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Executive Times |
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2008 Book Reviews |
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The
Squandering of America: How the Failure of Our Politics Undermines Our
Prosperity by Robert Kuttner |
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Rating: |
*** |
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(Recommended) |
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Click
on title or picture to buy from amazon.com |
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Democracy Robert
Kuttner’s new book, The
Squandering of America: How the Failure of Our Politics Undermines Our
Prosperity, proposes a restoration of democracy and greater regulation of
markets to temper capitalism with government intervention. Kuttner argues
that the dominance of politics by big money has disenfranchised ordinary
citizens, who have not benefitted from the recent decades of prosperity
nearly as much as the very wealthy. He calls for citizens to vote out the
moneyed interests and vote in an approach to managed capitalism that spreads
wealth throughout America. Here’s an excerpt, from the end of Chapter 4,
“Financial Engineering and Systemic Risks,” pp. 126-129: The latest wave of asset
rearrangement is fueled by four realities. First, in the aftermath of the
stock market bust of 2000, investors are hungry for the
supernormal yields they briefly enjoyed in the bubble of the 99os. Money from
quasi-public institutions such as university endowments and pension funds, as
well as individual investors, has been pouring into hedge funds and
private-equity funds. Second, a climate of low interest rates makes these
deals irresistible, especially since the interest is tax-deductible.
Regulatory laxity is a third factor, and the use of hedge funds or
private-equity firms evades even the minimal regulation required of normal
mergers and acquisitions. Finally, these deals are relentlessly promoted by
other middlemen—commercial banks and investment bankers, which make money off
the fees. This trend invites several big
questions. How could financial markets be so inefficient that insiders could
find literally billions of spare dollars to exploit in a single deal, by
cashing in the difference between the price that the stock market places on a
company and their own valuation of the underlying assets? This practice, known
as risk arbitrage, has been around for decades—Robert Rubin made his money as
a "risk arb"—but it has never been so central to financial markets. And is the stock market really
so undervalued? In the 1970s and 1980s, when the movement to deregulate financial
markets gathered force, we heard a lot about a core postulate of conservative
Chicago School economics: the Efficient Market Hypothesis. Supposedly, markets
were efficient by definition. Whatever the market deemed to be the price of a
stock was its true value. Therefore, regulators should leave markets alone.
Today, the same Chicago School economists, who once touted the efficiency of
stock market pricing, are apologists for private-equity deals that supposedly
take advantage of the same stock market's inefficiency—its apparent failure to price
shares accurately. But both claims can't be true. Either way, the markets are
not as efficient as they're cracked up to be. And what about the stock market
itself ? In principle, stock markets exist to connect entrepreneurs with
investors. There is a legitimate middleman function in underwriting new
securities: taking the risk of evaluating an entrepreneur, floating a new
issue of stock, pricing it, and selling it to the investing public.
Investment bankers can make fortunes performing that role. But what is so
seriously the matter with the stock market that a whole new layer of
essentially parasitic middlemen is necessary to carry out the ordinary
functions of capital markets? It would make more sense to
expose the stock market to greater public scrutiny and increase its
efficiency directly—and to get rid of the incentives that allow windfall
gains to the new middlemen. Some private-equity firms do add value,
especially when they supply equity capital and when they hold stock and
improve the management of a firm for the medium or long term. But public
policy needs to change the current incentives that reward the short-term
acquisition of sound corporations and allow middlemen to strip them of
assets. Specifically, the interest on the borrowed money that underwrites
leveraged buyouts should not be tax-deductible. Deal makers who take entire
companies private only to take them public again in a short period of time
should be subject to a windfall profits tax. New owners of a firm acquired
mostly with borrowed money should be prohibited from voting themselves
extraordinary dividends. There should be limits on the transactions fees
paid to middlemen. And, in the case of a company with assets over a set
amount, say $50 million, exactly the same public disclosures should be
required, whether the owners are the general shareholding public or
private-equity firms and hedge funds. You
can bet that this proposal, like the reining in of hedge funds, is nowhere on
the public regulatory agenda. But that is just a mark of the degree to which
regulatory policy has been captured by Wall Street. Wouldn't such a proposal gum up
the efficiency of markets? On the contrary, it would take a lot of the profit
out of deals aimed mainly at the enrichment of middlemen. It would put
pressure on companies to improve their performance organically. It is bizarre
to use the highly leveraged sale and resale of entire companies as the
preferred way of holding their managers accountable. Taking some of the
profit out of these superheated buyouts would also redirect more investment
capital and entrepreneurial, zeal to the creation of real wealth rather than
the manipulation and rearrangement of paper. Defenders of private equity
make three arguments. First, they contend, there are many badly managed
companies. By grasping the potential for changes in how an enterprise is
run, private-equity owners can pay above-market prices, unlock hidden value,
reap just rewards, and improve the efficiency of the economy. Back when
private equity was a small niche, this picture described at least some
private-equity owners; and there are still some private-equity firms that buy
and hold for the long term. But today the norm is becoming a strategy of
stripping assets for quick return. The new wave of private-equity funds do
not get involved in the details of running firms. They are the antithesis of
careful management. A second oft-heard argument is
that private-equity purchasers of companies "must have" some special
proprietary knowledge or skill; otherwise, they would not pay above-market
prices. And to compel additional disclosures would destroy their ability to
bring new economic efficiencies to the company, and by extension to the
economy. But today's private-equity players increasingly are using a generic
cookbook: borrow a lot of money, take the company private, pull out windfall
dividends, and sell off the remaining assets. There are few genuine
management secrets worth protecting. This
brings us to the trump card in the defense. Obviously, say apologists for
private equity, the whole process would not work if private-equity owners
could not find buyers. And if buyers are willing to pay more than the
private-equity owners' own previous purchase price, then by definition
private equity "must have" added value. But take a closer look. If
the whole deal is financed with tax-deductible borrowed money, and
private-equity owners make windfall gains by paying themselves exorbitant
special dividends, then a private-equity firm can actually sell the company,
or its pieces, for less than its own acquisition price and still come out way
ahead. In a rising stock market, with
low interest rates, private-equity owners can make exorbitant short-term
gains by putting up a small amount of equity and borrowing the rest. Their
windfall is the difference between the return on total capital, which need
only be normal, and the return on equity—even if they bring no additional
management expertise. But in a down market, or a period of rising interest
costs, the magic of leverage goes into reverse. So private-equity fever
brings risks both to sound enterprises and to the economy as a whole. There have been times in
American history when regulators have stepped in precisely to throw a little
"sand in the gears" of financial speculation, as the Nobel
laureate in economics James Tobin famously put it. Tobin was no wild-eyed
radical. He was a member of the Council of Economic Advisers under President
Kennedy. Tobin made his sand-in-the-gears comment in the course of proposing
a special tax on short-term financial transactions, aimed at discouraging so
much speculative activity. The Tobin Tax was never enacted, but it won the
support of other mainstream economists such as Lawrence Summers, the former
Treasury secretary and before that the chief economist of the International
Monetary Fund. The whole series of post-1929 reforms was aimed at making
either illegal or unprofitable entire categories of speculative financial
transactions. All of these, from stock pools to evasions of margin
requirements to insider trading, have been reborn in the financial
engineering of the current era. The addition of a new layer of
middlemen and the dysfunctional operation of corporate governance and capital
markets are two sides of the same coin. If corporate executives were more
effectively accountable to boards of directors and directors more accountable
to shareholders, the system would not need private-equity firms and hedge
funds to claim that they were rendering managers more responsible and markets
more efficient by buying and selling entire companies with tax-deductible borrowed
money. Unfortunately,
serious reforms of financial markets are nowhere on the horizon. Instead, in
the deregulated climate, new abuses and risks continue to proliferate. The
mood in the citizenry might just be ripe for considering many of the ideas on
the pages of The
Squandering of America. We may not like adult supervision, but recognize
that in some sectors, it’s required. Steve
Hopkins, February 21, 2008 |
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The recommendation rating for
this book appeared in the March 2008 issue of Executive Times URL for this review: http://www.hopkinsandcompany.com/Books/The Squandering of America.htm For Reprint Permission, Contact: Hopkins & Company, LLC • E-mail: books@hopkinsandcompany.com |
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