indebted government

–          Tax avoidance schemes

–          Tax shelters / Offshore finance

–          Anti-Estate Taxes (eg Death Taxes)

–          “Ownership” and “Personal Responsibility” policies (ie, the stated ideology that the economy is better off when more people “own” their things) (ie, policies that place more risk on individuals [the “owners”])

–          Hard money – or at least “Sound money” (very low or zero inflation), no matter what

–          Anti-Union (pro “Right to work”)

–          Globalization  / Offshoring

–          Anti-standards (such as building codes – especially in your offshore factories)

–          “Structural Reform” (aka reduce employer obligations to worker’s and make it as easy as possible for employees to be terminated)

–          An unbalanced government budget (if it ever gets balanced, find stuff to increase spending or lower taxes – preferably on the wealthy)

  • (of course, you can’t declare that this is your policy preference – so during elections, talk about “balancing the budget” but don’t actually let it get balanced in practice)

–          Unrestricted campaign finance (the wealthy can’t drive policies in their favor unless they can use their money to influence policy)

–          Resist cultural change (once “Greed is good” and “Wealthy people deserve their wealth (if you like: because God favored them: Don’t Argue with God)” have cultural underpinnings, you need it to stay that way)

–          Public education isn’t that important (if you have wealth you can pay for whatever education you want, but for everyone else, education just enables them to question the status quo. Most workers don’t need an education since complicated jobs can be replaced with machines, computers, and robots. Besides, education ultimately costs money so increases wage demands – and consumes the time of potential workers, decreasing the labor pool, increasing wages.)

You could go on and on with this. But it’s pretty clear where each political party has aligned itself. In many cases, there are individuals and camps within a party that (at least outwardly) disagree with their party’s position on one or a few of these items. Recent political history seems to indicate that most of the time these policy deviances are either mere electioneering, or the politician becomes aligned (even if against their will) with party policies once in-office simply by exposing the politician to the party’s fund-raising electorate. And, no, the Libertarian Party is not really a distinct camp. These days it is simply the non-theocracy branch of the Republican party.

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About stormculture

In pursuit of reality.
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