I have a number of threads to write about today but I am going to make this a mono-themed post and save the other themes for future days. One thing I did want to flag is Willem Buiter’s recent piece called “The Simple Analytics of Helicopter Money: Why It Works – Always”. I think this is a pretty good piece on some macro concepts in terms of framing policy choices available. So I will try to put something together on that subject.
What I am going to discuss today is financial gimmickry and wage growth. This piece is an outgrowth of a piece I am writing for the New York Times on corporate buybacks and capital investment plus a segment I recently did on Boom Bust at RT about inversions. The video is attached here.
Here’s the narrative that makes sense to me. Six years ago, I presented you with a chart that showed US hourly earnings deflated by the consumer price index. The resultiong real hourly earnings chart showed a deep stagnation in real hourly earnings that had only been overcome by the increased participation of women in the workforce and the resulting increased labor participation rate in the US.
The uptrend we see in this chart was broken by the Great Financial Crisis as this recovery has been the weakest in terms of wage growth of all post-war US recoveries – even as the labor participation rate has sunk to levels not seen since the late 1970s.
(source: Bloomberg)
So, the situation for the average wage earner in the US has not been easy over the last 40 years. And it is in this context that we have to think about income inequality and corporate inversions. A number of factors have come together in the 1970s-2010s time period to create the picture:
- Waning union power, outsourcing and offshoring have reduced labor bargaining power
- Globalization has created greater labor price competition, further reducing labor bargaining power
- Mergers and acquisition and economies of scale have increased the bargaining power for internationally-active corporations in particular.
- International competition, options-based executive compensation schemes, the increased importance of shareholder value as a goal for corporations has increased the need to boost earnings per share
The result is that companies turn to financial engineering to boost earnings per share when organic growth opportunities have waned. One such gimmick is tax inversions. But these inversions have the negative long-term effect of reducing capital re-investment and thus reducing labor income and consumer demand capacity.
In this context, the interesting bit about a recent bill introduced by Democratic Senator Chuck Schumer is that it has no chance of passing due to Republican opposition. At the same time, however, because it is retroactive, it is a signal to companies that at any point in the near future, their actions of today can be counteracted by legislative fiat, when the political situation is favourable. I think this is a very ingenious way of trying to engage in moral suasion because it is an implicit threat about future legislative action even if the present bill cannot pass Congress.
The video is below with my part at the end, with more after the break for Credit Writedowns Pro subscribers. Good interviews with Nomi Prins and Richard Heinberg as well
If we look at tax inversions, a lot of it has been driven by the desire to repatriate cash earned overseas without paying the 35% tax on corporations. Looking at the pharma industry is instructive here. From 1980 when a serious double dip recession crisis began until 1992 when the first jobless recovery was occurring, the publicly-traded pharma industry in the US was able to return almost 10x money to investors in share appreciation. This compared very favourably to the S&P that returned under 4x money to investors. But by that time, consolidation in healthcare management organization customers and competition from generic pharmaceutical offerings began to have a negative impact on Big Pharma. That’s when the merger wave began.
Beginning in 1994, pharmaceutical companies started merging like crazy, beefing up R&D to improve their pipeline to counteract generics and taking on the improved bargaining power of HMOs. While this process was successful in stemming the tide, the heyday was over for Big Pharma returns. All of the increased returns were in essence a form of financial engineering from economies of scale and increased bargaining power or tax breaks.
That’s when the cost cutting and eventually the tax inversions began. See, the tax inversions were at the long end of a chain of events that demonstrate that Big Pharma no longer was as profitable via organic growth. First, growth was engineered via merger, then via cost cuts and then via share buybacks. But as everyone knows, the pharma industry is very global. And despite low marginal rates due to tax loopholes, pharma’s prodigious overseas earnings would have to be taxed at 35% upon repatriation. That’s not going to work if organic growth and cost cutting can no longer boost earnings and you need to add to earnings per share. The tax hit is too great. Thus, the need for inversions was clear.
The problem with this approach from a macro level is that it has a negative impact on consumer spending capacity. A company that increases earnings per share by reinvesting earnings in the business and growing organically because of profitable business opportunities is adding to GDP through capital investment, while a company increasing earnings per share by buying back shares is not. And ultimately, this means less income available for wage earners that earn wages associated with the capital investment.
During the period from 1980-82 forward, wages have stalled. But households have been able to ride the increased labor participation partly attributable to increased female participation to higher household income. Moreover, interest rates have declined so steeply in that period that households were also able to lever up and debt service costs have remained low. That has meant that the US economy was able to grow despite the move toward outsourcing, offshoring and financial engineering. Yes, there has been an increase in income inequality due to wage stagnation. But the economy overall has grown.
Zero rates means this game is over. Unless the Fed can normalize rates without cratering the economy, we will enter recession with record low rates, such that non risk-free interest rates and debt service costs will rise markedly without any potential for interest rate relief via Fed policy, absent heavy credit easing. My analysis says then that the high profit margins of today are an artefact of low wage growth due to poor labor bargaining power and financial engineering via share buybacks, tax inversions, cost cutting and other gimmicks that are not about top line growth. This is an ephemeral position that will come under assault when the credit cycle turns down.
I believe the Fed’s tightening bias is going to be a catalyst for these events. And thus I would look at safe haven assets like Treasury bonds to outperform in the last quarters of 2014 through 2015. Whether the US is able to weather the storm is irrelevant. What does matter, however, is that the source of profitability can no longer continue.