Jonathan Macey schools Krugman on private equity

There is life imitating art, art imitating life, and then there is make-believe. Not surprisingly, Paul Krugman chooses the third option, at least when it comes to his belief that Oliver Stone's "Wall Street" gave an accurate picture of how private equity firms work.

(I do agree with Krugman's contention that government is not a business and that a businessman is any more capable of being an effective president than a career politician. Nonetheless, Krugman then wants us to believe the same tired song that government creates prosperity by spending, while businesses create recessions by becoming more efficient and by employing more capital. I can see a politician making such a statement, but an academic economist is supposed to understand something about the Law of Opportunity Cost.)

In his most recent column, Krugman quotes Gordon Gekko's famous "greed is good" speech as though that actually were accurate economics -- that corporate raiders could make money by buying healthy firms and then destroying their value.

What Krugman wants us to believe is that companies like Bain Capital would target successful, healthy, profitable firms, purchase them, and then make money either by running them into bankruptcy and then selling their assets. Now, perhaps at Princeton University, they teach that firm owners become wealthy by driving their firms into insolvency, but I would like to know how the market value of a company would INCREASE when it is careening into failure.

In an excellent article in the Wall Street Journal, Yale law professor Jonathan Macey explains how the private equity system actually works (as opposed to how Krugman says it works). (I don't have the full article available, and if I am able to do it later, I will post it.)

Macey's point is simple; a firm like Bain Capital purchases a firm that is underperforming relative to similar companies, restructures it, and then sells it. In order to profit, the private equity firm must be able to sell the firm (or its assets) for more than it paid for the company at the beginning.

Some common sense is in order, as Macey notes. A company cannot purchase a healthy company, run it into the ground, and then sell it for more than for the purchase price. While Krugman might believe that business people are utterly stupid (as opposed to professors and politicians), they are not so stupid as to buy high and sell low and do it consistently -- and remain in business.

If the Bain Capitals of the world are going to make profits, then they have to sell businesses or their assets (or both) for more than what they paid for the company, and they are NOT going to be able do that by looting a company. That simply makes no sense, which is why I hardly am surprised that both Krugman and Newt Gingrich seem to share the belief that businesses can profit by buying healthy companies, destroying them, and then getting even more value from their sale.

None of this means I am endorsing Mitt Romney for president. I hardly am enamored with his candidacy, but when people like Krugman and Gingrich demonstrate that they are utterly ignorant of how the leveraged buyout process works while condemning the whole practice, I'm going to speak up for the simple reason that someone needs to be able to explain some of the simple yet profound tools of economics without the political baggage.