Friday, December 9, 2011

Do leveraged buyouts destroy the economy? Krugman thinks so

It is interesting to watch the millionaire Paul Krugman turn into a populist, as the more he goes off on "taxing the rich," the more he demonstrates his own economic ignorance. In a recent column, he attacks Mitt Romney for being a "job destroyer" because Romney's firm, Bain Capital, engaged in leveraged buyouts, likening him to the villain of Oliver Stone's move, "Wall Street."

Not having seen "Wall Street" or its sequel, I'm not particularly interested in Oliver Stone's view of the world, especially since Stone worships dictators such as Fidel Castro and Hugo Chavez, both of whom have reduced their respective countries, Cuba and Venezuela, into economic basket cases. Nonetheless, the theme that Krugman wants to portray is that leveraged buyouts usually are bad and that they "destroy jobs."

The problem is that Krugman (once again) does not understand the simple Law of Opportunity Cost, which is pretty common among Keynesians. He writes:
So Mr. Romney made his fortune in a business that is, on balance, about job destruction rather than job creation. And because job destruction hurts workers even as it increases profits and the incomes of top executives, leveraged buyout firms have contributed to the combination of stagnant wages and soaring incomes at the top that has characterized America since 1980.
It is hard to know where to begin, but I will start by saying that the official rate of unemployment by itself is no measure of prosperity or even the health of the economy. I recall watching two economists debate each other on television about 30 years ago, with one of the economists having come back from a trip to Romania and talking about the poverty that he witnessed there.

"But there's NO unemployment there," the other economist shot back. (The second economist is a Marxist and teaches at a university where I used to live.) To the Marxist, "unemployment" was the trump card: "Aha! You claim Romania is a bad place to live, BUT EVERYONE THERE HAS A JOB! SO THERE!!"

Indeed, after the communist regime fell there, the curtain was lifted and people found out just how poor Romania was and how even the government's official "we have no unemployment" line was fraudulent. Nonetheless, people on the left still hold that unemployment really is the only variable that matters, economically speaking.

When it comes to issues of leveraged buyouts, Krugman's logic goes south, especially on the employment situation. First, we have to remember that a viable firm is one in which the value of the whole is greater than the sum of its parts. This is important, because Krugman wants us to believe that firms like Bain buy healthy and viable companies, destroy them from within, and then pocket the money and throw people out of work. Furthermore, it is the creation of unemployment, according to Krugman, that creates the "wealth" for people like Romney.

Now, we have to understand that the ONLY way for Bain or any other firm in this situation to make money is for the standard "buy low, sell high" and the only way that such a thing can happen with a leveraged buyout is for the sum of the parts of the firm be greater than the value of the firm as a whole. In other words, the firm has to be in trouble, whether it be mismanagement or something else that has made the company decline in value.

For example, Bain could NOT have purchased Apple for a leveraged buyout, since the value of Apple as a firm would be greater than all of the individual assets that Apple possesses. Yet, if one reads Krugman's column, he wants to paint a picture of Bain purchasing a company that is doing great, and it just destroys it so that some rich guy can walk off with money in his pocket.

Logically speaking, that is not possible. One cannot purchase a viable, healthy firm, sell off its assets, lay off its workforce, and make money. For that matter, the kind of cost-slashing measures that might occur if a corporate raider actually tries to save the firm are not arbitrary; they are done because the value of the sum of the parts is greater than the value of the whole.

Employees who go through such buyouts generally don't have happy stories to tell about it, but one should remember that if a firm is in a situation in which it finds the value of the sum of its parts to be greater than the value of the whole, the hard truth is that those employees most likely are going to lose their jobs, anyway. Why? A firm in that condition is not likely to last long, as it has an illness that either can be fixed only with new management or entrepreneurial ideas, or is going out of business (where its assets will be sold at a bankruptcy auction).

An analogy is the junkyard for cars. Many of the cars that are brought to junkyards still can be operated, and many of them could be fixed to the point where they might work. Junkyards, however, don't make money from fixing the cars on the lot. Instead, they make money by selling the parts taken off the junked cars to mechanics and dealers or selling the components as scrap to be recycled.

That is the hard reality of the world of leveraged buyouts. A firm is not a candidate for such a fate unless buyers perceive either that the company is going out of business or is so mismanaged or has unnecessarily-high costs of production. As everyone knows, leveraged buyouts are risky in that the raiders sometimes don't get what they anticipated, and when people lose their jobs, there are hard feelings.

However, Krugman would have us believe that leveraged buyouts are the CAUSE of unemployment, as opposed to the fact that job losses in such situations come about because the firm no longer was as viable as it once was. True, I realize that Keynesians probably are incapable of thinking of something in terms of opportunity cost, and they certainly can find no value in someone breaking up a firm and selling off the assets when the conditions allow them to do so.

In Wonderland, economies grow because of the nebulous thing called "aggregate demand," which is created by governments creating money. There is no such thing as opportunity cost in that world, and the entrepreneurial processes of creating more goods while using fewer resources does not spell growth to them, but rather unemployment.

Krugman wants us to believe that people get rich in a market economy by causing large-scale unemployment. In a market economy, people become wealthy by providing something that others want and are willing to give up something scarce that has value to others in order to obtain that new good or service. In the process of doing so, entrepreneurs create employment opportunities that enable more and more people to be able to obtain things that they previously could not.

Unfortunately, Krugman has chosen another path of explanation and the end result of governments following his advice is more poverty, inflation, and, in the end, more unemployment.

9 comments:

Salamano said...

What about the situation where "Company A" is profitable, but can be calculated to be even more profitable when various labor and pension contracts can be done away with-- and various productivity ratios can be increased?

"Company B" could conceivably buyout "Company A" with a sweet deal for owners/board members, and then when reforming the company can usher in a new regime of productivity combined with a less-positive environment for a lesser number of employees-- and more profitability.

Is this correct?

This could be an example in which the sum of the parts are not as valuable as what the sum of the parts "could be" under different employment settings that are worse from the perspective of the employee. In this way, the company itself doesn't even need to be in dire straits to be attractive for a leveraged buyout, no?

Dan said...

Well said Will. Any accounting graduate like myself could have told Krugman he has no idea what he's talking about. Companies that engage in merger's and acquisitions will play a premium because the company feels their is potential for growth in the newly acquired company, it's called goodwill in the financial statements. If you pay less then what the company is worth, that's always a sign that their are some major problems that are currently here or are coming in the future. For these firms to be liquidated at this point frees up resources to be better used. So yeah, Krugman does wish us to all live in poverty, hey at least we'll all be equal (expect for the political class)

RSS Ronald Reagan said...

Excellent post as usual. I only have one critique. You say, "people on the left still hold that unemployment really is the only variable that matters, economically speaking."

I contend they aren't even consistent on that. Do you recall in--I believe it was the late 1980s--when Al Sharpton was out raising cain in some urban community or other about the lack of "jobs with dignity"? Of course, Sharpton wasn't the only one doing this. I can well remember the gripe against the Reagan years (aside from describing it as "the decade of greed") was the complaint that all Reagan produced was "a bunch of hamburger flipper jobs."

Major_Freedom said...

Salamano:

What about the situation where "Company A" is profitable, but can be calculated to be even more profitable when various labor and pension contracts can be done away with-- and various productivity ratios can be increased?

"Company B" could conceivably buyout "Company A" with a sweet deal for owners/board members, and then when reforming the company can usher in a new regime of productivity combined with a less-positive environment for a lesser number of employees-- and more profitability.

That is different from a leveraged buyout that leads to breaking up companies. This is a buyout that improves the productivity of the company by reducing the amount of labor needed.

That is also a good thing because it means labor is released and made available to help produce other things that consumers want but couldn't buy because the necessary labor wasn't available.

In this case, it would be akin to "Gordon Gekko" buying out a horse carriage factory, and turning it into a car factory with fewer workers than before.

The released labor from prior horse carriage making would then compete in the labor market, which will raise the supply of labor. If the labor market is not hampered with by politicized "protected" unions, minimum wage laws, etc, and currently unemployed workers can freely negotiate with potential employers, then the temporarily unemployed can find new jobs, and because wage rates are now slightly lower, business costs will fall as well, and for manufacturing processes, that will tend to lower the output prices will fall to the same extent as well.

So the fall in wage rates, since it is tend to matched by the same fall in prices, does not lower worker's standard living because of that. However, because the productivity of the economy is now higher (since there is more being produced on account of the first company's increased productivity), it means supply is increased that much more, which means prices for goods falls by MORE than the fall in wage rates.

The final outcome is thus a rise in real wages. Yes, workers are on average making lower nominal wages, but their real wages are higher, since the prices of goods falls by MORE than the fall in wage rates.

The thing you missed in your question is that there is no permanent state of unemployment for the temporarily displaced workers who are released on to the labor market on account of investors abandoning old or obsolete methods of production, and adopting better or newer methods of production.

Since workers have an obvious interest in keeping their jobs, the same way that investors/entrepreneurs have an obvious interest in retaining their income stream, then ECONOMIC COMPETITION INDUCED LOSSES AND UNEMPLOYMENT is often the ONLY way that people will stop doing what they are doing, and be compelled to improve the way they do things because innovators have discovered a better way of doing things and are attracting business away from those who refuse to change.

Sure, if investors and workers refuse to change, if they are stubborn, if they insist on using the old and obsolete methods of production, then their losses and their unemployment would be THEIR FAULT. It won't be the fault of the Gordon Gekkos, who are moving the economy forward and recognizing improvements and implementing them when they see them.

If you had your way, if unions had their way, if the government had its way, we would all still be going to work at the horse carriage factory.

Anonymous said...

I understand your example.

But, instead of the 'Horse Carriage / Buggy-Whip' example, let's try something more modern. Say, the buyout of a coal mining outfit whereby the assets are 'broken up' to suitors, who at the end of the day continue to maintain the exact same coal output, but with less labor. The employees in this example are only of high-school education, and who's resume only includes a truncated career in coal mining. The nearest coal mine not owned by this particular company is 100 miles away, but does not have openings.

Does this example contain released employees that can realistically compete in the labor market to produce something new? Would not this reality cause ripples in the economic picture that are different than the expected modeling in your example? (playing devil's advocate)

Major_Freedom said...

But, instead of the 'Horse Carriage / Buggy-Whip' example, let's try something more modern. Say, the buyout of a coal mining outfit whereby the assets are 'broken up' to suitors, who at the end of the day continue to maintain the exact same coal output, but with less labor.

If they intended to reduce the amount of labor, then it must have been for lowering costs of production. With lower costs, they can sell at lower prices. That's a boon for the consumers who now pay lower prices for those goods.

The employees in this example are only of high-school education, and who's resume only includes a truncated career in coal mining. The nearest coal mine not owned by this particular company is 100 miles away, but does not have openings.

Are you this charitable and concerned for investors and innovators when they get outcompeted or incur losses, such that we have to suppose "there are no other investment opportunities available to them that matches their management skills and experience"?

Workers of coal mines will have to find other jobs, which they, contrary to your hypothetical example, will almost certainly be able to find, provided that the labor market is free from coercive interference.

It will take only a few months of on the job training for ex coal miners to develop new skills, that are needed to produce goods that consumers demand given that they have more of their coal needs being met. Perhaps other commodities mining like gold, or iron, or platinum, or copper.

Ex coal miners will not stay unemployed forever. There wasn't famine or mass deaths when horse carriage factories went out of business because of the invention of cars.

Does this example contain released employees that can realistically compete in the labor market to produce something new?

Well, when you presume there are no other opportunities in your example, then you have already answered your own question. The key is whether your assumption is even accurate to the real world.

The more free the labor market is, the easier it is to find another job. The more the government interferes in the market to prevent job losses, the more rigid the labor market becomes, and thus the more terrifying the prospects of layoffs will become. It is counter-productive to hamper the hiring and firing process in an innovating economy.

Kold_Kadavr_flatliner, sub/dude said...

What reeeeelly matters, friend, is OUR Divine Judgment; everything depends on what Jesus proclaims after. Not the ongoing battle between the L and the R; not how much moolah you made last year; not how much wealth them filthy billionaires stole from U.S. for their BlackOps programs. Our Divine Judgment... in which one-outta-one must croak. Think. Know. Grow-up. No, not in maturity, that, too, but in 'lifting-thy-head' above the clouds. Lemme wanna give you a parable on my finite extistence --- My sis is a hardcore Democrat: she calls me qweer for going to church, yet, she has queer friends (she doesn’t realize, however, all of mortal humanity is being played like a game by the NWO). Scary what the stanky, worldly BO thinks that sinfull mortal can become - we're all gonna croak, puppet BO, controlled by the billionaire, fat-cats-who-think-they-can-outsmart-Jesus. What #@!! morons. If he gits another term, fulla outsourcing our jobs, whorizontal abortion like babies are subhuman, outNout homosexuality, open-borders with white-trash-TexMex's, and 'posse comitatus' with FEMA, we've completely lost - lil we can do when God's outta-the-picture in BOs immature atheism. God, help U.S. Help us poor, mortal souls on earth who wanna Wiseabove.blogspot and go beyond to Heaven. Puh-leeze. Thanx for lissen'n, brudda. God blessa youse -Fr. Sarducci, ol SNL -PS- Is it any wonder then why our Mother (the Mother of God) said recently only ¼ of humanity wood enter Heaven?

Anonymous said...

Of course you can buy a healthy firm. The question is how healthy is the business, and is it undervalued? Another is, does the purchased company have much debt? A yes to both questions creates an opportunity for a buy out. You could never raise enough debt financing to buy Apple, at present. But a firm earning $100 million? $40 million? One that is publicly traded? Absolutely.

And because of the leverage, the debt can be transferred back to the original firm, which the creates the situation Mr. Krugman so aptly described.

Any first year economics student, or business consultant, or anyone who has worked at a place like Bain Capital can explain this.

Anonymous said...

What about a situation where a company is making X% profit but investors & senior management realizes they can make 30-50% more profit if they shutter the company manufacturing & take it to China? My feeling is that other than heigh tech,pharma,food & few other areas, most other manufacturing can be easily done in China. Are we looking at a future where some countries will be Research focused (high knowledge economies) & others that are manufacturing only! In that case, if most Americans do not have the skills (most get some art degrees!) for this new world....do you foresee prolonged unemployment that will only worsen (flipping burgers or other service jobs) for ordinary americans? I think a fresh MBA student can write a convincing business case for making most of the production in China.