Dr. Sherry Jarrell

Oh, the Irony: The Market Speaks, and Obama Has to Listen!

In a recent article, Moody’s announced that because of the U.S. federal government’s excessive spending and historic debt levels, it might have to reduce the Aaa rating of U.S bonds (http://thecitysquare.blogspot.com/2010/02/us-aaa-bond-rating-threatened-by-obama.html and http://risingpowers.foreignpolicyblogs.com/category/multipolarity/)
 

What this means in practical terms is that the cost of borrowing by the U.S. government will rise, which will increase spending via more borrowing or higher taxes or more money creation to pay for the higher interest costs.  Sound like a vicious cycle to you?  

Has anyone noticed the absolute irony of the world capital market having a seat at the table that assesses the viability of Obama’s policies? Obama has spent the last year denigrating free markets, and has laid the blame for the credit crisis squarely at the feet of those "greedy capitalists." Now he has to deal with a rating agency, which plays a pivotal role in the functioning of those very capital markets, evaluating the creditworthiness of the policies of the White House and its Budget Director, Peter Orszag.  

How wonderfully ironic! 

 

Every Economist, Mr. President? No, sir!

The President seems to believe that he can say whatever he wants and no one will hold him accountable. He now claims that "every economist, from both sides of the aisle, believes that the stimulus program created jobs." http://www.washingtonexaminer.com/opinion/blogs/beltway-confidential/Obama-says-every-economist-back-claim-stimulus-saved-or-created-two-million-jobs-83550017.html

I am an economist, Mr. President, and I know, based either on simple first principles of economics, or on a more rigorous controlled study of labor markets in each major sector of the economy, that the unemployment rate would have been much lower today had the stimulus program never occurred.  

You are either woefully unaware of the facts, Mr. President, or are purposefully distorting the facts. Neither is good.  When are you going to realize that just because you say something does not make it so. The world does not contort itself to support your version of the truth.

Do not put words in my mouth, sir.

The Farcical Freeze

President Obama's proposal to freeze parts of federal government spending over the next three years is a lot like a smoker buying a truckload of cigarettes today, then promising to "freeze spending" on cigarettes tomorrow.  He can keep smoking for years to come without spending another dime.

Federal government spending has increased so much over the last year -- by some estimates at a rate of 34% (http://www.usgovernmentspending.com/year2009_0.html#usgs302 -- that in December of 2009 the debt limit had to be raised to $12.4 trillion to help absorb a record-shattering $1.4 trillion deficit (http://www.washingtontimes.com/news/2009/dec/25/senate-oks-rise-in-debt-limit-to-124-trillion/).

The promise to freeze spending is actually a guarantee that spending will remain at record high levels for the next three years.  It effectively prevents a reduction in federal spending. 

How disingenuous of our President.  

 

The Fed sets up Unit to Police Itself

I'm not quite sure how I feel about this yet.  The Fed has just announced that it has appointed a long-time staffer with the New York Fed to head a newly created branch to oversee the the parts of its balance sheet acquired in efforts to bail out firms like AIG.http://blogs.wsj.com/economics/2010/01/21/new-york-fed-sets-up-unit-to-handle-bailout-balance-sheet/?mod=rss_WSJBlog   

These massive asset purchases, orchestrated by Timothy Geithner, the current Treasury Secretary and former New York Fed official, ballooned the Fed's balance sheet from $800 billion in primarily government bonds to $2.3 trillion in toxic assets.   

Now the New York Fed is overseeing the assets brought into the Fed by the Treasury Secretary as he moved from the New York Fed to the Treasury.  All while the Treasury functions are supposed to be isolated from the Federal Reserve's role in its implementation of monetary policy.
 

Smacks of the fox watching the hen house....

Actual Unemployment is Worse

Keep in mind, even as the number of first-time claims for unemployment insurance rose again this week, that the 10% U.S. unemployment figure understates the actual number of unemployed. Even the 17% underemployment figure, which includes those who are either unemployed or who are working part-time but would like to work full-time, fails to include many of those who have lost their jobs but, because they fail to qualify for unemployment, are not being tracked.  I know several such people personally; one has been unemployed for over a year. 

My point?  Structural unemployment is a serious economic issue.  But the solution is not to funnel more unemployment benefits to the unemployed.  The best thing the government can do is to reduce the barriers it has erected to a vibrant economy, including oppressive taxes, fees, paperwork, bureaucracy, and regulations that repress business productivity and raise prices.  By reducing these explicit and implicit costs, there is absolutely no doubt that the private economy will be able to employ more workers as it produces more output at lower prices. 

The best thing we can do as private citizens and neighbors is to treat each other right.  Keep the economy moving.  Put in a good day's work.  Volunteer or learn a new skill if you can't find a job.  Fill a need.  Buy smart.  And, finally, elect business-friendly local and national politicians.  It matters. 

Capitalism and the Daimler-Chrysler Saga (Part 3 of 3)

This is part 3 of a 3 part post on the saga of the ill-fated 1998 merger between Daimler and Chrysler.

The Daimler-Chrysler merger was troubled from the beginning. Investors sued over whether the transaction was a 'merger of equals' or a Daimler-Benz takeover of Chrysler. A class action lawsuit was settled in August 2003 for $300 million. A lawsuit by activist investor Kirk Kerkorian was dismissed in April 2005, but claimed the job of the merger’s architect, Chairman Jürgen E. Schrempp, who resigned in response to the fall of the merged company's share price. The merger was also the subject of a book Taken for a Ride: How Daimler-Benz Drove Off With Chrysler, (2000) by Bill Vlasic and Bradley A. Stertz.

It is questionable whether the merger ever delivered promised synergies or ever successfully integrated the two businesses. As late as 2002, DaimlerChrysler appeared to run as two still-independent companies.  In 2006, Chrysler reported losses of $1.5 billion.  In 2007, it announced plans to lay off 13,000 employees, close a major assembly plant, and reduce production at other plants in order to try to restore profitability.

It was all for naught.  In May of 2007, DaimlerChrysler announced that it would sell 80.1% of Chrysler to Cerberus Capital Management of New York, a private equity firm specializing in troubled companies. Daimler continued to hold a 19.9% stake. Daimler paid Cerberus $650 million to take Chrysler and associated liabilities off its hands, an amazing development given the $36 billion Daimler paid to initially acquire Chrysler. Of the $7.4 billion purchase price, Cerberus invested $5 billion in Chrysler Holdings and $1.05 billion in Chrysler’s financial unit. The de-merged Daimler AG received $1.35 billion directly from Cerberus but invested $2 billion in Chrysler LLC itself.

On April 27, 2009, Daimler AG agreed to give up its remaining 19.9% stake in Chrysler LLC to Cerberus and pay as much as $600 million into the automaker's pension fund.  On April 30, 2009, Chrysler LLC filed for Chapter 11 bankruptcy protection and announced a plan for a partnership with Italian automaker Fiat. On June 1, Chrysler LLC stated they were selling some assets and operations to the newly formed company Chrysler Group LLC, with Fiat retaining a 20% stake in the new company.

On June 10, 2009, the sale of most of Chrysler assets to "New Chrysler," formally known as Chrysler Group LLC, was completed. The federal government financed the deal with $6.6 billion in financing, paid to the "Old Chrysler.” The transfer does not include eight manufacturing locations, nor many parcels of real estate, nor equipment leases. Contracts with the 789 U.S. auto dealerships who are being dropped were not transferred.  Not a hint of the disastrous Daimler-Chrysler merger remains.

Capitalism and the Daimler-Chrysler Saga (Part 2 of 3)

Yesterday, I posted part 1 of 3 parts on the saga of the 1998 Daimler purchase of Chrysler in which I set up the question:  would the Daimler Chrysler merger, with its internationally traded share and U.S. disclosure rules, be enough to offset the secrecy of the German corporate governance standards at the time of the merger? In today's post, I provide the answer:

When DaimlerChrysler (DCX)  incorporated it adopted German corporate governance standards.  U.S. institutional ownership in Chrysler was largely replaced by European banks that not only directly monitor the working capital financing of DCX but also may sit on its Management and Supervisory Boards.  Such superior access and corporate control created distinct advantages for large German institutional owners relative to minority owners; foreign shareholders in the U.S. found themselves among this minority group.  These advantages included the ability to: expropriate the private benefits of control from minority shareholders; share these benefits with management, effectively creating a collusion, and; profit from trading DCX shares with superior information.  As a result, minority owners priced their shares less aggressively – i.e., the bid-ask spread widened -- to minimize their losses from transacting with controlling shareholders.  As their spread increased, U.S. minority shareholders’ trading costs rose and U.S. trading volume fell as it migrated to Germany, the relatively cheaper trading venue.

The merger between Chrysler and Daimler and consequent changes in corporate governance create an ideal clinical study for isolating our hypothesis about the failure of the enhanced disclosure requirements to effectively compensate for lax corporate governance standards in protecting minority shareholders.  To test this hypothesis, we explored changes in the bid-ask spread that are associated with the change in corporate governance and the control over the flow of information about the Chrysler assets.  We look “inside” the trading mechanism that creates the observed transacted stock price, namely the bid-ask spread, to generate evidence on shifts in the quality and quantity of information available to minority versus controlling shareholders.  The bid-ask spread should grow as minority shareholders learn that traders on the other side of the spread possess superior information about the company, information which is linked to their majority control of the firm and its senior management compensation, asset disposition, and financing and risk-taking strategies.

We found that the decision to merge and become a German stock corporation significantly weakened the protection of minority shareholders, particularly prior owners of Chrysler assets, and led to their expropriation by controlling shareholders and principal creditors of the consolidated firm.  The answer lies in the lack of protection afforded minority shareholders by the German corporate governance structure of the newly combined DCX entity.

Capitalism and the Daimler-Chrysler Saga (Part 1 of 3)

In a paper co-authored with Rick Harris, Tom McInish and Bob Wood, we explored the Daimler-Chrysler merger of 1998 to examine the interplay between disclosure rules in the U.S. and corporate governance standards in Germany.  Here is an overview of what we found.

Large shareholders typically control European and Asian industrial giants, leaving minority shareholders less than well protected.  In several studies of the legal protection afforded minority shareholders across 27 countries, German shareholder protection ranked among the very worst. In the early 1990s, Daimler-Benz, one of the largest firms in Germany, was no exception.  In 1993, with Deutsche Bank owning 24% of the equity, Mercedes AG Holding 25%, and the Emirate of Kuwait 14%, its controlling shareholders decided to cross-list Daimler-Benz on the New York Stock Exchange (NYSE).

All foreign firms that cross-list [list their shares for sale in more than one country] in the U.S. subject themselves to stricter disclosure standards.    In addition to listing on a major U.S. stock exchange, Daimler was required to file financial statements with the SEC and report any material non-financial information as well.   Cross-listed firms are also followed more closely by U.S. stock analysts and the business press.  These legal disclosure requirements and additional scrutiny by the investing community improved both the quantity and quality of information available to all shareholders about Daimler.

By early 1998, the cross-listed Daimler shares were widely held and actively traded worldwide, including significant volume originating in the United States. In September of 1998, Daimler and Chrysler shareholders, majority and minority owners alike, overwhelmingly approved a merger creating DaimlerChrysler AG (DCX) through an exchange of the cross-listed share for the first “global registered share” (GRS).  The so-called “merger of equals” was widely expected to realize both operating efficiencies and, via the informational transparency of the GRS, improved access to international capital markets.

Part 2 tomorrow.

Engine of Economic Growth is Sputtering

The engine of world economic growth is sputtering.  The most clearevidence of this is the lack of new business formation in developed nations across the globe.  Over the last year, the number of entrepreneurs starting new businesses in the wealthiest of nations dropped 10% from the 2006-07 level; in the U.S., that number fell by 24%. http://www3.babson.edu/Newsroom/Releases/globalgem2009.cfm

The contaminants in the fuel line are oppressive government policies that increase the cost of doing business, increase unemployment, and raise the risks to the current labor force of quitting their jobs to try to start new businesses.  

At a time when government should be encouraging venture capitalists and the formation of new business, it is instead putting on the brakes to this source of economic growth in the form of cap and trade, compensation regulations, fees on banks, and myriad other explicit and implicit new taxes.  In 2009, nearly half of U.S. employment was generated by small businesses; U.S. companies started through venture capital employed more than 12 million people, or 11 percent of private sector employment, and generated $2.9 trillion in revenues, or 21 percent of U.S. GDP.  

Fully 100% of economic growth is created in private industry.  Government simply redistributes that wealth, destroying some portion of it in the process.  Never have we needed non-interventionist government policies more.

We Need a New Term for Federal Reserve "Profits"

The Federal Reserve, it has been reported, earned record "profits" of over $46 billion in the year ending December 31, 2009.  The previous record profit was $34.6 billion in 2007. The Fed earned $31.7 billion in 2008. The financial crisis has apparently been very good for the Fed, although, as a non-profit entity, all its profits are turned over to the Treasury.  As an aside, I wonder what the Treasury plans to do with its windfall?Reduce taxes? Hmmm. 

Be careful, however.  "Profits" are a bit of a misnomer for the Fed's activities, because they pay for what they do by creating money out of thin air.  To buy a financial instrument such a treasury bill or mortgage-backed security, which is added to the left-hand-side of their balance sheet as an asset valued at cost, they create (and I do mean "create," in the true sense of the word) an equivalent amount of deposits on the right-hand-side of their balance sheet. It does not "cost" them resources as it would you, or me, or a business.  The "expense" is deducts from revenues to arrive at this period's profits consist mainly of employee salaries.  
 

So if the Fed purchased a bunch of assets with reserves that they created, where do the "profits" come from?  Keep in mind, there are two major drivers of profits.  One is efficiency, or doing more with your resources. The second is pricing power, being able to charge an above-competitive price for a good or service either because you own something scarce or you make up the rules of the game.  

First, two minor sources of income to the Fed are the interest and fees it charges for operating the financial system, such as check clearing and interbank electronic payments, and those it charged participants in the emergency loan programs it undertook to support credit cards and auto loans.

By far the largest source of revenue to the fed, however, came from its open market operations and the purchase of toxic assets.  The Fed had about $1.8 trillion in U.S. government debt and mortgage-related securities on its books by the end of 2009, four times the level in 2008, and the interest payments it collected on this huge pile of assets generated much of their (so-called) profits.  But interest payments are only one source of returns on financial assets. The other is "capital gains" or "price appreciation."  If and when the Fed sells these assets, some of them considered "toxic," there is a real risk that they will incur significant capital losses.   For example, the central bank recorded a $3.8 billion decline in the value of loans it made in bailing out Bear Stearns and AIG.

So the Fed’s profits are this period’s interest income minus the Fed’s minimal operating expenses; the capital base on which it earns income is basically “free.”  And all of these figures focus on one-period accounting entries, ignoring the huge potential negative stock of value the Fed’s activities are generating.

Don’t misunderstand. The Fed provides an invaluable service to the national and world economies, and they generally execute those services very well.  But when they begin to try to act like a business, replacing existing investment banking with their own activities, and parade around profit figures as if they meant the same thing as private industry profits, we must step back and take a moment to understand that Fed profits mean something entirely different from corporate profits.