Fed Has No Magic For Unemployment

Chairman Bernanke's suggestion that the Federal Reserve System has tools available to address extraordinarily high unemployment rates goes against basic economics, whose mechanisms are described in the web sites of the Fed's own Regional Banks, such as the Dallas Fed to pick one of many.

It isn't a matter of dissent for Philadelphia Fed President Charles Plosser to say, "I am really doubtful that monetary policy is a tool that is going to help us very much."  It's basic economic theory.

An operation to effect a twist in the yield curve won't help employment, but it will help Wall Street trading desks, bond funds, and corporate treasurers, folks who don't need more candy.  Mortgage rates are already at 4%, and housing is still on life support because only the top tier borrowers get the published rates.

Monetary policy has already created extraordinary support for mergers and acquisitions, dividend increases and share buybacks.  Witness, for example, Ecolab's strategic entry into the water and energy businesses through the acquisition of Nalco.  Ecolab's $2 billion in corporate debt refinancing is being led by a strong syndicate of banks, and in addition Ecolab announced a $1 billion share repurchase program.  Liquidity and access to credit in investment grade corporate markets is not an issue for monetary policy.

We may be soon hearing about large corporate downsizing from companies like Bank of America and Yahoo, if the latter were merged with another competitor.  None of these decisions will be affected by a manipulation of the yield curve by the Fed.  More small bank failures add a steady stream to the unemployment pool.

Unemployment in traditional economic terminology is frictional, cyclical or structural.  Following the global meltdown and the weak recovery, we have the worst of all labor market worlds.  Structural changes have been underway for many years due to China's mercantilist policies and our ceding ground on both light and intermediate manufacturing.  Cyclical forces will come into play once again if the economy falters in the fourth quarter. Finally, there is no appetite for corporations to add workers, especially with tepid sales growth and little pricing power.

A highway infrastructure program will certainly help unionized trades, which is probably a good Fall election time strategy, but it won't help the tens of thousands of people, from several generations, that are on line at job fairs, seeking employment in corporate America.

Corporate Welfare for Bank Investors: Paulson's Gift

The current week's stock market meltdown took me back to October 13th, 2008 when then Treasury Secretary Henry Paulson summoned the CEO's of ten leading banks to an emergency meeting in Washington, D.C. The worst weekly decline in stock market history, to that time, precipitated the meeting.

Pietro Veronesi and Luigi Zingales of the U of Chicago Booth School of Business wrote a paper, "Paulson's Gift," which is a well reasoned analysis of the net benefits to society of the plan to inject $125 billion of preferred equity into the nation's top banks, as well as providing them with extremely valuable financial guarantees.

The lack of a rapid resolution authority for these SIFIs (Strategically Important Financial Institutions) and the desperate condition of Citigroup and the former investment banks, including Paulson's own Goldman Sachs forced an emergency plan that was "very expensive for taxpayers."

In a creative use of CDS rates, the authors generated a Fama analysis of the news events disclosing the investment and its impact on the value of the investment claims for the ten bank holding companies. For the intervention to have social value, it had to accomplish something which the market could not do, while providing a net social benefit to taxpayers.

Bank bond holders made out the best from the taxpayer handouts. The value of their holdings, the authors estimate, increased by $120.5 billion between October 10-October 14, 2008. Bank equity holders overall lost $2.8 billion, with JP Morgan Chase stock holders losing $34 billion, while shareholders of Citigroup and Goldman Sachs gained $8 billion each from taxpayer largess.

Preferred equity value rose by $6.7 billion. The value of derivative contracts increased by $5.3 billion.

Taxpayers might have made a small, risk unadjusted gain on the preferred equity investment and attached warrants, but the granting of a three year FDIC guarantee on all new, unsecured bank debt issued by the ten banks before June 2009 and an extension of FDIC insurance to all non-interest bearing deposits, swung a small benefit to a cost of $21 to $44 billion, according to the paper. Champagne corks must have been popping on Wall Street.

The authors, Charles Calomiris and others have proposed various automatic mechanisms for debt-equity swaps which economically dominate the Paulson plan. However, we've done nothing with the bankruptcy laws, nor have we created any special resolution authority for SIFI's that might avoid similar problems in the future.

As the authors point out, "the pressure for governments to intervene is irresistible," and now banks know that they are permanently backstopped for injudicious risk taking. Let's hope that we don't have any similar, daffy ideas coming out of this week's stock market decline.

Debt Fixes and Recession: Not The Problem

A New York Times blog has taken the blatantly political position that debt limit or spending reduction "fixes" could be what tips the economy back into a recession. Think of the economy as a house in which the two elderly residents have been slowly asphyxiated by a gas leak. As they lie moribund on their living room floor, a tornado comes and destroys their house crushing the poor couple. They become casualties of the tornado, as reporters on the scene show. Got that? Does that make sense?

The demise of the American consumer sector was a long-time coming, and a confluence of forces were at work. The same Times blog reported that the 2008 Census data showed median household income actually fell in the decade to 2008. This is a fundamental, secular problem, working slowly and insidiously like a poisonous gas. With interest rates low and the housing bubble growing into the Goodyear blimp, consumers filled the gap with both secured and unsecured credit. The latter, as we all know, is especially toxic when it is supercharged with absurd fees of all kinds that bear no relation to the issuer's cost of funds and a normal profit margin.

The tornado raging through town was of course the 2008 global financial system meltdown, which destroyed consumer's residential equity, and subsequently turned a decade of stock returns into a big zero. This had a catastrophic effect on consumer balance sheets. Another unfavorable secular trend built into this period was the rise of the Chinese mercantile machine, into which U.S. corporations were only too happy to feed domestic jobs, which further hampered the real hourly earnings of workers who who were able to maintain their jobs.

The chart below, which comes from the Minneapolis Federal Reserve Bank's research presents an "autopsy" on the American consumer household:

Both the debt-to-assets ratio AND the debt-to-income ratios are still near their all time highs more than two years into a recovery! The current recovery is the weakest by far in terms of consumer financial measures. The current recovery is shown by the two tiny drops in the debt and income ratios. Typical recoveries are characterized by very sharp rebounds off the lows, driven by strong real fundamentals like rebounds in housing, autos, consumer goods or new orders. This one takes us into dark territory.

It was laughable when the stock market run began to see commentators trumpeting "consumers have repaired their balance sheets!" We also know from corporate earnings reports, conference calls, and the financial press that companies are still generally loathe to expand employment, and even a small bounce in temporary workers has flattened out.

Monetary policy has been out of bullets for a while. QE-V won't cut the mustard for this problem. Of course there have been repeated FedSpeak comments about "fiscal stimulus," while also talking about the need to tame deficits in order to placate the investor gods who brought us into this mess through the shadow banking system.

Fiscal stimulus--short of a New, New Deal--would have a marginal impact on the deep, and broad-based pain felt by millions of households, and embedded in the above graph. Both parties need to stop posturing and worrying about their own 2012 reelection issues: show some leadership, please!

What's Next For China?

Back in December, I posted a reflection on on the terrible track record of long-term forecasts, and it was mindless euphoria about the Chinese economic miracle that stimulated that post. David Beim of the Columbia University Graduate School of Business has written a paper for the NBER, "The Future of Chinese Growth," that brings a thoughtful eye to the consensus forecasts.

China's economy has had a thirty year run, ended 2010, where real GDP growth averaged 10% per year! This is extraordinary by any measure. Beim points out that this performance was driven by two, high octane sub-periods. The first was the explosion of Chinese entrepreneurship launched by Deng Xiao-Ping in the 1980's in which the central government subsidized and sponsored private enterprises in China's villages. These efforts distributed their benefits widely throughout the country and were domestically focused.

Beim identifies the next phase as being driven by the annexation of Hong Kong and by the political accession of politicians with Shanghai loyalties. These two forces led to the development of large, coastal-oriented enterprise clusters that were export-oriented, with mainland China supplying large, efficient production and distribution facilities and cheap provincial labor, with the Hong Kong Chinese supplying management expertise and finance. Continuing huge capital investments financed by Chinese banks fueled the export boom that has brought us to where we are today. The benefits of this phase have accrued to a new elite, and this drive was one hundred percent export oriented.

Invoking the neo-classical growth model of Solow and Swan, Beim shows that China is already experiencing diminishing returns to capital, and he suggests that Chinese banks may be ignoring balance sheet issues associated with their cowboy underwriting standards during the export-led boom. Everybody, even the popular press, has written about the need for the Chinese economy to shift to domestic consumption growth. Beim's thesis is that this will be easier said than done. If this is the case, it would seem that the bubble inside the Chinese miracle could end badly. It's definitely thinking outside the box.

The Fed Fires Another Blank

Today's readers of the Fed tea leaves were not impressed, as the market decline continued into day two. To paraphrase the press release code, the recovery is underwhelming. Macquarie Asia economist Richard Jerran, quoted in the Wall Street Journal, cites a very interesting paper by Hiroshi Ugai, "Effects of the Quantitative Easing Policy," which draws eerie parallels between the actions of the Bank of Japan (BOJ) in the aftermath of the late 1990's crisis and the current actions of the Fed.


From March of 2001 through March of 2006, the BOJ substantially increased the monetary base by increasing the current account balances (CAB) held by member banks with the BOJ through increasingly massive monthly purchases of securities. Incidentally, JP Morgan estimates that the Fed will account for 15% of Treasury demand as a result of the latest policy guidelines.

At the same time, BOJ made a decisive commitment to a zero interest rate policy (ZIRP) until the day that the CPI stopped declining. Although the Japanese economy showed several, short-lived recovery episodes, prices declined continuously from 1998 until the autumn of 2005.


Instead, Ugai concludes that the real benefit from the BOJ policy was not due to quantitative easing at all, but to the ZIRP, or commitment to keeping interest rates low indefinitely. We know that the Fed has studied the Great Depression, but perhaps the better analogy now would be the Japanese experience.


It was troubling to read in the Fed press release that lending by banks "has continued to contract."

Looking at corporate results from Cisco, which exceeded earnings expectations, we see that revenue was below Street expectations. This in spite of the fact that economic statistics, though reported with a lag, show double-digit year-over-year spending increases for equipment and software.

CIO's Michael Cembalest and Hans Olsen of JP Morgan's private banking group make a very telling point about what's driving the current profit recovery. They note that corporate profits have beaten expectations for the past five quarters. At this stage in the recovery, a 5% growth rate would reflect nominal GDP growth in excess of rising unit labor costs. However, the current profit rebound comes from declining labor costs, low real wage growth and sustained high labor productivity. The JP Morgan team believes that this kind of engine for recovery should not command a very high P/E multiple because it is not sustainable. The latest readings on productivity, the slowing of export growth, and weakness in Britain and Germany all reinforce the notion of a lower market multiple.

The JP Morgan team point out that macroeconomic trends are unusually important in evaluating investments in the current world economic cycle, and we agree.

The Management Myth

Today's Wall Street Journal carries an interesting article by Philip Broughton, who writes about Matthew Stewart's book "The Management Myth." It discusses some first principles in thinking about corporations and the values that sustain the American model. We've written about these issues before, using the work of Professor Rakesh Khurana of the Harvard Business School.

Stewart approaches the issue by looking at the consulting business and how it operates within the largest American corporations. He notes that work of these consultants--you know the names-- are "built on a science of management that is both narrow minded and intellectually bogus." The skeleton of modern consulting practice evolved from the early work of "efficiency experts," and like a comet's tail, picked up material as it moved through time from economics, organizational theory, computer systems, pop psychology, and marketing. We've even picked up an odd label or two from genetics, when we speak about "growth being built into the corporate DNA." Now, that is real blather, but you hear it on almost every other corporate earnings call.

Stewart also talks about the corporation as being "obsessed with its own perverse value system and view of human nature.." Corporations are torn between presenting themselves as "environments" where people can realize their aspirations and contribute to some high-faluting corporate goal, or as "black boxes" devoted to growing earnings at 15% a year come hell or high water. Both kinds of entities wind up having cultures or value systems, but in the case of public companies rarely does anyone know where these came from. Apple for example started in a garage with the legend of Wozniak and Jobs, and somehow whatever drove that original culture is supposed to be continued into the papacy of Jobs. It really makes no sense. The American corporate view of human nature is still overwhelmingly Theory X, which everyone publicly repudiates but lives with every day.

Larger private corporations, where representatives of the founders are still active, seem to do a better job of articulating a value system with continuity that evolves into a culture that mirrors the value system. The changeover of corporate management in public companies makes it hard to accomplish the same continuity.

I've counseled some of my very talented financial staff not to shortchange themselves by going into MBA programs in finance. They were more than capable of absorbing all the rote technical material on their own. They owed it to themselves to learn much more about foreign languages, culture, philosophy, anthropology and economics. One of them solved the dilemma by going to business school in India from Minnesota! I'm anxious to see how it turns out. We should be educating our future business leaders much more through what's called the Core Curriculum at Columbia, or the classics at Chicago. More Plato, Seneca, and Montaigne and less Porter, Black-Scholes, and Merton.

(Eco) Imagine That!

GE CEO Jeff Immelt recently lamented our national obsession with financial services , and he gave a plug for prosaic activities like manufacturing. He's put his finger on something that's very important for the future in which our children will live and work. Not everyone will be able, or want to, get a job with Goldman Sachs or a hedge fund.

In the simple two by two (two countries and two classes of goods) models of international trade theory, it was pretty unreasonable to get a "corner solution" where one country completely specialized in producing one tradeable good. Indeed, it's just not healthy for a society to be totally specialized. We shouldn't all be "knowledge workers," whatever that means.

GM factories converted to the WWII effort were able to go from producing cars to airplanes because the workforce had the skills to bend metal and to join parts together. If General Electric is to benefit from its eco imagination strategy, it will need a large supply of mechanical, industrial, electrical and chemical engineers, as well as a dedicated and savvy technical workforce to manufacture products for the smart grids of the future in high tech assembly modules. Some of the kids interested in these careers may not go to college to study business and accounting, but they may need technical associate degrees. Hopefully, our society will also value art, music, theater as professions, so that our culture serves our humanity as well as our commerce.

Our financial services sector needs to get smaller, and much of what it sells are commodities, like white bread. We don't need the best and the brightest to develop new forms of life insurance. Financial innovation, with all the blowhard rhetoric aside, is not like scientific innovation. All of our decades of financial innovation brought us not a cure for cancer, but a financial nuclear winter. Enough already!

Sharing A Podium

About ten days ago, I was invited to a second year law school class on corporate governance at the University of St. Thomas, given by adjunct Professor John Stout. I shared a panel chair with Tom Holloran, who heads up the Center for Ethical Leadership in the Professions. I talked about the changing role of a public company CFO in relation to the board of directors. Tom--who incorporated Medtronic, was CEO of Dain Rauscher and CEO of Medtronic--talked about a wide range of issues that really got me filling up my notebook.

Tom described business as a "morally serious calling." In a law school associated with a Catholic university, the word "call" or "vocation" has a particular meaning. In his mind, business must provide an environment where employees can find personal satisfaction and a life of commitment to others. In my fifteen plus years as a Wall Street analyst, visiting hundreds of public and private companies, I can count on one hand the number of times I heard an executive speak to these kinds of ideas.

He said that if an enterprise were to describe itself solely in terms of a mission to maximize shareholder value, then Tom believed that the employees of that enterprise would find that "their calling lacked nourishment."

He then quoted Bartlett and Ghoshal, "A New Manifesto for Management," who said, "Purpose--not strategy--is the reason an organization exists." When I was the CFO at Possis Medical, we developed a new tag line under our logo that said, "Bringing Medical Possibilities to Life," and it was clear, easy to remember, and it summarized what we were all there for--our calling, so to speak.

I found a related article from Bartlett and Ghoshal in the MIT Sloan Review (vol. 43:2, 2002) and here is some material from the abstract:

"Forget capital; it's relatively easy to obtain nowadays. Today's scarce, sought-after strategic resource is expertise, which comes in the form of employees. Although organizations have changed mightily from the days of hierarchical, top-down management, they still have a long way to go."

Human resource professionals should have an important seat at the table in trying to maximize the return from human capital. In fact, HR is most often a record-keeping, compliance-oriented, lawsuit-preventing function that is the caboose on the executive management train.

Bartlett and Ghoshal talk about two tasks, a linking task and a bonding task. The describe the linking task as finding "a way to embed individual-based knowledge in the company, making it accessible and useful not to just one unit or one function, but to the entire organization."

In my website, www.firstprinciplesbiz.com, I use a term"embedded knowledge," which means everything that is known and has been deposited in an organization through the cumulative experiences of executives, managers, and line employees that have been part of the organization's life. This embedded knowledge can be tapped, but it is a process like spelunking or setting a new route on a mountain. It's iterative, has long pauses, retreats and straight shots upward. The authors are directing HR executives and managers to institutionalize a process for "linking" this individual-based knowledge. For you IT experts out there, a collaboration tool can help, but it's more than a piece of software. It is a mindset and a culture that has to be established first, and it rarely has, in my experience.

The second "bonding" function is described as creating an environment where people can express their individuality and align their efforts with a purpose. While Bartlett and Ghoshal assign this task to HR, it seems to me that this is something that has to come from the very top, if not the board of directors then from the CEO, with continuity beyond the tenure of one individual.

Of course, the rewards from hewing to a purpose and creating an environment where sustainable value is created must then be shared throughout the organization. This is also where the modern public corporation has fallen down with its continuing acquiescence to out sized compensation for CEO's regardless of performance.

Performance Appraisals

A recent Wall Street Journal story by Professor Sam Culbert of UCLA lambastes the annual corporate employee performance review. He is absolutely right on point, but his is neither the first, nor the most detailed critique. Tom Coens and Mary Jenkins provided this in the 2000 book, "Abolishing Performance Appraisals."

Best Buy decided some time back to stop focusing on an employee's shortcomings, which are unfortunately the focus of a performance review. The traditional, hidebound review may focus on shortcomings related to outputs, timeliness, ability to work with a team, or even personal habits. Instead, Best Buy decided to focus on the employee's assets and on ways to strengthen and enhance them. This is much more enlightened, and can create an atmosphere where everybody wins.

Here is some text from Professor Culbert's article:
"You can call me "dense," you can call me "iconoclastic," but I see nothing constructive about an annual pay and performance review. It's a mainstream practice that has baffled me for years.

To my way of thinking, a one-side-accountable, boss-administered review is little more than a dysfunctional pretense. It's a negative to corporate performance, an obstacle to straight-talk relationships, and a prime cause of low morale at work. Even the mere knowledge that such an event will take place damages daily communications and teamwork."

It is sad to see that the idea that the archaic performance review tool may not be working could be considered "iconoclastic."

One of the first principles for an effective team manager is to have the right players on the team, and second to have those players assigned to the roles in which they can perform the best and deliver the most value. The manager's task is then to make sure that the employee is empowered to deliver by having the appropriate tools, processes, directions and management support. Very often, a employee's not delivering on performance goals is related to management's failure to provide some of the requirements that empower the employee to deliver.

Hence, it is much better to focus on the positive--namely, how were the employee's assets used over the time period, and what can be done by everyone (the employee, supervisor, team members and management) to improve the asset utilization and performance?