Fed’s ‘hard cheese’ for the average American

The Federal Reserve’s long-awaited September meeting ended with the Fed once again deciding not to raise interest rates. We have seen this movie before.

Consider a society in which government has been traditionally run by the Old Guys political party. They are great believers in “prudent government,” and their definition of prudence includes balanced budgets; having the government spend no more than it collects.

But along come the ambitious New Guys. They form their own political party with the goal of winning control of the government in the next election and begin campaigning aggressively on a platform that discredits the competence of the Old Guys.

“Look at our unpaved roads,” the New Guys thunder in their campaign speeches. “The people deserve paved roads so they can travel more safely and easily. But the incompetent Old Guys who run our government won’t give us the roads we need.”

To which the Old Guys calmly respond, “If the people really want paved roads, then the government should certainly provide them. But paving our roads will cost money, which would necessitate a tax increase.”

“Nonsense,” the New Guys shoot back. “Everybody knows the government is riddled with waste, fraud, and abuse. We’ll get rid of it all, which will free up more than enough money to pave our roads without raising taxes.”

Needless to say, the voters are drawn to the New Guys’ message of having the government pave the roads without making people pay more taxes. Getting something for nothing is very hard to resist in a society that lives beyond its means and wants political leaders who make certain the good times never end.

On Election Day, voters hand the government to the New Guys with a solid majority. But not long after they take over, the New Guys come face to face with two awkward realities.

First, there is not nearly as much waste, fraud, and abuse in government as they expected, and it doesn’t come close to adding up to the cost of paving the roads. In fact, the administrative cost of eliminating waste, fraud, and abuse is going to be more than the savings from doing so.

These all-too common realities put the New Guys in a real bind. The savings with which they planned to cover the cost of paving the roads turned out to be illusory.

They respond by punting on the use of fiscal policy to raise the funds necessary to pave the roads and deliver on their campaign promise before the next election.

Let’s get our “independent” central bank to pursue a policy of easy money and near-zero interest rates. That way, government will pay increasing portions of their ongoing expenses by simply “printing more money.” After all, the government has a monopoly on money as a commodity.

Equally important, Wall Street, which helps fund our campaigns, loves low rates and cheap money. Banks will pay almost no interest on savings, lending the savers’ money out to businesses, private equity funds, and hedge funds. Low rates also help companies that export goods.

Variations of this scenario have long played out in governments and it just happened again with the Federal Reserve’s decision not to raise interest rates. It’s a good deal for financial institutions that can play games with the cheap money they have been given without investing in the real economy.

As for the savers, including those who thought they had enough put aside for retirement, they will just have to learn to take more risks to achieve higher returns. As the Brits would say that’s “hard cheese” for the average American.

More evil has been carried out in the name of central banking than by any other force in human history, including religion.

Originally Published: September 26, 2015

Google’s search need look no further than GE

Google has announced plans to reorganize its businesses under a General Electric-like conglomerate called Alphabet. If the new company wants to maximize overall performance, it should take a close look at Jack Welch’s work as GE’s CEO.

Under the new structure, Alphabet will be the corporate parent of a portfolio of diversified businesses. Google Inc. will be part of the new entity and include YouTube, Android mobile software and other web-based products. Alphabet will also include expanding and emerging businesses such as Nest, the smart-thermostat maker, cloud storage, Calico, Google Ventures, Google Capital, etc., with self-driving cars thrown in at no extra charge.

Each business will operate autonomously with a chief executive officer (CEO) and report to Google co¬≠ founders Larry Page and Sergey Brin, who will serve as Alphabet’s CEO and Alphabet president, respectively.

The average consumer of Google products will see no meaningful change. The co-founders hope restructuring will enable them to have a strong CEO run each business, freeing them to focus on capital allocation and maximizing all the businesses’ long-term performance. Managing a portfolio of diverse units to maximize the overall value to various stakeholders is the key corporate strategy challenge.

For many talented people at Google, the change will provide an opportunity to be their own CEOs, thereby stoking entrepreneurialism and helping to retain great talent. For investors, the conglomerate structure should provide greater transparency into how Google invests in various businesses and how the businesses, including the core, are performing.

Alphabet should study how General Electric (GE) operated as a conglomerate during Jack Welch’s 20- year tenure as CEO, when it managed businesses as disparate as jet engines, dishwashers, and a TV network.

Among the reasons GE succeeded as a holding company was that the majority of businesses within its portfolio shared a set of resources that linked them and could be readily leveraged into new businesses. By transferring and sharing specialized expertise, technological know-how, and other valuable resources across its units, the firm was able to perform better and create value greater than the sum of its individual parts.

For example, value was created by training managers, notably at GE’s famed Crotonville Center, regularly moving its world-class managers among the various businesses and driving strategic initiatives such as best manufacturing practices across all units. It was no accident that Welch spent two months a year on personnel evaluation of his top 400 managers. The focus at GE was not just on managing capital allocation, but on developing human capital as a scarce strategic resource.

GE’s umbrella brand was applied to businesses as diverse as financial services (GE Capital), medical imaging (GE medical diagnostics) and lightning (GE light bulbs). Using an umbrella brand in a diversified firm not only has the potential to reduce costs by spreading the fixed cost of developing a brand across many businesses, but also to link its products to a name consumers trust. This, among other resources, could be exploited, transferred and leveraged across a range of businesses.

Simply put, GE was an astute enabling corporate parent that nurtured its individual businesses to become a whole that was far greater than the sum of its parts. The diversified businesses performed better under the auspices of a single corporate parent that they would have had they been stand-alone businesses. The best parent companies create more value for stakeholders than any of their rivals would if they owned the businesses

Jack Welch identified GE’s critical resources, especially human capital. He created a learning organization and transferred resources over a broad range of businesses and geographies. The challenge for Google under the new structure will be to turn all its businesses into an integrated whole that is truly more than the sum of its parts.

To paraphrase Stephen Sondheim’s song, “Having just a vision’s no solution. Everything depends on execution. Putting it together, that’s what counts!”

Originally Published: September 19, 2015

Will Fed finally raise interest rates?

Investors are trying to figure out whether the Federal Reserve will increase interest rates for the first time in nine years at its Sept. 16-17 policy meetings. The guessing game is complicated by recent stock market volatility amid concerns about China’s economy, but it is unlikely the Fed would delay its rate hike solely because of the China effect.

The timing of the Fed’s decision to reverse its near-zero interest rate policy is further complicated by conflicting economic signals that emerged from the last major data point before the Fed meets to discuss a rate increase. The Labor Department reported that the U.S. economy created 173,000 new jobs in August, less than expected, but the headline unemployment rate dropped to 5.1 percent, the lowest since April2008 and a level the Fed considers to be full employment.

Weekly earnings increased to a 2.4 percent annual rate in August and average number of hours worked also rose; all good for increased consumer spending.

Wages and GDP from the second quarter that showed a 3.7 percent annualized growth rate may keep rate increase prospects alive. Moreover, a tightening labor market and decisions by several state and local governments to raise the minimum wage might give the Fed confidence that the inflation rate, which collapsed with oil prices, will move closer to their 2 percent target.

On the other hand, the broader measure of unemployment, including those stuck in part-time jobs and discouraged workers who have stopped looking for work, remains at 10.4 percent. The labor participation rate remains low at 62.6 percent.

And just to make things more complicated, the reported jobs and GDP numbers are far from certain. As always, you can expect revisions in the coming months.

In an effort to induce growth during the financial crisis and subsequent Great Recession, the Fed aggressively eased monetary policy in the final months of 2008, slashing short-term interest rates.

The Fed used additional tools to stimulate the economy by easing credit and keeping interest rates low. Making housing more affordable and enabling households to refinance their mortgages at lower interest rates would free up income for consumer spending. For corporations, reducing the cost of capital would promote investment. Commentators routinely argue whether QE has improved the real economy. Critics contend that reliance on ultra-low interest rates is insufficient to accelerate economic growth. The policies may support economic activity, but can’t take the place of fiscal policies such as addressing mounting debt, rising entitlement program costs, the need for infrastructure investment, repairing the tax code, and trade policies that advantage the American worker.

These critics argue that the Fed’s policies transfer wealth away from savers and force savers and pensioners to take on more credit risk in an effort to boost returns in an era of low rates. Corporations use cheap money to engage in stock buyback programs rather than capital investment.

Put another way, the Fed pushed trillions of dollars of new money into banks, but too little trickled down to the real economy and job creation. According to this crowd, the Fed has been fighting for the one percenters.

John Stuart Mill said, “He who only knows his side of the case knows little of that.” It will be very interesting to see what the Federal Reserve does when it meets later this month to sort out piles of conflicting data and decides whether it’s finally time to raise interest rates.

Originally Published: September 12, 2015

Not ‘too big to fail,’ too interconnected to fail

At about 12:30 a.m. on the morning of Monday, Sept. 15,2008, a press release went out from the 158- year-old investment bank Lehman Brothers announcing it was seeking bankruptcy protection. Lehman’s downfall would become the watershed event of the financial crises.

While this event may not be seared into American memories like the Sept. 11 terrorist attacks, the collapse of Lehman triggered the worst financial tsunami since the Great Depression and was a seismic shock to global financial markets.

It was the largest Chapter 11 bankruptcy in American history to that point, and triggered the longest and deepest recession in generations. Within 21 months, $17 trillion in household wealth evaporated; the unemployment rate doubled to 10.1 percent in October 2009; and the nation’s credit system froze up, costing millions of Americans their jobs, homes and savings.

The weakest recovery since World War II drags on. Despite unprecedented monetary policy in which trillions spent on quantitative easing and near-zero interest rates benefited those who wear Zegna and Ferragamo, it has not helped the average working American.

Main Street has taken a beating. Wages have been rising at the slowest pace since the 1980s, while the rising gap between workers’ productivity and their wages is diverted to stockholders and management.

The government underestimated the repercussions of letting Lehman fail by failing to anticipate the systemic risks posed by Lehman’s bankruptcy. Both Lehman’s size and its interconnectedness with companies worldwide effectively created a credit event that far surpassed the magnitude of any that had come before.

Financial firms were not “too big to fail,” they were too interconnected to fail. The companies were reliant on one another in a variety of ways that were essential to the smooth running of the financial system. The feds failed to grasp the impact of a mortgage written in California that had been sliced and diced and sold several times and ended up in the portfolio of a Norwegian pension fund.

Six months before the Lehman crisis, the feds kicked in almost $30 billion to facilitate the shotgun marriage of Bear Steams to JP Morgan. But this time they refused to backstop losses from Lehman’s toxic mortgage holdings. Why did the government step in to bail out Bear but fail to rescue Lehman, a firm twice Bear’s size?

In part, Lehman Brothers was allowed to fail because of Bear Steams. The political fallout from Bear’s bailout worked against Lehman. Public backlash against taxpayers potentially assuming Bear’s losses made rescuing Lehman Brothers politically untenable. The feds believed they could not enact a second bailout just weeks before a presidential election.

They also thought a bailout might lead other firms to expect a similar treatment. The feds were reduced to jawboning Bank of America, HSBC, Nomura Securities, and Barclay’s Bank to “rescue Lehman on their own”. This proved fruitless without government assistance.

So the second domino would fall; it would not be the last. Only days later, all hell broke loose and the feds had another change of heart; they opened their checkbook and bailed out insurance giant AIG, which was on the verge of collapse. Since there were no “white knights” with sufficiently deep pockets to buy AIG, they had only one option: To effectively “nationalize” the company. They provided an $80 billion credit line from the Federal Reserve, plus additional loans and other direct investments that eventually totaled more than $170 billion, in exchange for an 80 percent equity stake in its ownership.

So the die was cast. Henceforth, the feds would be the business community’s sugar daddy; passing out allowance money by the billions to unruly children such as General Motors and Chrysler, while trying to keep them from squandering too much of it on “tooth-rotting candy” in the form of huge bonuses and lavish perks for top management.

To paraphrase Ralph Waldo Emerson: “A foolish inconsistency is the hobgoblin of little minds”.

Originally Published: September 5, 2015