MMT 4: Sectoral Accounting

July 6, 2018

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This is the fourth in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

“The family that pays together…”

During my college years, I used to look forward to seeing my hometown girlfriend when I came home at Christmastime. I’ll call her “Thelma” to protect her privacy in case she’s still trying to live down her association with me. One time when I was in her family’s kitchen, I noticed a posted sheet of paper that recorded all the borrowing and lending that had been going on among the children, probably related to Christmas shopping. So Thelma might have lent her brother Sam $5 when he was short of cash, and on other occasions Sam might have lent money to Dave, and  later he might have lent money to Thelma, and so it went. After Christmas, I imagine they totaled up all the debits and credits to see where everybody stood. My contribution was to write at the bottom of the sheet, “The family that pays together stays together,” much to the parents’ delight.

Let’s suppose that when we balance it all out, Thrifty Thelma has lent $100 more than she borrowed, Sam has come out even, and Deadbeat Dave has borrowed $100 more than he lent. So the financial balances are:

Thelma +100, Sam 0, Dave -100

Every debt creates an asset for someone and a liability for someone else, so the balances have to add to zero.

Oh, I left something out. Thelma’s Chinese friend Meili had a yard sale, at which Thelma bought $140 worth of stuff. She was short of cash because of all the Christmas shopping, so she gave Meili an I.O.U. for the debt. That changed Thelma’s balance from +100 to -40. If we include Meili in the accounting, we now get:

Thelma -40, Sam 0, Dave -100, Meili 140

Notice that not only do the balances add to zero, but the sum of the balances inside the family (-140) must offset Meili’s external balance (140).

Debt can easily be moved around. Thelma could offset her $40 debt by lending $40 to Sam, which would give us:

Thelma 0, Sam -40, Dave -100, Meili 140

Taking it a step further, Sam could now assume the remaining family debt by lending $100 to Dave:

Thelma 0, Sam -140, Dave 0, Meili 140

Oh, Oh, “Uncle” Sam has wound up in debt to the Chinese! And Sam could even create surpluses for everyone except himself by borrowing from Thelma and Dave:

Thelma 100, Sam -340, Dave 100, Meili 140

You can probably see where I’m going.

Sectoral surpluses and deficits

Sectoral accounting in Modern Monetary Theory distinguishes three economic sectors: government, private domestic, and external (relating to foreign countries). Each sector can be in surplus or deficit, and the three financial balances have to add up to zero. For every surplus, there must be a deficit, and vice versa.

The government’s financial balance is given by T – G, where T is taxes net of transfer payments and G is government spending. The balance is a surplus when T > G and a deficit when T < G .

The private domestic financial balance is given by S – I, where S is saving and I is investment. If all saving is spent on investment, there is no financial surplus, just an addition to real assets like factories. If S > I, the surplus accumulates as financial assets. If S < I, the deficit results in some liquidation of financial assets. S – I is also called Net Acquisition of Financial Assets (NAFA). S – I was also discussed as a leakage from spending in the last post, when I was analyzing how much of the national income goes into spending.

The external financial balance is given by -CAB, where CAB is the Current Account Balance. I defined that earlier as the difference between money flowing into the country and money flowing out of the country, taking into account both trade and investment income. We are accustomed to looking at this from the U.S. point of view, where a positive value would indicate a surplus in our favor. Now we have to reverse the sign, because we want a positive value to indicate a surplus in favor of foreign countries. This is just what I did when I expressed Thelma’s debt to Meili as Meili’s surplus. For the United States, CAB is negative because of the trade deficit, so the external financial balance is positive, representing a surplus held by foreigners.

This surplus is different in one respect from Meili’s surplus. She held Thelma’s I.O.U. for goods Thelma hadn’t yet paid for. The Chinese hold a surplus in dollars for goods Americans have paid for. Those dollars are a financial asset for them, but a liability for us, because they are claims against our economy that we “owe” them. The dollar itself is a kind of I.O.U., and that makes the Chinese our creditors and Americans their debtors.

With the sector balances defined that way, the three balances must add to zero:

(T – G) + (S + I) + (-CAB) = 0

This formula follows logically from the formulas for GNP and GNI given in the last post, but I’ll spare you the proof.

Here are recent estimates derived from the National Income and Product Accounts tables published by the U.S. Bureau of Economic Analysis. (The numbers are published quarterly and revised frequently.  They are annualized to estimate one year’s financial flows in billions of dollars.)

-1,022 + 609 + 413
(govt./private domestic/external)

The annual government deficit balances the private sector and foreign surpluses. The government takes on debt, while the private sector and foreign countries accumulate financial assets. Foreign investors now own about a third of the stock in U.S. companies, for example, and they got a nice financial windfall from the cut in corporate taxes.

Since the external sector has a surplus, the two internal balances must add up to a deficit just as large. And since both the external and private domestic sectors are in surplus, the government must have a deficit large enough to offset both of them.

Who should carry the debt burden?

Reducing the government’s debt burden requires either reducing the external trade imbalance or reducing the private sector’s surplus.

The United States would like to be more competitive in world markets, but there are several strong reasons why we aren’t:

  • As a country with a relatively high median income, we can afford to buy a lot from other countries.
  • The dollar is a strong currency on world markets. Other countries are willing to hold dollars and financial assets denominated in dollars, especially bonds issued by the U.S. Treasury.
  • Countries with low wages are able to produce more cheaply many products formerly made in America.
  • Some countries engage in unfair trading practices, although that is beyond the scope of the authors’ analysis.

Most of these will be very hard to change, even if we can agree they should be changed. Given that the external sector is in deficit from our point of view, and so has a surplus from the foreign perspective, which of our internal sectors should balance it with a deficit?

The text argues against allowing the private domestic sector to be in deficit:

We know that the private sector cannot sustain deficits permanently. This is because the flows of spending which deliver deficits have to be funded…. Private deficits ultimately manifest in an increasing stock of debt being held on the private sector’s balance sheet.

This process of debt accumulation is limited because at some point the susceptibility of the balance sheet to cyclical movements (for example, rising unemployment) increases and the risk of default rises….

In the long-term, the only sustainable position is for the private sector to be in surplus. An economy can absorb deviations around that position but only for short periods.

That leaves the government as the sector to take on deficits and debt accumulation. Unlike the private sector, government can sustain deficits because it has the power to create money when it spends beyond its tax revenue. I’ll describe the monetary operations by which it does that in the next post. Like Sam in my family example, government assumes the burden of debt so that the other sectors can maintain and grow their financial assets.

Under these conditions, regularly balanced budgets are hard to imagine. Not only would they reduce GNP, national income, consumption and saving, as discussed earlier; but they would force the private sector to incur annual deficits about as large as our trade imbalance, constantly shrinking our financial assets.

American society has done a useful—and maybe at least temporarily unavoidable—thing by piling its debts onto the entity most able to sustain them. That has enabled private wealth to keep flowing—to the rich anyway—even as our manufacturing declined and our global competitive position worsened. That’s one way to keep an economy growing, albeit at a sluggish rate with little gain for most workers.

Mutual dependency

Sectoral accounting reveals just how much creditors and debtors are mutually interdependent. If debtors want to spend more than their current income, they need creditors. If creditors want to acquire financial assets, they need debtors to accept the corresponding liabilities. In foreign relations, the U.S. is the debtor and our trading partners are, on average, the creditors. In domestic sector relations, the public sector is the debtor and the private sector is the creditor.

If we are to blame one side or the other, which side should it be? If debt is the fault of the deadbeat debtor, then we should be beating up on the United States for being a debtor nation, instead of attacking our trading partners for selling us more than we sell them. If debt is the fault of the predatory lender, then we should be angry at the private sector for accumulating assets, not at the public sector for accepting the liabilities. Who is doing whom a favor here?

Government is not some kind of alien invader or colonial power that preys on the “free market.” By giving in to the demands of assertive constituencies, government runs up the debts that become financial assets for someone in the private sphere. These include demands for high transfer payments from the elderly and the poor, demands for low taxes from corporations and the wealthy, and demands for the world’s highest military spending from the military industrial complex.

Too much of a good thing?

I think the text makes a pretty strong case that public debt is more sustainable than private debt, and that public deficits can stimulate the private sector. The authors would actually like to see more such stimulus, through government spending aimed at putting more people to work.

But this analysis also got me thinking about something the text does not discuss. If public deficits are not as bad as we’ve been led to believe, is it also possible that private surpluses are not as good as we’ve been led to believe? The private sector is better off running surpluses than deficits, yes, but is there any limit to how big the surpluses should be, especially when the financial assets are going primarily to make the rich richer?

I’m not worried about the government running out of money, because technically a government that controls its own currency never has to. I am more worried that a large pile of surplus capital not invested in productive assets supports a booming, high-flying financial sector that engages in too much speculation. In a worst-case scenario, business investment is flat, and the economy is growing only because of government’s deficit spending. Income, consumption and saving are rising, but the growing gap between S and I indicates a growth of surplus capital. Capital always seeks a good return, and if businesses aren’t investing enough to provide it, capitalists are tempted to resort to financial speculation. Financial firms can raise money selling “junk bonds” promising high interest rates, then use the money to buy up existing companies not to expand them, but to loot them of their assets or flip them for a quick profit. Banks can make risky mortgage loans to unqualified buyers, but then package them and pass them off as AAA-safe investments. Speculation can take many forms. But when it becomes rampant and people lose confidence in the value of financial assets, bubbles burst and financial crises occur.

We know what a financial crisis looks like because we have recently lived through one. Have the underlying dynamics of our economy changed very much since then?

Continued


Glass House (part 2)

April 5, 2017

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Yesterday I gave an overview of Brian Alexander’s Glass House, his story of the economic decline of Lancaster, Ohio. Today I will fill in some of the details about the decline of its principal employer, the Anchor Hocking glass company.

First, a word of caution. The financial wheeling and dealing that helped bring down Anchor Hocking is very complicated and sometimes shrouded in secrecy. Alexander is not an economist or CPA, so he has to rely primarily on the stories told by his informants to make sense of it all. What he does have going for him is that he is a good journalist, he digs deep into the information available to him, and he knows the town of Lancaster well, having grown up there himself. Ultimately, we cannot know what would have happened to businesses like Anchor Hocking if they hadn’t been targeted by other companies as sources of quick profits. However, I think Alexander makes a pretty good case that the leveraged buyouts and revolving door of owners did more harm than good.

Newell

The first company to acquire Anchor Hocking in a leveraged buyout (in 1987) was Newell Corporation, a maker of household goods like window shades and hardware. The good news is that Newell’s management “introduced a few needed modern efficiencies and systems that Anchor Hocking had neglected–like data and accounting techniques, order tracking, customer service methods.” They succeeded for a time in making Anchor Hocking more profitable. On the downside, they sold off some parts of the company and eliminated an important segment of Lancaster’s leadership by bringing in outside executives who didn’t reside in the town. They persuaded local authorities to take money away from public schools in order to finance tax breaks. They were also harder on workers, eliminating training opportunities and quickly firing those who didn’t hit performance targets.

The larger problem was that Newell was becoming financially overextended because of its continuing acquisitions. Its merger with Rubbermaid in 1999 “nearly killed the company,” because Rubbermaid was in such bad shape and the deal left Newell with such a debt burden. Newell no longer wanted to put any money into Anchor Hocking for maintenance or improvements. It sold off the company in 2004, one year after getting the tax breaks from the town.

Cerberus

Anchor Hocking’s next owner was the private equity firm Cerberus. Its business was buying and selling companies, not manufacturing as such.  Here things get a little complicated. Cerberus formed a new company, Global Home Products Investors, LLC, to buy Anchor Hocking and two other businesses from Newell. Global Home Products borrowed most of the money it needed to make the buys, meaning that it and not Cerberus bore the cost of the acquisitions. To make things more confusing, it borrowed a lot of the money from a Cerberus affiliate, so that Cerberus made money by lending to GHP, its own creation. That also meant that “Anchor’s cash flow wound up supporting the structure of Global Home Products [and ultimately Cerberus], and because of that it starved.”

Anchor was still profitable, but GHP’s need to get money out without putting much in soon began to hurt the company. Maintenance was neglected; quality suffered; cash flow deteriorated; and the retirement plan was underfunded. After a while Anchor Hocking wasn’t even paying some of its suppliers. In 2007, after only two years in business, Global Home Products filed for bankruptcy. The bankruptcy proceedings were contentious, but in the end GHP’s lenders got paid, while the pension plan lost millions and retirees lost medical benefits.

“Meanwhile, Cerberus continued to thrive. As of mid-2016, Cerberus was one of the largest private equity firms in the world, with more than $30 billion under management, and [founder and manager] Stephen Feinberg was named as one of Donald Trump’s key economic advisers.” Trump, of course, also knows something about continuing to thrive while taking his acquisitions into bankruptcy.

Monomoy

As a result of GHP’s bankruptcy, Anchor Hocking was sold at auction to the sole bidder, Monomoy Capital Partners. That was an investment fund controlled by the private equity firm Monomoy. As with the Cerberus deal, the purchase was made with mostly borrowed money. The deal was structured so that the debt was incurred by Anchor Hocking rather than by Monomoy.

Monomoy’s intention was to manage Anchor Hocking for a couple of years and then sell it at a profit. Most of what Monomoy did “followed the standard private equity playbook: jawbone the unions, cut costs even at the price of damaging longer-term success, do a sale-leaseback of real property assets, take whatever public money you can get from communities eager to save their industries…and collect fees.” The sale-leaseback occurred when Monomoy sold Anchor Hocking’s distribution center for a quick $23 million, a “shortcut to make the company look profitable, though at the price of a twenty-year lease.”

Before Monomoy could sell Anchor Hocking, the financial crisis intervened, discouraging lending and putting a chill on leveraged buyouts.  Still stuck with a company it didn’t want to keep, Monomoy took cash out in 2009 by resorting to a “dividend recapitalization.” “Monomoy had Anchor Hocking borrow $45 million. Anchor then paid Monomoy Capital Partners, LP, $30.5 million as a dividend.”

In 2012, Monomoy merged Anchor Hocking with Oneida, another troubled company that it owned, naming the combined company EveryWare Global. In 2013, Monomoy sold a minority share of EveryWare Global to a special purpose acquisition company controlled by the Clinton hedge fund. Most of the money for this purchase was also borrowed, and that too became part of EveryWare’s debt. At this point, “EveryWare Global was drowning in over $400 million in liabilities. It possessed just over $100 million in total assets.”

As the excessive debt strained EveryWare’s cash flow, Monomoy threatened to shut down Anchor Hocking unless the union agreed to a deal: Monomoy would give the company a cash infusion of $20 million, but the workers would accept lower wages, an end to company contributions to retirement plans, and higher insurance premiums. The unions accepted the ultimatum in the summer of 2014. Despite those concessions, EveryWare declared bankruptcy in 2015. This time, the lenders took over the company. They appointed a “turnaround board” of bankers and other glass industry outsiders to fix up the company for sale, like a rundown house.

The losses were hardly distributed evenly. Alexander concludes:

From the standpoint of a private equity firm, it was a success. Like a lucky old lady hitting a slot in Reno, Monomoy put a little money in and pulled a wagonload of money out.
….
Monomoy sent what was left of Lancaster’s once-grand, 110-year-old employer into bankruptcy court while it made off with millions and the employees walked their wages and benefits backwards in time. Lancaster’s social contract had been smashed into mean little shards by the slow-motion terrorism of pirate capitalism.

Continued


Glass House

April 4, 2017

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Brian Alexander. Glass House: The 1% Economy and the Shattering of the All-American Town. New York: St. Martin’s Press, 2017.

Ask any American why so many manufacturing plants have been closing across the United States, and the answer you will probably get is that they moved to Mexico, or their products couldn’t compete with Chinese imports. Brian Alexander doesn’t deny the role of globalization and foreign competition in the decline of a Midwestern manufacturing town, but he has a different story to tell. It’s a story that is more about the workings of the domestic economy in an era of extreme inequality. Playing a prominent role in this story are private equity firms that buy and sell companies for short-term gain, finding ways to profit even at the expense of the acquired companies themselves and the communities where they are located.

An “all-American town”

The setting for Alexander’s story is Lancaster, Ohio, a manufacturing town that flourished in the decades after World War II. In 1947 it was celebrated by Forbes magazine as the “epitome and apogee of the American free enterprise system” (in Alexander’s words). Its largest employer was the Anchor Hocking glass company, formed by the 1937 merger of Hocking Glass and Anchor Cap and Closure. It was one of the biggest American companies to be located in a small town. “By the late 1960s, it was the world’s leading manufacturer of glass tableware, the second-largest maker of glass containers–beer bottles, baby food jars, coffee jars, liquor bottles–and employed more than five thousand people in Lancaster, a town of about twenty-nine thousand back then.” This was the era when a young man could graduate from high school, join the union, and make good enough money to support a family at a middle-class standard of living. Production and consumption worked together in a virtuous cycle: The workers, who in the 1940s included many returning GIs, “were marrying, setting up house, and having babies. And they needed glass: glass dishes glass tumblers, glass cookware, glass jars.”

Managers and laborers didn’t always see eye to eye, but they lived in the same town, grew up attending the same public schools, made friends across class lines, and shared some civic pride. Wives, who were less likely to be employed, devoted themselves to civic causes for the betterment of the community.  While emphasizing Lancaster’s general harmony and community spirit, Alexander does not overlook the flaws. The small minority of African Americans in town “were treated as barely tolerated guests” and confined to the lowest jobs.

Perils of private equity

By the 1980s, Anchor Hocking was facing some new economic challenges. Aluminum cans and plastic bottles were replacing a lot of glassware. Large discount retailers like Walmart were pushing suppliers to lower prices. Global commerce was increasing, and America’s strong dollar was making imports relatively cheap and exports relatively expensive. Nevertheless, few analysts were ready to give up on the company. Because glassware is breakable and often heavy, it isn’t the easiest product to import. Anchor Hocking also had the advantage of experience and versatility. “No other company made glass using as many different processes, or had as many different products sold to retailers, the food service industry, candlemakers, florists, winemakers, and distillers.”

Anchor Hocking remained profitable, but its declining revenues made it a target for takeover bids. Other companies, especially private equity firms, saw an opportunity to buy Anchor Hocking at a reasonable price, make some changes to boost profitability, and then sell it for a quick gain. In theory, such a takeover could be a win-win for everybody–the firm that makes the acquisition, the investors or lenders who finance it, and the employees of the company acquired. The trouble is that the acquiring firm can arrange things so that it can get more out than it puts in, even if the acquired company continues to do poorly. In fact, the acquiring firm’s quest for short-term profits can actually impede long-term growth and help it do poorly.

Private equity firms have a number of techniques for maximizing gains for themselves while imposing risks and costs on others. They acquire businesses by borrowing other people’s money, but structure the deal so that the debt is carried by the company acquired. Much of that company’s revenue then has to go to debt payments rather than to investments in future performance. New owners looking for quick profits may relentlessly cut costs by cutting wages, skimping on maintenance and training, or underfunding retirement plans. Product quality, worker morale and customer loyalty may suffer.  They may sell off assets and then have the company lease them back, producing a short-term gain at the expense of a longer-term cost. Private equity firms can also charge acquired companies high fees for advising them on what to do. Even if the acquired company has to declare bankruptcy–and Anchor Hocking did it twice–the private equity firm will have taken out more than it put in, leaving any losses to be borne by workers, retirees or other investors.

No wonder that the critics of private equity firms have viewed them as “chain-saw cowboys who slashed employment, cut investment, and shut down marketing and research–all in order to goose the bottom line just long enough to foist a shiny, but hollowed-out and highly indebted, company onto new buyers and then count their money on the helicopter flight from Manhattan to their summer houses in the Hamptons.”

Signs of social decay

By the time a series of new owners had bought and sold Anchor Hocking, the company was a shadow of its former self, with many of its operations shut down or sold off and most of its workers gone. Along with the decline of other manufacturing firms in Lancaster, the impact on the town was devastating. The poverty rate of families with children under five rose to 38 percent, while the percentage of mothers who married the fathers of their babies declined. Department stores that had served the middle class disappeared, and “retailers to the impoverished” like tattoo parlors, dollar stores, pawn shops and payday loan offices proliferated. Loans  for people with shaky finances became more available, but at subprime, exorbitant interest rates that kept people deeply indebted.

More subtle but equally important was the impact on local culture. What Alexander calls “a subculture of immediate, if temporary pleasure” spread at the expense of the traditional culture of work, responsibility and aspirations for the future. Robbed of so many opportunities to produce something of value, more people focused on consuming things, especially pain-killing drugs. The fact that dealing drugs was more lucrative than most of the jobs available to people of limited education fed the supply along with the demand.

As the tax base eroded, and as confidence in government and the future declined, the town spent less on things like schools and good roads. And yet it scraped up money to provide tax breaks for the companies that promised to come in and save local businesses. The top executives of those companies didn’t live in Lancaster and had little stake in the town and its residents. What was left of the local leadership was “incompetent, or just overmatched,” which reinforced the lack of confidence in government. Those residents who did have good jobs were often people who commuted to Columbus and had little time for participation in local affairs.

As for the town’s future, Alexander has this to say:

Lancaster, as a place, would survive; it was too big to dry up like a Texas crossroads bypassed by the interstate. Maybe it would sell scones and coffee to visitors and one day complete a transformation, already well under way, into a Columbus bedroom community with organic delis and rehabilitated loft apartments in the old Essex Wire building. Or maybe it would slide into deeper dysfunction. For sure it could never go back….

Continued

 

 


Trump Order is Bad News for Retirement Savers

February 9, 2017

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On February 3, President Trump issued a memorandum to the Secretary of Labor regarding the “Fiduciary Duty Rule” that was scheduled to go into effect this April. Suggesting that the rule “may not be consistent with the policies of my Administration,” he directed the Department of Labor to reexamine the proposed rule and consider rescinding or revising it.

The Department of Labor has been working on this rule since 2009 with the aim of improving the quality of investment advice received by investors in retirement plans. With traditional pensions on the decline and participant-directed retirement plans like 401(k)s and IRAs replacing them, more people need investing advice than ever. This has highlighted a problem described in a Department factsheet:

Many investment professionals, consultants, brokers, insurance agents and other advisers operate within compensation structures that are misaligned with their customers’ interests and often create strong incentives to steer customers into particular investment products. These conflicts of interest do not always have to be disclosed and advisers have limited liability under federal pension law for any harms resulting from the advice they provide to plan sponsors and retirement investors. These harms include the loss of billions of dollars a year for retirement investors in the form of eroded plan and IRA investment results….

To put it bluntly, too many so-called advisors recommend the products that earn them big commissions, not the ones that offer the best value for the investor. When we buy a car, we understand that the dealer is just a salesperson who would love to sell us the most expensive car, whether we need it or not. When we go to a doctor, we expect the recommended treatment to be in our best interest, not what is most profitable for the doctor. The question is what is the appropriate standard of care when we depend on an advisor’s expertise for our financial health.

The proposed Fiduciary Duty Rule would require all those who provide retirement plan advice for compensation to adhere to a fiduciary standard, which requires “putting their clients’ best interest before their own profits.” This requirement would apply whenever advisors recommend an investment, if they are compensated in any way for doing so. It doesn’t matter whether the client is paying for the advice itself or whether a sales rep is earning a commission for selling a product.

Closing a loophole in the fiduciary standard

Debate over the fiduciary standard goes back a long way. I have discussed it before, especially in Section 11 of my “Sound Investment” series and in my review of Helaine Olen’s Pound Foolish, a critique of the personal finance industry.

Many people may not realize that the fiduciary standard is already well established in law. The Investment Advisers Act of 1940 required anyone giving investment advice for compensation to register as such and adhere to such a standard. So what’s the problem? The Securities and Exchange Commission made an exception for those whose primary business is trading securities, even if they also give some advice to their customers. In recent years, brokers and other sellers of financial products have expanded their financial advising functions and often receive compensation for them. Nevertheless, the SEC continued to maintain that they did not have to register as investment advisors nor adhere to a fiduciary standard because their advice was “incidental” to their job as brokers. So two types of advisors, those obligated to put their clients’ interests first and those without such obligation, have co-existed in the financial services industry, with the general public often unable to tell the difference. Brokers and insurance agents have been able to call themselves financial advisors, without being obligated to recommend the products that are best for their customers.

After the Great Recession, the Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) gave the SEC the authority to reexamine the issue and write a new regulation. After studying the matter, the SEC concluded that the loophole it previously created should now be closed: “The standard of conduct for all brokers, dealers and investment advisors, when providing personalized investment advice about securities to retail customers…shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer or investment advisor providing the advice.” The actual regulations that will implement this principle continue to be hotly contested. Meanwhile, the Department of Labor has finalized a fiduciary rule based on a different statutory authority, its authority to regulate retirement plans under the Employee Retirement Income Security Act of 1974 (ERISA). The DOL’s rule would apply only to financial advice relating to retirement plans, not to investments more generally. This is the rule whose implementation the President is now blocking.

Last month, the Consumer Federation of America issued a report, “Financial Advisor or Investment Salesperson?: Brokers and Insurers Want to Have it Both Ways.” The report documented the two-faced way that “transaction-based financial professionals” describe themselves:

When they are marketing their services to the investing public and enticing clients into handing over their hard-earned savings, these sales-based financial professionals present themselves as “trusted advisors” whose only concern is their clients’ best interest. But try to hold them legally accountable for meeting that standard, and those same “advisors” quickly change their tune. Because they are salespeople who are “merely selling” investment products, they claim, no fiduciary standard ought to apply.

In their marketing materials, brokers and insurance companies use terms like “financial advisor,” “financial consultant,” or “retirement counselor” to describe themselves. They characterize their services as “a comprehensive approach to total wealth management delivered by your most trusted advisor,” and claim to be “safeguarding the money of others as if it were our own,” to quote some of their websites. Surveys show that this kind of marketing is successful in getting the general public to confuse sales reps with the registered investment advisors who actually are held to a fiduciary standard. But when they are fighting that standard in legislative hearings or in court, they are quick to claim that they are just salespersons. They deny having the special relationship of trust that would justify classifying them as fiduciaries under existing or proposed law.

The high financial stakes

The Consumer Federation described how savers are being hurt by this situation:

Investors who unknowingly rely on biased salespeople as if they were trusted advisors can suffer real financial harm as a result. It is estimated, for example, that retirement savers lose $17 billion a year or more as the result of the excess costs associated just with conflicted retirement advice. The cost on an individual basis, in the form of lost retirement savings, can amount to tens or even hundreds of thousands of dollars over a lifetime of investing, money that retirees struggling to make ends meet can ill afford to do without.

Here’s a hypothetical example. Suppose you save $500 a month for 20 years in a tax-deferred retirement plan holding mutual funds, for a total investment of $120,000. With a 7% annual return after expenses, you would accumulate $260,463 over the 20 years. However, if you lost $25 of each $500 invested because of unnecessary commissions or fees, and then received only a 6% return because of higher annual mutual fund expenses, you would accumulate only $219,469, a shortfall of about $40,000. Multiply this by millions of savers and you begin to see the size of the problem.

Of course, every company that charges high fees, commissions or expense ratios will try to justify them as fair compensation for value provided. So the question is whether investors who are being charged more are receiving any added value. Although investment returns can be all over the map, most of the evidence does not support the contention that the investment products pushed by brokers and insurance reps outperform investments that are available less expensively elsewhere. In particular, index funds that you can buy directly from companies like Vanguard and Fidelity with no sales commissions and rock-bottom expense ratios outperform the majority of high-cost actively managed mutual funds. For more explanation of why so many aggressively marketed investments have such disappointing returns, see Section 6 of my “Sound Investing” series.

When I worked as a registered investment adviser (the kind who was legally bound by the fiduciary standard), many clients came to me for a portfolio review. Using standard measures of costs and risk-adjusted performance, I routinely found overpriced, underperforming, and often unnecessarily confusing products that had been recommended to them by brokers or insurance agents. In most cases, they would have accumulated more if they had gotten simpler and better advice.

What we see here is a massive and unearned transfer of wealth from middle-class savers to financial service companies that too often serve themselves at the expense of their customers. This is one reason why the era of self-directed retirement accounts has also been an era of increasing inequality in the distribution of wealth. The new regulations are intended to give middle-class savers a fighting chance.

Alleged adverse effects of the fiduciary rule

Businesses that oppose consumer protection initiatives rarely admit what really concerns them, that a new rule may interfere with a profitable business model. They almost always claim that it will hurt consumers in some way that consumer advocates and regulators fail to see.  President Trump’s order takes a pro-consumer stance by asking the Department of Labor to examine whether the fiduciary rule would “adversely affect the ability of Americans to gain access to retirement information and financial advice.” The implication is that retirement savers may be losing something if they cannot get the “free” advice offered by brokers and insurance agents, even if that advice is flawed by conflicts of interest that work against investors’ best interests.

Investors of modest means do need financial advice that doesn’t cost them much, and accepting the recommendations of sales reps is one way to get it. Investment advisors who do not make their money from sales commissions derive their income from flat fees for advising sessions or for writing financial plans, as I did, or from asset management fees based on a percentage of assets under management. Making a living while keeping these charges affordable for small investors is not easy. It is one thing to set a fiduciary standard, but another thing to make fiduciaries available at a price most savers can afford.

However, the fiduciary rule need not leave most retirement savers with no affordable advice at all. The kind of basic advice that small investors need to handle their retirement plans is already pretty widely available, and could be even more available if employers and schools made more of an effort to provide it. Most savers will do fine putting the bulk of their retirement savings in a single “target retirement fund,” or in a small number of index funds covering domestic and foreign stocks and bonds. (Of course, they need to follow other basic advice like getting an early start and saving 10-15% of income.) Financial professionals can still make a good living selling advice to people of means who are interested in playing riskier or more sophisticated investment games. But for the average worker, the present system relies too heavily on a business model that institutionalizes conflicts of interest and needlessly skims off too large a portion of the savings that people need for their retirement.

President Trump’s order is an anti-consumer measure shrouded in pro-consumer rhetoric. It purports to protect American savers, while really protecting businesses that charge them too much and deliver too little. It ignores years of research by the federal government’s own agencies as well as by professional financial planners, academics and consumer groups. It shows that the people who have Trump’s ear are the billionaires and bankers he has brought into his administration, not advocates for the general public. It is one more piece of evidence that–populist rhetoric notwithstanding– he intends to serve the economic elites rather than the people.

 

 


Postcapitalism (part 4)

May 18, 2016

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The last part of Paul Mason’s Postcapitalism discusses how the transition out of capitalism might unfold, with special attention to the role of the state in facilitating change.

To review, Mason expects information technology to liberate people from the capitalist market economy. We will be liberated as workers because fewer hours of paid work will be required to produce the necessities of life. We will be liberated as consumers because goods and services will be more abundant and less expensive. We will be able to devote more of our time to voluntary activity and sharing.

A rough road

If this sounds too rosy and idealistic, readers should take a close look at Chapter 2, “Long Waves, Short Memories,” and Chapter 9, “The Rational Case for Panic.” Mason does not expect a smooth, leisurely and pleasant transition beyond capitalism, but something more tumultuous. As the historical material in the book makes clear, the history of capitalism is not just a story of steady progress through technological innovation and rising productivity. It is a story of periodic crises as the profitability of existing industries wanes and capital has to find new opportunities elsewhere. The transition now underway is especially difficult because it calls into question the viability of capitalism itself. As production becomes more knowledge-based, the means of production become harder to own and maintain as sources of private profit. Since the 1970s, capitalists have been counteracting the tendency for profits to fall by holding wages down in the developed countries and exploiting the cheap labor of poorer countries, but at the cost of increasing inequality and social resistance.

To make matters worse, new environmental and demographic conditions are delivering “external shocks” to the economic system. The prime example is climate change, a problem that Mason does not believe the market can solve on its own. When the price of fossil fuels goes up, energy companies take that as a signal “that it’s a good idea to invest in new and more expensive ways of finding carbon.” When the price goes down, consumers conclude that they can drive more or buy less fuel-efficient vehicles. However the market fluctuates, the price does not factor in the externalities, the true costs of environmental impacts on the global economy.

Another shock is the “demographic timebomb,” the addition of another two billion people to the planet by mid-century, most of them in poorer countries. In the richer countries, falling birth rates and rising longevity are creating rapidly aging populations. With fewer working-age people to support more retirees, workers are under pressure to generate enough wealth to save for their own long retirement as well as contribute to the support of today’s retirees through payroll taxes. Demographic change puts additional stress on the economy in several ways: requiring the financial system to deliver high investment returns for retirement accounts, increasing the demands on public spending for the elderly, and increasing the flow of migrants from rapidly growing poor countries to slower growing but aging rich countries.

The world cannot afford a leisurely transformation to the postcapitalist economy Mason foresees. The world needs a rapid deployment of new technologies to produce as much as we can, but do it in a cleaner, greener way that mitigates environmental damage. The potential benefits are enormous, but the task of getting from here to there is daunting.

“Project Zero”

Because of the urgency of the situation, Mason believes that a spontaneous process of increasing information-based activity is not enough. The process needs to become a conscious project, based on the insight that “a new route beyond capitalism has opened up, based on promoting and nurturing non-market production and exchange, and driven by information technology.” He calls it “Project Zero” because “its aims are a zero-carbon energy system; the production of machines, products and services with zero marginal costs; and the reduction of necessary labour time as close as possible to zero.”

The state has a special role to play in Project Zero because only the state is “centralized, strategic and fast” enough to address the urgent problems. However, Mason rejects the old socialist idea of a centrally planned economy, arguing that a centralized bureaucracy cannot respond to new data fast enough to keep up with the pace of change in the information society. Recall the earlier point that the key agent of change will be the educated and networked individual, which implies a high degree of decentralization.

Limits on private capital

So what can the state do to facilitate the transition to postcapitalism? First, it can curb private economic power in industries where it has become a danger to the public good. The energy industry would be one, as the discussion of the climate issue illustrates. The state should actively discourage fossil fuel production and encourage cleaner sources of energy. Mason also sees a much larger role of government in the financial industry. One proposal sure to provoke controversy is that the state take control of the central bank in order to implement a monetary policy that helps debtors more than creditors. That would be a looser monetary policy that keeps interest rates low but allows the inflation rate to be somewhat higher. Over time, that erodes the real value of debt, in contrast to a strict monetary policy that protects wealthy lenders by placing primary emphasis on fighting inflation. Since government itself is a large debtor, that would help governments recover from the fiscal crisis resulting from demands for both low taxes on capital and high spending on social programs to assist struggling wage-earners.

Mason would also reorganize the banking system to make it less profit-driven, by encouraging non-profit banks, credit unions, peer-to-peer lenders, and “a comprehensive state-owned provider of financial services.” He would regulate the remaining profit-oriented banking to curb wasteful speculation and encourage its proper role of efficiently allocating capital to productive activities.

In the economy as a whole, the state would act to insure that what profits remain would be a reward for entrepreneurship, and not just a “rent” based on ownership. Creators of new knowledge would get the rewards of intellectual property rights, but those rights would be short-lived to encourage the flow of knowledge and the continued incentive for further innovation.

Liberating workers

Another thing the state can do is strengthen the legal rights and protections of workers to give them more bargaining power in their relationship with capital. This will indirectly encourage the fuller application of new technologies that can produce economic abundance. “If we legally empowered the workforces of global corporations with strong employment rights, their owners would be forced to promote high-wage, high-growth, high-technology models, instead of the opposite.” Owners would try to make each worker as productive as possible if they could no longer profit from paying such low wages.

An obvious objection is that higher wages and productivity would have the downside of less employment. But for Mason, less employment in capitalist workplaces where owners profit by overworking and/or underpaying workers is ultimately a good thing. Ideally, workers would be better paid for the hours they worked, but also have the option of working fewer hours. They could then experience the decline of paid employment as a liberation, not an involuntary displacement.

The other side of the transformation of work is the increasing opportunities for work outside of traditional profit-centered firms, such as in non-profits and co-ops. Mason recommend that the state “reshape the tax system to reward the creation of non-profits and collaborative production.”

Liberating consumers

The replacement of millions of workers by automated systems is unlikely to be experienced as a good thing unless it has benefits for people as consumers, not just as workers. Here the state can facilitate the transition by providing a basic income to all households, to support those who are voluntarily or involuntarily outside the system of paid employment. That can improve the safety net for those who are displaced by new technologies. It also “gives people a chance to build positions in the non-market economy” by subsidizing participation in volunteer work, co-ops and adult learning opportunities. Market work would still be rewarding as long as minimum wages were higher than the basic income.

In the long run, the abundance of things made available by hi-tech production methods would bring the monetary cost of living down and reduce consumers’ dependency on earned income. People could rely more heavily on non-market forms of sharing, since they would have more time for unpaid but socially useful activity. As the income tax base became smaller, government’s ability to pay a basic income would decline, but so would people’s need for one.

Can democracy survive the transition?

Just about every one of Mason’s political suggestions goes against conservative thinking, which sees the free market as the creator of wealth and the limited state as its supporter. In the conservative view, the state should tax and regulate capital as little as possible, protect wealth against inflation with tight monetary policy, and keep people dependent on paid employment by providing only the most meager welfare benefits. Mason ends his book by warning that if the democratic state tries to facilitate a transition beyond capitalism, the economic elite may decide that preserving capitalism is more important than preserving the democratic state!

How long will it take before the culture of the Western elite swings toward emulating Putin and Xi Jinping? On some campuses, you can already hear it: “China shows capitalism works better without democracy” has become a standard talking point. The self-belief of the 1 per cent is in danger of ebbing away, to be replaced by a pure and undisguised oligarchy.”

We can already see the beginnings of an alliance between right-wing autocrats and blue-collar workers fearful of losing their jobs, especially in doomed occupations like coal mining or pipeline construction. If such alliances succeed in taking over the governments of developed countries such as the United States, then things could get pretty ugly in the next few decades.

In the last great transition of capitalism, in the early twentieth century, authoritarian politics had to be defeated before the democratic state could help create a broader-based prosperity. (Third-world peoples and racial minorities remained excluded however.) We should not be surprised if the same turns out to be true of the twenty-first century, as we struggle to create a more inclusive and sustainable prosperity.