Some years ago I worked for a large insurance company. I was originally hired to help deal with a class action suit, but soon found myself working on something different, demutualizing the company. Mutual insurance companies are owned by their customers, not by shareholders. This has a number of advantages, but it means you don’t have shares, and thus buying out other companies requires cash, and you yourself can’t be bought. You also can’t give stock options to your executives (not a small matter, these days).
Mutual companies also have one big social benefit: they provide insurance cheaper, because they don’t have to pay dividends or stock options and they return profits beyond those expected to the policy owners. (Stock options supposedly don’t have a price, but they do in effect, both because of the rampant use of company profits for buybacks and because of how they change company behavior.)
Demutualization requires a vote by the shareholders. There was never any question that it would pass, however, since it amounted to cashing out a lot of money. For big policy owners the take could be in the millions, for smaller ones ten to twenty thousand wasn’t uncommon.
This part is important, so pay attention: this was the first cashing out moment, and what it was was a transfer from the past and future to the present. Going forward every future policy holder would pay more money for their policies in order that the current generation could take out value.
The price of the shares was set at about $18 dollars, as I recall, they fell a couple bucks, then they spent the next two years rising, peaking around $40. The CEO had bought five million dollars of shares at the initial price, which everyone knew was less than the company was worth, he did very well.
But the real change was driven by what is called “market’ discipline”. Suddenly we needed to make 15% profits every year.
Insurance isn’t a business where you should be making that sort of profit. Virtually no business is, but insurance in particular should be stodgy and boring and conservative, because its job is to be there when the customer takes their losses.
Friends would ask me about the company in those years, and I would say “it’s being run reasonably well, considering, but they’re burning down the house to make the profits.”
What do I mean by that? They were pushing out senior junior employees. In the pension department, for example, almost all of the senior customer service reps were gone within two years. Why? Because the new regime expected insane numbers from them. Those numbers could only be produced by, well, lying to management.
Meanwhile, every month the sales numbers were being manipulated more and more, with sales which hadn’t actually completed being moved forward as if they had been. Jobs were taylorized and de-skilled, so that employees had no real knowledge of the process, this in a company with the highest average face amount (amount covered, like a million dollars or 10 million) in the industry.
Products were designed overly fine, so that if customers missed a single payment by even a week, they would likely go into default, but those losses wouldn’t show up for years, since it would take time for the defaults to occur.
And the company went out and bought a big, moribund insurer, with an extraordinarily sick corporate culture and then struggled to make it work.
Bottom line: that company couldn’t make 15% without cutting corners which shouldn’t be cut. You can provide worse customer service to multi-million dollar clients for a few years, but eventually your rep catches up with you. My job was to deal with those customers, and as mistakes and problems occurred, I would burn through my social capital. Most of my clients loved me, but there are only so many problems people will tolerate. The same sort of thing was happening everywhere. Eventually it came home to roost, and they stopped sending us as much new business.
For a few years, heck, for a decade, it mostly looked good to outsiders. The company produced its 15%, the stock did well, and everyone outside the company was happy.
Then the shit hit the fan in 2008, and the company took the shock badly compared to equivalent competitors. All of the corners they had cut came back to haunt them.
When you have a good company, product or service, you can always cash it out. You just cut corners for years, and cruise on your reputation. And for years, it works, until it doesn’t.
Which brings us to this news story, about how the fashion company Hermes doesn’t want to be bought out by a conglomerate.
Family members recoil as they recall an LVMH official’s suggestion that Hermès bolster sales by creating a line of lower-priced bags.“It’s exactly what you shouldn’t do,” Mr. Dumas says. “Because you will make a cheap Hermès bag which will sell like hotcakes for three years, and after three years people will say, ‘Hermès is not what it used to be.’ ”
Mr. Thomas says: “If you tell me I have to double the profit of Hermès, I will do it tomorrow. But then you’d have no Hermès left in five years.”
There’s a man who gets it.
Here’s the rule, whenever greed becomes a primary motivator, and an acceptable primary motivator in a society, the society burns itself down. It extracts money by destroying actual long term value. This has been going on in the West, with its most extreme forms in the US, for over 30 years.
But as a society, what you get is money while destroying actual value. The society as a whole is poorer than it would have been otherwise.
An actual capitalist society (which we do not live in) makes cashing out very difficult. You don’t want people creating money by destroying value, and you don’t want viable ongoing concerns arbitrarily destroyed or weakened. Whenever a company is bought out by borrowing the money, then making that company take on a loan to pay back the original loan and then another loan to pay the buyers even more money, money has been extracted while value has been destroyed (layoffs and other cost cutting inevitably follow).
As a society, allowing this sort of behaviour is death. You must make sure that people do better by adding value than by destroying it. Forceful short term extraction of money destroys value. The only profits that most people should see are long term profits. Want to get rich? Great. Either create something genuinely new under the sun (and no, Facebook is not something genuinely new, it is merely the winner in a market someone was going to win) or stick it out for a good twenty to forty years, taking your legitimate profit each year.
When you make it possible for people to get rich by destroying jobs that actually create value, by destroying companies which are actually viable, you are destroying your own society’s prosperity.
Notorious P.A.T.
Don’t worry, if we give those rich people tax cuts, they will create jobs. Any day now.
Seriously though, how do you make cashing out difficult (which I sure support)? High tax rates on top earners?
Morocco Bama
Excellent post. I agree with you completely. I’ve been in similar situations to what you have described here, and this is my exact observation. The microcosms you and I have witnessed are the indicative of the macroeconomics, and so, here we are. Unfortunately, not enough people see it this way, and so that destruction of value continues unabated, until there is nothing of value left, aside from bits and bytes on fancy sand.
lambert strether
Hold tight wait till the party’s over
Hold tight We’re in for nasty weather
There has got to be a way
Burning down the house
Here’s your ticket pack your bag: time for jumpin’ overboard
The transportation is here
Close enough but not too far, Maybe you know where you are
Fightin’ fire with fire
Cathie from Canada
Somebody (IF Stone? Ben Bradlee? ) once described the basic dynamic of business failure this way: its when General Motors thinks it is in the business of making money, and forgets it is in the business of making cars.
Charles H. Green
Terrific comment. First-rate. Thank you very much for being so articulate on this critical issue
Jim from Seattle
Awesome post, Ian. Thank you for putting this into context. I’ve always had the suspicion that LBOs and Private Equity firms were inherently evil. Now i understand why.
guest
Excellent post and epitath for America.
How do you make cashing out difficult? Easy. First of all you don’t tax capital gains and dividends at half or less the rate of ordinary income. You tax it the same or higher. Say 90% for short term capital gains, 80% for second year, 70%, etc.
There are dozens of things you could do to make the tax system simpler, more fair and better for the long term economy. Basically they are all the opposite of what is considered fair (to the rich) or good for the economy (of the rich) that they teach in business school, and then repeat ad nauseum as conventional wisdom on MSNBC and the rest of the cesspool of what passes for journalism and economics in the west.
Mandos
On an OT but related note, can I send up an MMT bat signal to some of the MMTniks that I think occasionally read here? This is hard to do since I got the boot from Corrente. The MMT references start towards the second half of the linked thread.
Cujo359
That’s the story of many American industries these days, Ian. They’ve been “restructuring” themselves into irrelevance or incompetence, and often both.
Suspenders
This reminds me a lot of video game publisher/developer EA (Electronic Arts), as well as Activision. They buy out successful game studios, then get them to release shitty/endless sequels that make money but end up destroying the franchise. When they’re done milking, they shut the studios down, fire everyone, and the cycle repeats.
Morocco Bama
The title of the thread is figurative, of course, but when one applies it to Japan’s impending Nuclear catastrophe, and Nuclear power in general, it is quite literal. Our species may well have been able to survive a natural event that physically destroys much of our human-made infrastructure, but when you take the implications of all the Nuclear Power stations in the world melting down concomitantly, there is simply no chance for survival, thus science enjoined to greed has secured the fate of our species, and of most living organisms on earth. Nuclear power was always an abomination….a genie that should never have been loosed from its bottle, but like the story of Adam & Eve in the Garden of Eden, humankind couldn’t contain itself, it had to eat of the one forbidden tree. I’m not religious, rather a strong agnostic, but that story is great metaphor for the advent of Civilization and its technological implications. Once humankind crossed over from hunter-gatherer to Civilization based on centralized and planned economies, we ate of the tree and our fate was sealed, because destructive outcomes could now be centralized, concentrated and highly leveraged to a much more substantial percentage of the entire population than was ever previously possible under a highly diversified, and geographically dispersed hunter-gatherer society.
Suspenders
I think you’re being much too morose Morocco. Any event that causes meltdowns to occur in a large percentage of the worlds nuclear reactors is probably an event that we wouldn’t have survived in any case, thus I don’t see that as an actual problem.
Also, yes, we’re in the unique position of being able to destroy ourselves, but that doesn’t mean that we will. Humans we’re just as likely to become extinct in the natural world even without technology and civilization (some population bottleneck theories say that we damn near disappeared at a few points), so I for one will take the risk of technology over natures vicissitudes.
Morocco Bama
I disagree, Suspenders. The system that now flourishes despises diversity and seeks homogeneity, on a grand reproducible scale, allowing for faulty decisions to affect every single individual, and life form on the planet. Diversity via decentralized societal structures stand a much greater probability of surviving such an event.
I for one will take the risk of technology over natures vicissitudes.
It’s not a matter of you, or I, taking or not taking anything. It’s here and it’s what we have, and it’s what we’re going to have, and it’s what will be the death of us. It doesn’t care what you, or I, think about it. It marches on, unassailed. You/I feed it, and it feeds you/I everyday, day in and day out, year after year, until we’re no more.
Oh, and nature’s vicissitudes will occur regardless of our technology, and also, partly, because of it. Technology doesn’t trump nature….it’s the other way around. In the case of the unfolding nuclear power crisis, technology ensures our fate when a catastrophic natural event unfolds….an event that didn’t have to be extinction level.
Of course, I’m sure the dime store liberals would conjecture that such an existence would be likened to no existence at all, so why not end it all if you can’t have Williams-Sonoma, Starbucks, Volvo and Fiji bottled water.
BlizzardOfOz
I have this sneaking suspicion that what these eco-liberals actually hate about nuclear power is this: it offers abundant energy and the ability to sustain a large population, without, unlike oil, a plausible way for liberals to go around saying it will be our doom. They think humans are a cancer on the planet, so anything that sustains them is bad.
dude
Your example of Hermes is exceptional. I don’t know how many times over the past 30 yrs I have heard marketing and business gurus prattle on and on about “branding”, then continue down the path of selling 3rd and 4th rate goods under an esteemed name. The prostituting of ones reputation is never a pretty sight, and it leads to a lot of deception.
I wish the founders and builders of those fine reputations simply wouldn’t leave their businesses in the hands of others along with their “brand names”. They should require the brand-name to follow them out the door.
Which reminds me of a certain salesman’s phrase you hear a lot, particularly in the construction industry:” Oh, you know Company XYZ that I used to represent? Well, it was bought out by Company ABC, so now we call ourselves Company QRS. But make the same things now, just like before.”
When you hear this, get away from the salesman PDQ.
Ian Welsh
The problem is really simple: if Japan goes off nukes, they will replace it with coal, which is worse. What Japan needs is turbines capable of properly using tidal power.
Ian Welsh
For cashing out, there are a few necessary things, the first of which is to tax capital gains very highly. In fact, unless you’ve held the asset for at least 10 years, I’d tax it at higher than the rate for general income. The second thing is to make leveraged buyouts extremely difficult to execute. The third thing is to brutaly restrict any payout of theoretical future profits right now. You get paid only what is paid now, not on theoretical values.
myiq2xu
Excellent post. The expression that comes to mind is “eating your seed corn.”
If an ambitious young executive wants to make a name for himself these days he should figure out a creative new way to extract value.
There will always be people eager to take the money and run. In a smart society they wouldn’t be allowed to get away with it.
peter cowan
Ian,
I’ve been reading your stuff since ~2003 or 2004, this one ranks up there with the best. that insurance job of yours sure has provided you a wealth of material over the years 🙂
tBoy
It is always easier to destroy/ransack than to build. Tax rules and regulations should penalize the former and reward the latter.
David Kowalski
No one can say we didn’t know we were burning down the house but the economic powers that be did it anyway in the U.S. There was a spate of books in the 1970s including many bestsellers that lauded the Japaneses model for building up long term profitability and sustainable companies at the expense of some short term profits.
Lo and behold, we went far beyond 1970s practices and entered into a stage of corporate locusts eating up every thing in sight for short term gains and next quarters stock prices. That isn’t “market discipline”, it is no discipline at all.
The practices are simple. Cut research and development except for methods of re-branding existing patents. Take huge losses now for small future gains and the stock market will love you. Fire people. Outsource, Depend on financial gains and game playing. Move on before the damage hits and ruin another company. And another. Oh, yes, loot worker pensions. Don’t fund contracted benefit payments. Any amoral person with money and an above average IQ can do this. It takes no special genius. It does require that regulators are toothless and alert and unions are irrelevant.
scruff
@Suspenders:
“On a long enough timeline, the survival rate for everyone drops to zero.” – Chuck Palahniuk.
That’s true for individuals and species, both. Doesn’t mean we should allow behavior that probably shortens that timeline.
@BlizzardOfOz: I’m willing to step up and admit to being someone who thinks that sustaining the current type of civilization is a bad thing. Ignoring both oil and nuclear’s environmental problems, even a perfectly clean unlimited energy source would lead to an apocalyptic scenario for every other species on the planet and eventually ours as well. This is not because humans are inherently bad; humans had been around for hundreds of thousands of years without being anywhere near as ecologically destructive as (most of them) are right now. Humans are not a cancer, but humans can act like a cancer, and they have been. The behavior Ian’s talking about in this post is just one aspect of the problem, viewed from a financial angle. The same kind of behavior is taking place in a generalized sense, though; ecologically, and even psychologically. So yes, some of us also dislike nuclear for the reason you say.
But it’s a damn good reason.
Notorious P.A.T.
Nuclear power has a lot to recommend it, no doubt. But you can’t look at Japan today and say people who have reservations about it are “gloom and doomers”. When a solar power plant goes wrong, you miss “Wheel of Fortune”. When a nuclear plant goes wrong, half the globe gets fallout dumped on it. And as we’re seeing, there’s a lot of ways for it to go wrong.
Petro
@BlizzardOfOz:
Sustains? Not so much. Sustaining good – it’s our Malthusian resource abuses that are “bad.” Luckily, that is just a behaviour.
Morocco Bama
What the hell is an eco-liberal? First I have heard of that term. It certainly doesn’t describe me. But since we’re playing that little game, how about a techno-liberal to counter your eco-liberal. The techno-liberal has rejected and replaced his/her God of the Abrahamic traditions with his/her new God, and new found faith in, Technology. Of course, this was after excursions into the Eastern religions and philosophies before becoming devout Atheists….as devout as any Fundamentalist Christian, Muslim or Orthodox Jew, that there is no God, and science and technology are the alpha and the omega……and humankind’s salvation.
This comes to mind.
http://images.wikia.com/planetoftheapes/images/4/4e/Mutant_service.jpg
Bruce Wilder
In general, after taxing “bads”, tax economic rents.
In the modern economy, this means finding ways to tax gateway rents, but it’s not necessary to be clever, just enact very high top rates on personal income from whatever source.
That an executive in an American company can make $10 million or more, per year, at the top of a large American corporation, sets up a corporate tournament for the top spot, which will attract sociopaths, and encourages short-tenures at the top.
That the biggest wage-earners in the world are hedge fund managers, and we have a special 15% income tax rate for them is a marker of just how crazy, policy is.
In an economy, in which network economies dominate, the corporate alliances and mergers grow like kudzu, seeking out gateway rents to exploit, in order to pay out the salary and bonus that runs into tens of millions of dollars. Felix Salmon has a nice piece about how the banksters are going after electronic payments systems. Corrupting the payments system, to skim a percent or two, could go way beyond burning down your house for heat; it’s like burning down Chicago, for a reading light.
HumbleAuthor
Consider yourself reposted!
Great analysis of a problem central to our current economic system – that we sacrifice capital for currency. Just like in an ecosystem, the greater the amount of capital, the more of a buffer we have against shocks, and the more carrying capacity the system has. The more capital exists, and by that I mean ALL capital – natural and man-made, the richer the economy and the greater its ability to support life. The company that sacrifices capital to make a profit is, in effect, eating itself.
I talked about this concept of capital adding carrying capacity to an economic system through comparing amphorae and intermodal containers:
http://greenreserve.blogspot.com/2011/03/of-amphorae-sea-containers-and-jane.html
Morocco Bama
I don’t agree with the notion that capital = value. I do believe capital covets value, and may also pretend to be value, but it is not value.
HumbleAuthor
Not saying that capital = value, but it can be cannibalised to make value. Capital is the economic equivalent of environmental carrying capacity. As capital expands and diversifies, it renders the economy more robust and healthy. A forest is capital. Managed properly, it can produce wood for milennia. The trees are natural capital. Trained people are human capital. Ridding oneself of them costs less, but diminishes the carrying capacity of the enterprise, making it susceptible to economic shocks. A factory is capital in the traditional sense we learned at high school, it creates products – but it can be sold for a boost to the bottom line when share price gets too low.
Just so, airline companies now typically don’t own planes – they lease them. This is a constant ongoing drain on resources to pay interest. They capitalised on their owned planes in the 80’s by selling them to the bank, went through a period of massive agglomeration fuelled by this cash, and now what have they to show for it? 2001 wrecked the already fragile airline economy and it’s only just recovering. It’s corporate cannibalism.
Celsius 233
Kudos Ian; good one.
The Ouroboros comes to mind; it would seem to be the perfect symbol for western capitalism…
StewartM
I once posted a proposal like this (coupled with income tax rates of up to 90 % or more):
Capital Gains tax = Income Tax Rate – 3 x N.
Where N = the number of years held, up to a maximum of 15.
The advantage of this proposal is that it would mean that wealthy people could lower their capital gains tax *only* by holding them 15 years or longer. Destroy the company you’re in charge of, and those stock options become worthless pieces of paper. Execs would hopefully have then every incentive to make sure when they depart that the company’s in better shape then when they took over.
Heck, enforce anti-trust law. Too many Comglom-o’s have been allowed to form that shouldn’t legally have happened. A case of buying out the regulators.
What about the creation of a national bank and (if need be) national insurance agencies run to break even? The whole fallacy that capitalism tends to reward is the notion that one can sit on one’s duff and manipulate money to get rich instead of creating real goods or delivering real services. In the current system, making money by manipulating money is too easy, so it sucks up investment that should go into improving the creation of goods and services. That’s why the financial sector in the US now consumes over 10 % of GDP (while the great postwar boom only required 4 %).
StewartM
BlizzardOfOz
http://www.math.columbia.edu/~woit/wordpress/?p=3515#comments
I thought this (physics) post ties in with Ian’s post. To summarize: a physicist points out that the PR people employed by the Large Hadron Collider are churning out useless hype about string theory and parallel universes. To that, a couple of commenters reply that they “have to say something” and the best way to get funding is with these fantastical speculations. In other words, science is another institution that is burning itself down, cashing in prior accomplishments and destroying future value. Shakespeare could have been talking about our society:
In me thou see’st the glowing of such fire
Which on the ashes of its youth doth lie,
As the deathbed whereon it must expire,
Consumed with that which it was nourished by.
Ian Welsh
I would prefer Capital Gains tax = Income tax +15 – 3xN
PPDCUS
Winning the Future …. for whom?
This story doesn’t address how public policies like tax cuts on profits that destroy value make this scenario much worse, not the same or better, accelerating the process. It’s as absurd as putting the CEO of GE in charge of creating jobs in America.
Oh wait, that IS the bold, new plan for Winning the Future, isn’t it?
StewartM
The basic idea would be that you could reward people taking *long term* risks with their money with a lower tax rate. The current system in the US calls one year’s holding “long term” and taxes at only 15 %. The subtraction method would also allow middle-class people who put money away for their retirements to pay little or no *income tax* on their savings. You could season the actual rates to taste.
I also proposed while doing that (to think of this as a whole package):
a) an income tax upwards of 90 %;
b) a health care tax of 10 % on all sources of income, to be taken out before income taxes are calculated; to fund essentially free health care. 10 % of GDP is about the averaged cost of health care everywhere else, so it should be so in the US.
(I personally believe that as we in the US suck at regulating business, long-term, that a system of highly regulated insurers a la the Netherlands or Switzerland or elsewhere won’t work here. That seems part of our culture. The best solution would be a combination of Canada’s universal insurance coupled with Britain’s National Health service, a Medicare-for-all coupled with a VA-for-all system. Reimbursement rates for the Medicare-for-all system for any other health care provider would be calculated on what it costs the VA-for-all system to provide the same care. Ergo, while you could have private clinics and hospitals exist, when you walk into any VA-for-All clinic or hospital, your treatment is totally free.
That I would hope would eventually force the for-profit sector of the US health care system, the part responsible for the current mess, out of business. We would be left with a combination of the VA-for-Everyone system and private non-profit deliverers (run religious and humanitarian agencies). I believe the latter could do quite well under reimbursements paid out on VA rates. They were never the cause of the problem.)
c) a retirement tax of 6 % on all sources of income, again taken out before income tax is calculated, with no caps, to fund Social Security–AND which would allow one to increase current payouts by 50 % or more, to take care of low-income people who rely almost exclusively on SS for their retirement income. (No, Alan Simpson, it’s not SS that’s busting the budget).
So our prospective billionaire, even with holding 15 years or more capital gains, still pays over 60 % of his income in taxes even in the best-case scenario. (10 % + 6 % + 45 %). That’s about 4 times their current effective tax rate and comparable to their effective tax rates in the 1940s-1964 era. A middle class retirement saver by contrast might escape the income tax part altogether but would still pay the 10 % and the 6 % portions (i.e., no income, whatever the source, escapes that taxation).
StewartM
Mandos
BoO: That’s normal in science promotion and very old. Lay journalists ask, “What can you say about [fashionable hyped thingy X]?” and the scientist has a choice between (a) “I don’t think it’s likely that this has anything to do with X, but rather about proving [unromantic apparently obvious/trivial (but actually profound) or too abstruse thing Y]” or (b) speculate vaguely but safely about something that will never happen, and hope that people forget about it in time so that budget terrorists don’t view it as a public target.
If the scientist/science promoter chooses option (a), then you have columnists in newspapers wondering what is the point of this boring expensive research, and a public whose dreams of transporter rays is dashed.
It’s not the science, it’s the journalists and politicians—and the public.
StewartM
I see this all the time, in my job and in the papers I read. The rise of supercapitalism has fostered rampant careerism in science. This is exacerbated by the fact that many science-dependent companies require their prospective managers to have a PhD in the field.
But to manage a department or a business, you don’t need any friggin’ PhD. A BS or MS will do just fine, because all you need to do is to be able to talk and to understand the language. The result of this is that you get 2nd-rate PhDs coming out of the schools, people whose interest truly isn’t in the science itself but in the $$$ in their eyes once they can switch from the technical to the managerial tracks. You create exactly the wrong type of “scientist” this way: instead of being tentative, hesitant, guarded, even pessimistic in their hypothesis, these are b0ld, arrogant, confident, and optimistic.
Of course management loves the new breed: what would you like to receive as an answer to “Can you technically do this?” An answer of “Hmm, perhaps, we’ll have to do a lot of work to demonstrate the concept first which will require a lot of expense” or “Sure we can!” I am reminded of the quip of Confederate general Joe Johnston, when he was fired for failing to express “confidence” in his ability to defend Atlanta: “Confident language is generally not regarded as a sign of military competency”.
The new breed also produces a lot of junk papers and articles, papers either contributing little in the way of worth or producing crappy data. Anything to pad the resume, baby.
Lastly, and related to this, there is this: there has been a veritable explosion of educational over-requirements for most job positions. PhDs are required for professional bench positions that used to be staffed by BS and MS people, BS and MS people are hired as technicians that used to be staffed by those with AS or technical school training, and lower positions, which used to be filled by high school graduates, now are being filled by people with some college degrees (either in the field, or in another science field). None of this is technically necessary: the jobs haven’t changed that much, they’re not more technical or more difficult than in years past. It’s a yet another form of pay cut for American workers to feed the profits of today. And it’s another form of class warfare, as the ability to go up the educational scale is usually related to the socioeconomic conditions of one’s birth.
StewartM
stevo67
Cashing out value is the exact same process used by the mob in Goodfellas. When Henry Hill’s friend partnered up with Paulie Cicero’s crew his business line of credit was fully maxed out until the only cash raising mechanism left was to torch the restaurant and collect from the insurance. Modern day Corporate America has learned these lessons taught by the Gotti’s and Tony Soprano’s well.
scruff
^^Indeed; confidence is the new competence. and positive thinking has taken the place of critical thinking.