Thinking Things Over
Musings on the Markets from Inside the Beltway
By John L. Chapman, Ph.D. Vol. I, No.7 090411
In this note:
- Lack of confidence, not uncertainty, is the enemy
- What President Obama said – and didn’t say
- Recessions end only via recapitalizing, not spending
- Whither stocks, in light of all this?
Lack of confidence, not uncertainty, is the enemy
Readers of these columns know we at Alhambra Partners steer clear of political embroilment. This is a cultural tone set by the firm’s founder and managing partner, and we all agree with and adhere to this policy. After all, we are paid to preserve and grow the wealth of our clients, and must do so regardless of the state of play in the political realm. We take politics as a “given”, much like the current price of the ten-year bond, and conduct our analysis and make our decisions accordingly.
But a confluence of events in the past week were all together so striking, they have collectively convinced us to take up some writing about the policy direction of the Obama Administration to, essentially, explain why none of Mr. Obama’s initiatives have worked, or ever can work. We wish to state at the outset that our criticisms in this vein are with respect to economics only, and are not in any way political. Indeed, we wish Mr. Obama well, and think it a shame the U.S. economy is not now growing at 4% per annum with a concomitant boom in job creation. So why can’t this happen? If China can grow at 10% per year, why can’t the U.S. grow at 3-4%? Next week we will provide the core answer to this question via the topic of the economic importance of capital to growth; here below we must address what happened this past week, extraordinary as it was.
We ask the reader to do a thought experiment: suppose you are a business owner, or as Marx would say, a capitalist. To personalize it, let’s assume you own a company that makes baseball equipment, and you compete with the likes of Hillerich & Bradsby, Nike, Rawlings, and Wilson. It’s a very competitive business, but the market is global, and so you export. You have four plants around the country, two union, two non-union, making everything from bats to gloves to balls to face-masks. Unlike other competitors like Nike who sell across a range of sporting goods equipment, your firm is a specialist: you are all baseball, all the time. That matters, because your cost structure is inferior to Nike’s. Hence you have to be better managers, manufacturers, and marketers – and better stewards of scarce capital – to survive and grow.
Now look at the news of the past week and consider your reaction:
- Friday, the Department of Labor announced there were no net new jobs created in the U.S. in July, typically one of the best months for hiring. Equity markets dropped 2.5% here and more around the globe. Slackening demand will certainly affect discretionary purchases for items like yours, so this is a concern.
- Thursday Solyndra, LLC, a manufacturer of solar panels in California, declared bankruptcy and laid off 1100 workers.
This firm had received $535 million in federal loan guarantees, all of it likely lost to the U.S. taxpayer. Lower-cost Chinese imports, with which you also compete, did this firm in, but it is clear this kind of industry is favored, and not an old “low-tech” one like, well, baseball bats. Indeed, the EPA has sent inspectors to visit your plants in each of the last two years asking about your emissions in your bat factories. Your plant has a miniscule carbon footprint compared to, say, a steel factory, but you do have an effluent-escape issue thanks to heat-treated products, and more regs are in the offing for these facilities. Beyond the tragedy of a likely total loss of half a billion dollars in taxpayer funds, along with 1100 jobs, this sorry Solyndra episode is emblematic of what can happen when government picks winners and losers, and will have a chilling effect on private capital wherever government gets directly involved in a business. A second government-subsidized solar firm, Massachusetts-based Evergreen Solar, also declared bankruptcy on August 17.
- Wednesday you were horrified to learn that the Obama feds had raided Gibson Guitar Company, ostensibly over a 100-year old law barring imports of a type of wood the foreign supplier was not supposed to be selling. The implication is that Gibson should have been monitoring India’s wood exports, even though India’s government filed no complaint against Gibson, or its native supplier. This sends shivers up your spine: you import wood, too, and may well need to incur costs now to track such issues. The federal government has now imposed at least $500,000 in costs on Gibson, based on lost sales due to forced closing, damage during the raid, and confiscated raw-materials inventory.
- The Boeing Company was in the news again this week over its dispute with Mr. Obama’s National Labor Relations Board: the NLRB has forbidden Boeing from starting up a plant in South Carolina that is non-union, even though it means 1200 jobs at least, in a plant nearly built for over $1 billion. The NLRB wants this plant to be located in Washington state, where Boeing is unionized. The laborers themselves, already hired and anxious to work in South Carolina for one of America’s iconic companies, could care less about this issue and want to get to work. But this is troubling for a firm like yours, with two plants in northern states that are unionized; you not only cannot feel safe ever trying to move production from union to non-union locales, but you are loath to hire at the non-union locations. You also, importantly, do not have the “connections” that a bigger firm like Nike has in Washington, D.C.; you’re a small or mid-sized firm with perhaps several hundred employees, and have no budget for a lobbyist office in the nation’s capital. Big firms like Nike have fully staffed government relations teams inside the Beltway, currying favor with elected officials in too many ways to describe here. But the point is, in any recession or downturn, the firms with connections and scale will survive, and the ones who are without, will not (e.g., cf. Goldman Sachs, Fall 2008, versus Lehman Brothers).
- Wednesday the Obama Justice Department stopped AT&T’s $39 billion acquisition of T-Mobile USA on anti-trust grounds, arguing it was anti-competitive, and that the U.S. needed four major wireless phone service providers to be a competitive industry. But it was more likely that consumer prices would have dropped with this merger thanks to cost efficiencies in a bigger scale network, pressuring margins of Verizon and Sprint as well. And AT&T was going to spend at least $20 billion in capital equipment expansion to tie together the networks, leading to thousands of jobs and better quality service for its customers. This would have engendered further competitive moves on the part of the other major vendors, to the benefit of consumers, not to mention freeing up scarce capital for T-Mobile’s German parent to better deploy elsewhere. Your industry is also in need of consolidation to capture efficiencies, in order to battle imports. And as a baseball-only focused firm, you have realized you need to broaden your lines; if you do not, you may well go the way of Solyndra. But you cannot afford, unlike a bigger full-line supplier like Nike, to spend millions on potential merger activity only to have the Obama Administration declare it null and void due to spurious anti-trust laws. So capital that might lead to job expansion is immobilized.
- On Monday the White House disclosed that it has 219 new regulations in process that will cost businesses at least $100 million each, the seven most expensive of which will be a combined $100 billion. These run the gamut of industry types, and involve everything from compliance in reporting performance, to labor force work rules, to EPA standards being met. All this regulatory overhead has a chilling effect on business in general, and of course directly impacts most all manufacturers. Indeed, there may now be a need for firms to hire full time compliance officers, given the aggressive EPA of the Obama Administration alone.
- Friday the Obama Administration’s Federal Housing Finance Agency (FHFA), as conservator for Fannie Mae and Freddie Mac, filed lawsuits against 17 financial institutions including Bank of America, Citigroup, General Electric, and Goldman Sachs, for fraudulent conveyance in the sale of mortgage-backed securities to Fannie and Freddie. While there may well have been some fraud involved, many of these same mortgage lenders also made billions of dollars of questionable loans due to government mandates (e.g., Community Reinvestment Act) or implicit pressure for currying other favors from the federal government; these same firms in many cases received federal bail-outs and are now trying to recapitalize. This action, which specifies no damages sought and may well be more political than anything else, nonetheless will curtail the recapitalization process and, at the margin, all lending activities. And it cannot be forgotten that any time a “bad bank” is impaired or suffers losses, “good banks”, that is, those who play by the rules and have strong balance sheets, suffer as well, due to industry insurance (read, “bail-out assistance”) funds: moral hazard in finance always means the good clean up the messes of the bad, with costs imposed on us all. And so for our baseball equipment maker, obtainable credit just got harder at the margin.
All of these items occurred in just the past week, yet every one of them would give our mythical manufacturer and marketer of basic consumer goods pause for concern. Even the one bit of “good” news on this front this week, Mr. Obama’s Friday rescission of new ozone-emissions regulations promulgated by the EPA that, according to their estimates, were to cost American businesses $90 billion per year by 2020, was done for purely expedient political reasons: zero jobs announced on Friday. Too much political pressure was in place in this case because of the job losses the new rules would have engendered immediately, due to non-compliance. Mr. Obama’s cancellation of the costly new rules – for now – is welcome relief for our baseball equipment maker. But it cannot be cause for new hiring and expansion, because these same arbitrary rules may return tomorrow. Note as well that all these items of the past week pale in comparison to the Obama Administration’s directives for the last thirty months, the most prominent of which are dramatic new increases in health care, financial services (Dodd-Frank), and energy regulation.
What is the punch-line to our mythical case study, which, while admittedly “stylized” to make this lesson starkly clear, nonetheless is very real for producers and entrepreneurs? What we plainly see is that in just the past week alone, a number of things occurred that make our mid-sized manufacturer worried about future prospects. Indeed, such a firm that is big enough to have sizable fixed costs, but not so big (e.g., not the scale of Nike) that it can either influence events in its favor in Washington, or compete against bigger firms in any coming industry shake-out, must per force remain frozen in its current competitive state. News items concerning lackluster economic activity, union work rules, EPA mandates, Department of Labor/NLRB practices, Justice Department industry oversight, bank credit access, and hundred year old laws governing international trade that may lead to unannounced raids and inventory confiscation all combined this week to give our mythical capitalist pause, with respect to any expansion plans. Indeed this week’s news alone may mean for our mythical firm the following:
- Lackluster jobs report means curtailment of marketing expenditures to ramp up sales
- Boeing fight means cancellation of any labor expansion or reconfiguration of union and non-union work forces
- Gibson Guitar episode causes higher import cost monitoring
- EPA regs mean higher operating costs in plants, often with zero environmental benefits for low-tech, low-grade
manufacturing like our mythical firm
- Justice Department action may give pause to merger activity
- The world of Solyndra-type deals in which we now live may necessitate lobbying efforts, which are costly for this mid-sized firm vis-à-vis a Nike; and Nike knows this, every bit as much as General Electric knows it pays to have friends in Washington
For this mythical mid-sized firm, competing in a tough consumer products sector that involves some light manufacturing, all external forces point to retrenchment and survival-by-hunkering down now. Profits can only increase via rigid cost-cutting in such an environment, and this cannot go on forever. And the unremitting fact is, it is these small and mid-sized firms which drive employment growth in the United States. For more than forty years there has been an overall trend of slight job loss in the Fortune 1000-scale companies, and big gains in smaller and mid-sized (entrepreneurial) firms. This process has been stunted in recent years, for all the reasons our mythical firm found this past week so discouraging.
The lesson here is that when pundits and politicians now talk about the problem being “uncertainty”, they have it quite wrong. The problem with the Obama Administration is that it has been, generally speaking, virulently anti-capitalist, that is to say, anti-enterprise, and anti-growth. Not uncertainty, but fear, which has now embedded a lack of confidence about the future in our economy, is the core enemy now. As was said of FDR’s policy outcomes in the 1930s, capital is now “on strike”.
Given the above, what is the solution to end this torpor and return to a high-octane growth economy? We’ll answer this in the coming weeks and months, starting next week, but will offer a prelude now, by saying that all the above-described Obama policies are done with the intent to steer spending and economic activity in ways favored by the Obama Administration. But the giant intellectual error of this Administration, now playing out in such a damaging way, is that it has confused cause with effect. Specifically, spending is an effect of economic growth and progress, and not a cause, in the main. Indeed, we produce in order to consume. To jumpstart the economy once again, we need policies in place that will replace the $12 trillion loss in capital wealth in the last few years by American households – and that can only happen by increasing output. Recessions end via recapitalization, and not spending, and it is recapitalization which allows for production and growth in output. This last week offered many examples of how not to foster this process, the only real way to increase jobs and wealth.
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Dr. Chapman is chief economist at Alhambra Investment Partners, and director of research at Hill & Cutler Company in Washington, D.C. . He and Alhambra founder Joe Calhoun are writing a book on investing and capital preservation in
the current turbulent era.