Talentless talent: Let's Outsource Financial Executives

Perhaps the most amazing thing about the AIG bonus scandal is the claim that it takes big bucks to retain top talent. Talent!? They ran a perfectly good insurance company into bailout-ville! With that kind of talent, who would be considered a talentless hack?

I suggest that we (the taxpayers and now the majority owners of AIG) outsource AIG's executive positions to India and China. If some poor schlub makes $20/hr. and produces goods worth $30/hr., he'll be let go if someone else (in a foreign land or perhaps Buffalo) can produce $20/hr. worth for compensation of $9/hr. After all, $20-$9 = $11 which is clearly > $30-$20 = $10.

Shouldn't the same reasoning hold for financial executives? Now here me out. If executives lose, say $100 billion, and get paid, say, $1 billion, shouldn't we be happy to outsource the position and pay maybe $100 million for somebody who will only lose $50 billion?

Let's take this a step further. It is probably pretty hard to make a profit because of competition and all that. But it should be pretty easy to break even. Not much "talent" at all in that. I bet that at $500k or a million a year (if Obama's tax on the rich goes through) there would be an ample supply of people talented enough to break even, a far superior outcome compared to the present.

In fact, I wish I were authorized to start taking applications or even drawing randomly from a qualified pool ... I would *love* to test this out in practice. I wouldn't want to take any random person -- we could end up with a Jerry Spring guest or Paris Hilton for goodness sake -- but say any random MBA from a top 25 business school. I would bet good money that s/he could outperform the current crop of top financial executives on a salary-adjusted basis. And that is all that matters, right?

Double Dip Recession

I know, I know it is a little early to call the end of the recession, much less the next one. But hear me out. The government's massive monetary and fiscal stimulus must raise output, at least the way the government calculates it. With the appropriate lag, the economy will grow again. The recovery will be a weak one, however, without robust job growth. Then a bout of inflation and the Obama administration's tinkering with taxes, health care, etc. will cause uncertainty that will put the economy back into a tailspin. The only question is whether this will play out before the mid-term elections or not and how voters will respond.

For history buffs out there, I'm using the Great Depression as a model here. We may someday speak of the "Obama Recession" in the same way we mention the "Roosevelt Recession" of 1937-38 today. As most people don't remember the Roosevelt Recession, which gets lumped with the downturn of 1929-1933 and blamed on Herbert Hoover, the stock market crash, investment banks, etc., the Obama administration may not see this as a big risk. He is already setting us up for this by his repeated insistence that he "inherited this mess." It's nice to have a shrewd thinker in office for a change!

Review of Hamilton's Curse by Thomas J. DiLorenzo

The subtitle of Hamilton's Curse by Thomas J. DiLorenzo (TJD) is ominous: "How Jefferson's Archenemy Betrayed the American Revolution -- and What It Means for Americans Today." According to TJD, Hamilton wanted a big, powerful government and a massive perpetual national debt and Jefferson wanted a small, limited one that would quickly eradicate the debt it took on during the Revolution. Jefferson was a free trader too, and knew that laissez-faire policies were "the surest route to peace and prosperity" (3). Hamilton, by contrast, believed "that government is best which governs most" (3). Unfortunately, from TJD's hyper-libertarian point of view, Hamilton won so today we live in Hamilton's world while we pay lip service to Jefferson.

I'm sorry, but this is a load of baloney. TJD would know that if he had bothered to read any of my work, including Hamilton Unbound, The First Wall Street, Financial Founding Fathers, or One Nation Under Debt, all available at Amazon. Instead, he bashes Chernow's well-written but economically un-astute recent biography of Hamilton, my review of which can be read here. TJD dismisses the claims of Hamilton scholars (but, tellingly, not me or Richard Sylla) that Hamilton created U.S. capitalism as "absurd" without actually rebutting them (5). And instead of trying to understand what Hamilton was trying to accomplish, he leans on the hoary caricatures of Hamilton as a protectionist (high tariff) and interventionist that have led in recent years to the lamentable use of Hamilton's name by the Brookings Institution (a leading liberal think tank), William Kristol (neocon editor), and Pat Buchanan (a so-called paleocon)!

Far from being "the champion of the Leviathan State" (9), Hamilton was a libertarian mugged by reality. He learned from hard experience that a limp-wristed state was just as big a threat to liberty as an autocracy. He therefore sought to create a vigorous government that could protect life, liberty, and property. But that is where he drew the line, and that is the right place to draw it. He wanted privately owned and operated banks, insurers, factories, even roads and bridges. He did not espouse the creation of a social safety net, income taxes, or free floating government fiat paper money.

As I argue in One Nation Under Debt, Hamilton wanted a government that was big only compared to what Jefferson wanted. Compared to today's behemoth, he wanted a tiny government, Jefferson a teensy one. Both would be with Ron Paul today. This is why TJD has to claim that it took "the relentless efforts of generations of his political heirs to install Hamiltonianism for good in this country" (7). Hamilton, by this definition, was no Hamiltonian! Again, TJD confuses what Hamilton really wanted with the use that others later made of his name. If TJD would have taken the time to read the original sources, or at least the relevant secondary literature (see above), he would have seen this and found a more appropriate scapegoat for his well justified abhorrence of the status quo.

In order to scapegoat Hamilton, TJD distorts the historical record severely. He calls this poor orphaned bastard (literally meant) from the West Indies "an aristocratic New Yorker," denies solid evidence of his abolitionist sentiments, and tosses around character aspersions like hand grenades. Worst of all, in my view, TJD grossly misunderstands Hamilton's view of the national debt. Hamilton did not champion "the creation of a large national debt" (p. 40), a large national debt was thrust upon him as Treasury Secretary. Where he differed with Jefferson was in how quickly to pay it off. Jefferson wanted to do so very quickly, even if it damaged the economy with high taxes. Hamilton wanted to do so over several decades, to keep taxes at more reasonable levels, to help jump start the modernization of the financial system, and to keep the young nation united. TJD, like many writers, completely misses the amortization feature that Hamilton built into government bonds and the fact that he gave public creditors a significant "haircut" or interest rate reduction by paying only part of the sum owed in 6 percent bonds and the rest in 3 percent bonds and zeros that converted into 6 percent bonds a decade later!

In short, this book is more diatribe than history, more fiction than fact. Our government is too big, waaaaaay too big, and our current national debt is getting out of control. But it isn't Hamilton's fault any more than Jefferson's.

Does Anyone Pay Their Taxes?

Our nation's debt is now almost $11 t ... t ... ttt ... tttrillion dollars yet it is clear that many people in high places don't pay their full due in taxes. A fourth Obama pick has now been nailed for tax "avoision."

This suggests two things to me:

1) Maybe the Senate should swap places with the IRS. It seems to be awfully good at sniffing out tax problems. Or maybe Obama should nominate everyone who makes more than $200-250k per year for something that would require a Senate looky loo. At the rate the Senate finds problems, it could pay down a good chunk of the debt. (Po' folks probably also have tax issues but it just wouldn't be cost effective to find $50 here, $500 there. Plus, there are so many of us, especially now.)

2) Maybe, just maybe, our tax code is too complex? Maybe people, even highly trained CPAs, do make honest mistakes because the code is so ... well, like a huge ever changing inconsistent blob?

Too bad the Flat Taxers of the 1990s messed up by seeming to argue for regressive income taxation instead of massive tax simplification. Cutting out deductions (especially that horrible mortgage interest deduction ... on new mortgages anyway) would allow Obama to slash nominal rates while increasing the total tax haul. Not to mention freeing up millions of man (and woman) hours currently wasted on figuring out how much one's season basketball tickets can be deducted.

The End of Capitalism? Or the "Mixed" Model?

I keep running into people who claim that capitalism is dead, Chicago is destroyed (i.e. the pro market sentiments long espoused by economics and related faculty at the University of Chicago), markets have been shown to be as effectively debunked as communism, and so forth.

I must confess I don't follow. The financial crisis certainly did draw the status quo into question, but that status quo was far from a "free market." It was more like Mancur Olson's old society crippled by special interests. The crisis showed that a huge part of our economy was FUBAR (let's say "fouled up" beyond all recognition). Why was it FUBAR? Not due to market or political forces alone but rather both of them acting in concert. Fannie and Freddie were the epitome of that!

Other areas of the economy are also FUBAR and I'm happy to announce that it looks like I've found a publisher for a book exposing them. With luck and some good writing, maybe I will be able to get enough people's attention to stop the next meltdown. Maybe.

Madoff, Satyam, and Other Scams: An Historical View

“For many months, my friendless family have to a great extent felt the want of the most ordinary necessaries of life – many months without meat & strangers to a single comfort – nearly all of them upon sick beds – my own health much impaired, and my mind tortured all day and all night,” Peter Randolph Beverely to told his brother Robert in February 1820, in the aftermath of America’s worst financial panic to that time. Beverely and his family were far from alone. The Panic of 1819 had ushered in a recession replete with high urban unemployment, low land prices, and a crush of lawsuits mitigated only by stay laws. The Panic brought something else with it, too, an increase in moral hazard. Some people, like Beverely, scraped by under difficult circumstances. “A Thousand Hungry Rascals,” however, were driven to desperate measures, including defrauding investors and fellow entrepreneurs. “The sudden change of fortune in so large a portion of the community,” Norfolk merchant John Cowper observed, “must produce very injurious effects on Society, not only in their own industry lost, but the industry of an infinitely greater number, who depended on them for employment. Men who have been accustomed to active lives, suddenly thrown out of employment, become at first depressed, afterwords desperate.” That desperation, he reasoned, much like a modern economist, would increase fraud and other disreputable activities.

As the economy worsens, be on the look out for desperate scams!

What in tarnations was Michael Steele trying to say?

I see that Keith Olbermann (who until recently I thought was a made up Saturday Night Live character), Jon Stewart, and other news comedians are making fun of Michael S. Steele, the chairman of the RNC, for completely flubbing the distinction between a "job" and "make work." Steele clearly botched the explanation but I'm blogging more to complain about the fact that everybody on the Left is either ignorant of the distinction he was trying to make or refuses to acknowledge it.

If I may ... he was trying to say ...
A "job" exists when an individual creates more value than s/he receives in compensation. The excess value s/he creates is shared with consumers, shareholders, and the government.

"Make work" exists when an individual creates less value than s/he receives in compensation. Private companies generally do not suffer "make work" for long (outside of executive ranks of course) because it comes directly out of the hides of shareholders, hence the layoffs that occur during economic downturns when many "jobs" become "make work."

Many of the positions that the stimulus bill will create (Steele apparently believes) will be of the "make work" variety. They will be created and will persist because the government wants them too, not because there is an economic reason for them to do, as with "jobs." The difference between the value created and the compensation paid is essentially welfare, a form of redistribution from taxpayers (and bondholders) to those hired on government projects.

Now, not all of the positions that the stimulus bill will create will be "make work." The infrastructure creation or maintenance jobs, for example, are NOT akin to digging a hole and filling it up again (the classic example of "make work"). On the other hand (my God, I'm becoming an economist!), most infrastructure projects would be best left to for-profit corporations. For more on this, see my recent paper with Brian Murphy, which can be downloaded for free here.

Moonlighting

At the behest of Jeffrey Pritchard, I posted about the causes and consequences of the financial crisis on AllFinancialMatters.com yesterday. Check it out!

Are Blasts from the Past Afoot?

Hyperbole to the contrary notwithstanding, the terrorist attacks on 9/11 did not change everything. Likewise, the Panic of 2008 will not change the fundamental facts of business. It may, however, dramatically change its face. In a topsy-turvy post-panic world your company’s biggest competitor might be a nimble newbie or a lucky small fry in just the right place at just the right time. The successful manager will know, as the Chinese do, that crisis spells opportunity as well as peril.

Some industries, like publishing, may be completely transformed in the next few years. Long on the ropes, newspapers and book publishers face dramatically declining revenues and a slew of new competitors, from bloggers to web videographers, free of traditional publishers’ costly overhead and antiquated distribution systems. Even college textbooks, long among the fattest of cash cows, may come under pressure from radical new business models like that of Flat World Knowledge, which claims it can make an adequate profit by giving textbooks away for free, online, without relying on advertising. Other long sagging and lagging industries, including construction, healthcare, higher education, and real estate, are also ripe for change.

The demise of the big investment banks has the potential to upend corporate finance, returning it to its roots. Startups may stay private longer and then go public via a direct public offering (or “OpenIPO”) facilitated by WR Hambrecht and Company instead of a traditional initial public offering underwritten by a bulge bracket investment bank. Direct public offerings were the norm in the United States before the Civil War and could become so again. Unlike intermediated IPOs where investment bankers set the selling price, modern DPOs use an auction process to discover the price at which all the offered shares will be purchased. The issuer is therefore never stuck holding unwanted shares and first day “pops” in the aftermarket are almost unheard of. DPOs are also considerably cheaper for issuers than IPOs.

Bond issuance and merger finance may also undergo major changes. Private placements have been an important part of corporate finance since the securities regulations of the Great Depression. In coming years they may become even more important because they will be easier for the remaining investment banks, small niche players called boutiques, to arrange than full blown public offerings. Boutiques will continue to offer M&A advice, but corporate law and accounting firms and commercial banks will certainly enter the vacuum created by the exit of the major investment banks.

For bank credit, smaller businesses may find it easier to turn to their local community banks or smaller regionals than to wait for the big boys’ balance sheets to improve. Community banks were largely untouched by the subprime mortgage mess and stand ready to lend to solid local businesses. Also, trade credit will probably make a comeback as businesses sitting on stashes of cash or with access to relatively cheap sources of external finance find it prudent to keep key suppliers or distributors afloat. As in the nineteenth century, credit may again cascade through the channels of trade, from the biggest, best, and oldest companies through their most important customers, clients, and suppliers to the small, weak, and new.

Insuring businesses against risks may also change in the next few years. Insurance companies did not take a direct hit from the subprime debacle – AIG failed due to risks taken at the holding company level, not because of losses at its operating companies. Nevertheless, the panic of 2008 clearly stressed many insurers already facing competition from new alternative risk transfer mechanisms (ARTM), including catastrophe and death bonds. Investors see much value in such bonds because they offer good returns that are not correlated with other financial markets, a clear virtue when almost everything else is down, as at present.

Adam Smith, Profitability, and Efficiency

“It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest,” Adam Smith wrote in The Wealth of Nations. “We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” True enough. The self-interest of profit maximization does keep us fed, clothed, sheltered, entertained, and much more besides. But profitability and economic efficiency are not always the same thing, and it is the latter that ultimately aids society. Profits, after all, can stem from sources other than efficiency, like rent seeking or market power, that are social bads.

For the last three decades or so, the general consensus was that markets could do no wrong and governments no right. Increasing numbers of people now realize, however, that some government agencies are economically efficient and some private businesses are not, though they may have been profitable for awhile. What matters, we are coming to realize, is not who owns or runs an organization but rather the structure of the market it operates in (competitive or monopoly at the extremes) and the degree to which internal incentive structures are aligned with the organization’s goals, as in the two by two matrix below.

Stereotypically, businesses inhabit the upper left quadrant, where competition and a high degree of internal incentive alignment ensure efficiency, while government agencies dwell in the lower right quadrant, the inefficient victims of monopoly and incentive misalignments. Some government agencies (and non-profits too), however, compete with other governments and/or private sector firms and have decent internal incentives. Think, for example, of the post office. Stockholder owned investment banks, by contrast, operated in markets that were less than fully competitive and had flawed internal incentives. Due to their market power and incentives they were profitable for a decade or so but ultimately their inefficiencies caught up with them, leaving society with the bill.

In the coming months and years, the government is likely to try to extend its purview, to regulate more aspects of the economy more thoroughly than hitherto. It may also try its hand at mortgage banking (via the remnants of Fannie and Freddie), commercial banking (via the Federal Reserve’s new lending powers), and maybe even automobile production. (If that sounds far-fetched, few before 1970 would have believed that the federal government would operate an extensive passenger railroad system for over three decades.) Rather than outright opposing such endeavors, American businesses would do well to use their expertise to try to move them as close to the upper left quadrant as possible. They would do well to try to move their own businesses in that direction as well, to fight their natural proclivity to create short-sighted incentive schemes and to strive for more market power. What ultimately matters for the economy is not jobs or profits but creating more output from the same input.