by
Jonathan Taplin
A Grand Theory of Our Present Dilemma
January 31, 2009 · 45 Comments
For the last month, I have been gripped by the gnawing sensation that all of the conventional wisdom about our current economic crisis is wrong. I think we are facing a crisis of capitalism, not just a periodic bout of market failure. What was most startling about yesterday’s GDP drop, was that consumer spending literally stopped. We have been riding in a vehicle turbo-charged with leverage and we just hit a brick wall.
“The drop in spending was so fast, so rapid, that production could not be cut fast enough,” said Nigel Gault, chief domestic economist at IHS Global Insight. “That is happening now, and the contraction in the current quarter, as a result, will probably exceed 5 percent.”
As I have said before, we are entering an Interregnum. Now the reason there was so much uproar about the Wall Street Bonuses this week is that the bankers didn’t realize this. The election of Barack Obama reintroduced the notion of a social contract. This is a very old notion as Karl Polanyi notes in his landmark book, The Great Transformation.
Take the case of a tribal society. The individual’s economic interest is rarely paramount, for the community keeps all its members from starving unless it is itself borne down by catastrophe, in which case interests are again threatened collectively, not individually. The maintenance of social ties on the other hand is crucial. First, because by disregarding the accepted code of honor, or generosity, the individual cuts himself off from the community and becomes an outcast; second, because in the long run, all social obligations are reciprocal, and their fulfillment serves also the individual’s give-and-take interests best.
<snip>
But men like Henry Kravis, Boone Pickens and Ron Perlman were not satisfied with these steady returns and Mike Milken, the junk bond king showed how with a lot of leverage they could “juice” those 4% returns into the mid 20% level. So in 1985 when Kravis’ KKR bought the Beatrice Companies (Tropicana, Samsonite) for $6.1 billion, most of the money used was junk bond debt. They then sold off individual brands, retired the debt and made a 30:1 return on their investment. Now everyone wanted in on the leverage game. Pension funds, college endowments and private investors battled their way to get in on these deals. The new normal was that money should earn 10%+ per annum. Like Adam Smith said, this was unsustainable.
Next, this mentality began to affect the CFO’s of even the most successful business. Joseph Schumpter in his classic text, Capitalism, Socialism, and Democracy talks about the “vanishing of investment opportunity”. In 2003 even after the tech crash, Microsoft had cash holdings of $49 billion. But did they invest it in some new breakthrough technology? No–they used the money to buy back their own shares! So Bill Gates, our genius inventor, felt the investment opportunities had vanished and so he bought back shares to keep his stock price up. This same strategy was deployed in boardrooms all over the country, but on Wall Street, big hitters desperate for “Juiced returns” demanded even more leveraged product. And so the genius quants in the basement invented new derivatives to which 30:1 and 40:1 leverage could be applied...
<snip>
http://jontaplin.com/2009/01/31/a-grand-theory-of-our-present-dilemma/
Printer-friendly format
Email this thread to a friend
Bookmark this thread
(1000+ posts)
Send PM |
Profile |
Ignore
