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Tuesday, July 07, 2009

Employee ownership has a place in recovery

I wish our economic troubles could be lit off like fireworks, sent off to explode somewhere far away. We'll likely face much more economic hardship. Talk of a second bailout has emerged in Washington.

One topic that came up with friends and family during the Independence Day holiday was the term "socialism," one which has been redefined as the spending of government money. The real term socialism means that workers own the means of production.

With the bailouts, the original meaning has been turned around to mean bestowing federal aid on a single corporate entity. This interpretation of the term has been more accurately termed "corporate socialism," a sort of Robin Hood-in-reverse where corporate entities receive public money.

If GM were actually socialized, the company would be under the control of its workforce, not government. With real socialism, the people who run the factory own it.

Worker-owned companies make money not for the benefit of its shareholders but rather for its employees. Employees would seek to making a living from what they produce and sell, rather than by borrowing or outsourcing to maximize short-term profitability.

Under true socialism, upper management has no role in managing shareholder relations, or seeing the stock price driven up, as the company is private and has no stock trading in public markets. The price of the stock is secondary to the benefit the company provides its workers.

Employee ownership isn't to say the company doesn't try to improve its profitability. It can sell itself, for the benefit of its workers, but it's more likely that a worker-owned company, being better aligned with the interests of the local community and its citizens, would seek to stay in business, to offer a source of local employment for future generations.

Rather than attract capital through outside investors, the company seeks to set aside profits, rather than borrow massive sums in order to grow. Of course this model of saving is far more sound for long term growth than trying to borrow one's way to prosperity. But less lending is hardly beneficial to the politically powerful lenders, who want an economic system based on debt because they profit that way.

Under a traditional corporate scheme, employees are considered "stakeholders," a little used but apt description of people who matter to the entity but aren't the core focus: which is profitability. Some corporations have made their workforce integral to their business strategies. Henry Ford did make paying a reasonable wage central to his business model, so those who built his cars could afford them. Virtually all companies do consider employees important stakeholders, but few would place the needs of their worker as equivalent to those of their shareholders.

Maybe what's needed to resolve the crisis is greater levels of employee empowerment. Japanese companies, for instance, take a much more deliberate approach to decisions in a protracted process of consensus-building. Another nice bonus is the novelty of employee ownership; Americans needn't feel imprisoned by industrial age modes of thinking, exempting of course Ford and a few other visionaries.

Employee-owned companies are a radical departure from pure capitalism, but if a company can make profits that way, no one can deny the validity of letting certain companies, especially failing ones, redesign their business model. Change is after all what is required by economic turbulence and challenges; doing as one has done in the past is like following a doomed course.

Change, unfortunately, is not in the interest of the government, which must like the convenience offered by regular paychecks because of the taxes they provide. But increased employee ownership might not be so bad if the alternative is stagnant tax roles and falling employment, or subsidizing ongoing failures via bailouts to shareholders and management.

Given the bureaucracy predisposition towards change, the approach to collecting taxes does matter. Originally corporations weren't responsible for withholding. Yet the industrial/assembly line nature of manufacturing industries lent itself to the taxing of workers. They received uniform pay at regular intervals. The factory produced goods consistently, it therefore could pay its workers regularly, and direct taxes withheld to government.

Also 401(k)s provide a rich stream of fees and revenue for banks and other financial firms administering the accounts. We saw the depth of this industry's greed in a series of mutual fund fee scams that resulted in $3.5 billion in fines in 2003.

[Update: I just read that Goldman Sachs may have been conducting illicit front-running operations via server routers, a process referred to as quant scamming, the digital equivalent of sniffing out server routes for web traffic in order to get ahead of trades. See bottom of this post.]

Traditionally, Americans were responsible for their taxes. Without withholding, the tax burden was clearly too much to bear. Unless you had sufficient savings on hand, you were in for big trouble come tax time. Enter withholding and the IRS, at precisely the time when America's industrial greatness peaked in 1913 or so.

The notion of regular income is clearly an attractive target for government. If workers were paid in stock, perhaps on irregular intervals, or moved to a trade-and-barter system, their incomes wouldn't be as readily taxed. So the industrial model fit, with workers paying their share of the taxes, an amount that was percentage-wise roughly equal to what their boss paid.

Enter Reagan and the age of the investor class. The idea behind this popular conservatism was that economic benefits of lower taxes and regulation would trickle down to the lower-paid end of the workforce. For a while, that approach seemed to work, generating unprecedented levels of participation in the stock markets. {Not often heralded in the economic media is the truth that ownership of stock by the middle class presages larger economic vitality. After the 2000-1 recession, investments in the market by middle income folks fell substantially, and could have predicted the broader market malaise.}

The idea of lower taxes was great, and the Earned Income Tax Credit did relieve working families. But the government began to run larger deficits, not a problem at first but a gradually growing threat. And over time, the disparity in income grew between the investors (top 20%) and top 1%). The wealth of the rich peaked during the Bush years. Coupled with globalization, domestic manufacturing was gutted, in a form of competition and direct threat.

The rich do pay the majority of taxes but they also make the most income. To keep up their money-making ways, the investor class has long sought to get preferential tax treatment. Executive compensation has skyrocketed largely through the use of stock options and awards based on performance, in lieu of direct pay.

Stock-based Compensation

Ownership of company stock is significant on two levels. Whoever owns more stock controls more of the company. Through dividends and capital growth, those with the most proportional ownership get the most profit. Stockholders are owners, so company stock purchase programs encourage the same sense of pride as a worker-owned company, making workers and management essentially one.

On another level, huge quantities of stock given to corporate managers by their boards is seen as a giant giveaway. Upper managers own large quantities of stock through board-ratified stock ownership programs, adding to a broadening discrepancy in incomes between top and bottom of the corporate pay scale. Average wages have scarcely grown in the past decade whereas CEO pay has gone up many multiples, especially in the US.

Recently, the banks' thrust towards higher employee compensation made the news and created a large political liability for the investor class and their supporters in Washington. Largely through stock options, executive pay has climbed to the point Congress and the President feel compelled to intervene.

New legislation working its way through Congress may only limit some kinds of compensation. With so much influence available on the Hill, the Wall Street lobby is likely to forestall or water down any potential reforms.

Choosing between regular salary and purely incentive-based pay is an old business school debate. If managers get paid more salary they may be less committed to their companies--the inverse of stock ownership. Still, higher pay has to make workers more loyal; if anything they'll be more eager to keep getting paid and keep their pay structure viable.

I'd say most company officers are better paid in cash rather than stock. Cash will incur a great tax cost burden however, which is a chief motivator behind stock grants which tend to be treated favorably under the tax code, a big bonus for top-bracket executives. The maximum marginal rate on income might be 30-33% while capital gains are taxed at a rate that taps out at 15%--a difference of maybe 15%, or $150,000 on every million of stock grants awarded vs. salary.

CEO pay can be performance-based even without stock, a fact easily forgotten in the era of corporate irresponsibility and greed. A company's executive pay committee could choose to pay based on performance, but the standards might be based on varying criteria. Clearly a drop in stock price during a recession isn't evidence of bad management, for instance. Increased sales could be fudged perhaps, or inventories could drop because of a short-running marketing campaign, which means sales can look good on paper but disguise other deficiencies.

In a bull market, compensation paid in stock has been a way to double up on the benefit of increased performance. Rising stock prices may or may not The bull market of the 1990s encouraged executive pay in stock but the rising tide may have done more to boost returns than any executive talent or ability.

When the stock boom lost its luster yet during Bush years executive pay continued to rise. Despite the flat stock market performance for most companies--with the Dow barely rising--much compensation came in the form of stocks, typically provided at below-market cost on a deferred basis, with the company paying the difference. Much has also been made of possible collusion between executive compensation committees, where board members offer a quid pro quo between large companies that inflates the size of stock awards for upper management. In return, board members get offered more seats on new companies, where they offer liberal compensation agreements.

In time, the stock is likely diluted. Adding millions of shares each year has the effect of weakening the value of existing shares. The company must also pay more dividends, which sap cash flow. Dilution was recently in the news as large financial companies made stock offerings in order to repay TARP funds; CItigroup is planning a massive conversion (60 billion shares) of preferred stock, which might lower the interest/dividend payments it makes, but has cheapened the stock considerably.

If upper management is paid in stock they might be motivated to "pull an Enron," which could be the use of off-balance sheet techniques, and liability-hiding chicanery that allows the corporate stock price to stay higher than if more transparency were offered. Then, even as they talked up the company, Enron's manager sold their private holdings. Much of the stock came at below-market prices through heavily subsidized stock purchase agreements, so selling stock makes sense, plus of course the taxes on capital gains are lower. (For more on accounting changes by FASB see this link in HuffPo.)

Back in 2006 or so, Indianapolis Power and Light was purchased by a foreign consortium. Before workers could sell their shares, upper management cashed in. By the time workers were able to sell their shares, they'd become almost worthless. I'd written about the event on this blog; I'd not been surprised at the collapse, but rather the complete, abject denial of worker rights to sell their stock held in retirement plans-whereas I guess the typical executive stock compensation program holds the stock in less constrained, more easily sold accounts.

Different treatment of employee and executive stock ownership accounts comes from the onerous fiduciary responsibilities associated with managing retirement accounts under the ERISA law governing tax-deferred contributions and withdrawals. Tax implications and legal ramifications of a company offering its stock to employees are complex--still, a well founded rule of financial planning is NOT to invest more than 10% of your worth in your company's stock. Should the company fail, you'd therefore lose not only your job but your retirement savings as well.

Tax structure, not surprisingly, is geared to reward investors. Workers meanwhile get to pay social security on all their income. Now if workers could be paid in company stock, a worker-owned company could really work but unfortunately cash money is how bills are paid. Perhaps mini-shares in a worker-owned company could be used in lieu of cash by local, accepting business. Heck California has already gone to this mode by issuing IOUs, which is what our fiat money system is built on. Maybe as state finances deteriorate nationwide, more states and even localities will turn to the production of their own stores of value, what is more commonly known as money.

It's amusing that the Federal government can get so excited about Private Barter Currencies like the Liberty Dollar when the state of California can flash in its flash warrants and IOUS that can be traded in a secondary market and are in fact no different from money. On top of this dubious prosecutorial position, the federal government has so mismanaged its access to credit that it can set no example for the states and citizens to follow. Unsustainable money policies are exactly that--unsustainable. In time, we'll know just how long our government could continue to borrow, or even run a monopoly on the production, issuance, and trading of various kinds of money. Later, we might see many currencies trading throughout the country. This would be especially true if the federal government could no longer borrow from abroad, or monetized its debt to the point inflation were out of control and the dollar unable to act as a store of value. In fact, it's been anything but, losing over 96% of its value since the creation of the Federal Reserve and IRS in 1913.

The only thing you can be assured about is that the US Federal Reserve Note will not keep its value over the long term. Silver, on the contrary, would buy in 1900 what it bought in 2000, four gallons of petrol, give or take. Why? Its simple. The silver supply didn't grow. The amount of dollars used and spent, put into circulation, during those 100 years grew far faster. Money may have been more broadly distributed, but the purchasing power of the dollars fell, redefining what it was to be wealthy. Yes, Americans experienced a much higher standard of living during the century, but the next question is whether Americans will be able to continue their past economic growth, particularly with a financial model that has at its heart hyper-cosumption and the creation of ever more debt.

As the recent correction has shown, the only way to sustain "growth" in our economy is to increase the supply of money, so much so maybe that the entire pile of paper that we call our wealth and income gradually perhaps more rapidly descends in value. For this reason I continue to recommend silver as a hedge against inflation, or more accurately, the over-expansion of the supply of Federal Reserve notes, more commonly known as the dollar.

We could be in a deflationary period, which makes cash more valuable as prices go down, but my guess is at the over-expansion of the money supply through chronic deficit spending will make the purchasing power of our money decline. So even if we think we're getting paid more, or producing more, all that has happened is that the supply of dollars rose and that each dollar is worth less.

Also, the more borrowing our country needs to do, the more it will be forced to rely on the Federal Reserve to buy back our bonds, using dollars they've borrowed from our own Treasury Department via the Bureau of Printing and Engraving. Net cost to them: a penny a bill, no matter what the size. In turn, the Fed will sell off the bonds--if it can. Demand appears solid--for now.

The Fed is dependent on demand from investors, who will at a minimum require more interest for their extension of finances. Already the Chinese grumble, raising serious questions about how sovereign our debt truly is, and how much independence from our creditors we have in designing our foreign policy. I doubt we'd ever attack North Korea without Chinese consent, although the reason for that may be more with the idea of losing one of the best markets for our nation's debt, not to mention the possibility of millions of PRC troops pouring over the border.

I have in the past pointed out the issue of crowding out, a business school-type term that means simply that government bonds are more attractive than other forms of debt. This phenomena occurs largely as the consequence of too much government borrowing, as it competes with private sector debt for a shrinking pool of cash available.

As the rates paid on government increase, so too does the spread on corporate borrowing, meaning corporations must offer more to remain attractive. The prices of their bonds will drop, to compensate investors for the additional risk.

The government, as the issuers of money itself, retains the exclusive, unrestricted the ability to tax. These powers means it is viewed as less risky debt by investors, under the grounds it can simply print the money out of thin air. Yet as our system stands structured, the Federal Reserve has to find buyers. Eventually the only way to sell our bonds might be to use money lent to the Fed by the Treasury.

Recently I've been reading that crowding out has not been in evidence ("As Treasury Bond Yields Rise, Why Are Other Yields Falling", marketoracle.co.uk) and that demand for corporate debt remains strong.

Rates that short-term US Treasuries offer remain low, meaning they're considered good stores of value in the short term. Even longer term government bonds are yielding fairly low rates. This would seem to indicate all the borrowing isn't having an effect on corporate investment, or the appeal of corporate bonds, for at least as long as yields on safer government debt remain low

Still, it's the general state of the economy that's keeping rates low. Once the economy begins to rebound, as it one day must, borrowing will get more expensive quickly. Lenders will want more in interest, especially on corporate and longer term debt. When there's a lot of risk out there, lenders demand more interest from private sector issuers. Inflation--the possibility that money itself will buy less--appears to be the chief risk, although there are many including of course the cyclical economic environment.

Inflation isn't all bad. Borrowers use new, cheaper dollars to pay back their loans. In this sense consumers could benefit, if of course they have access to credit. On the equities side, corporate profits might rise rapidly, along with real estate prices, but for now we seem topped out or dropping in those categories. Financial companies tend to suffer, as they deal in money, an item that becomes cheaper just as real assets--commodities, land, energy--become more costly in real terms.

We've been told the health of Wall Street is vital to restoring the economy. The idea of restoring access to credit became a key sticking point used by Geithner and Obama to sell TARP and the massive federal intervention in the credit markets, which came more through Fed discount lending programs (cash-for-trash, etc.) than TARP. Federal Reserve lending topped out at some $12 trillion plus, a fact the mass media neglected to tell most Americans. Whatever loans fail will become the responsibility of the taxpayer.

Yet in time, doubts about AIG have been stirred. Would the whole economy have tanked if AIG had been allowed to fail? I've written extensively on the bailouts and have come to the conclusion that derivatives compromise a huge portion of malinvestment. As a matter of fact, the amount owed, created in a shadow banking system built on CDSs and Mortgage-Backed Securities far exceeded the value of all mortgages in America. So to label the collapse on a few bad apples or "subprime" just doesn't hold up; the problems were in fact systemic and could have cascading consequences (although they may have been felt more by the investor class than the general economy.) Rather than throw huge sums at the problem, we needed to look at the causes of the crisis, make the necessary regulatory reforms, which include re-instituting Glass Steagal and imposing margin requirements on Wall Street speculators.

The impact of the derivatives mess will take years to unravel. Banks have hardly reestablished themselves on solid ground. Arguably inflation and unsound fiscal policies will make recovery that much more tenuous. And if banks, whose primary business is (or should be?) lending to consumers and not each other, face higher defaults, they can hardly be more attractive as investments themselves, or make more money.

We'll see the trend on interest rates, and crowding out, reverse not long after we've hit bottom. Despite all the cheerleading by Larry Kudlow, the green shoots appear to be more about using the media to send a message than report on reality.

If the stock market does reflect the economic environment 6-9 months ahead, we'll be facing the effects of a nascent recovery in the capital markets long before the real economy has had a chance to recover. In other words, the opportunity may lie in finding the bottom.

Rather than try and pick a perfect bottom on bonds, I tend to side with Axel Merk when he says "the cost of borrowing should increase substantially as the supply of new debt may simply dwarf the demand - in that context, it is not particularly relevant whether the demand is domestic or international; plunging bond prices in recent weeks may be a pre-cursor of what is to come." [link]

Too much government borrowing will inevitably and invariably lead to problems with the financial system. A hand on the printing press is simply too tempting, especially when the political consequences of raising taxes and cutting spend are so severe. As Merk says though, should the real economy begin to recover, the additional interest on the bloated debt could rapidly erode the dollar, making commodity prices and inflation spiral up, forcing higher interest rates and stalling the recovery.

One last point. Unmentioned by the mass media is the direct impact Iraq and Afghanistan are heaving on our government's ability to finance itself. As these wars drag on and more debt accumulates, we grow nearer reaching Osama bin Laden's vision for an American empire ruined by economic means. The strategic progress of the anti-American side is reason enough to believe our money is in for a serious collapse.

And our strategic competitors have also come around to the reality we're overspending and driving our currency to worthlessness. Rather than wait for that to occur, BRIC members are right now turning to alternative currencies, maybe even creating one from IMF warrants, to serve as an international reserve currency. Once that happens, demand for dollar will collapse. All those dollars that other countries now must keep in the vaults will likely be dumped, creating a vast oversupply.

While we might keep exports up, this will be due not to some strategic brilliance on our part but rather the fact that other currencies will rise in proportion to the dollar. Foreigners might also choose to purchase American companies and resources as they get cheaper, which is actually a great way to offset some of our past borrowing. To get the American economy back, borrowing will have to slow but this doesn't appear to be happening, at least not with our government spending. The more likely course of action is to simply use the Fed to keep buying the bonds our government sells.

The relationship between the Federal Reserve and our government has devolved into one of mutual dependency. The banks depend on access to US Treasuries at reduced interest costs (making their profits on the difference between what they borrow at and lend money out). Meanwhile the government appears willing to cede virtually all regulatory authority in financial matters to the Fed, essentially giving that private, for-profit entity the keys to our monetary system and dooming any chance of regulatory oversight or restraint.

Update (7/8 10 PM):

Just posted a comment titled "Whistleblowing vital" on a dailykos article that suggest the Goldman Sachs may have been using illicit internet programs to skim trades, a process referred to as "flushing quant trading."
See the article here. My post reads:

Nice to know there are patriotic Americans who will speak off when people are getting ripped off.
I couldn't help but notice that federal government sites were hit by DoD attacks recently. Could the hacking be a way to cover up past illicit actions, kind of like wiping out the old http addresses so as not to leave a trace of the routers used to sniff data?
Just how much does our government know? Is it like 9-11 where knowing something bad will happen--foreknowledge--isn't the moral equivalent of participating in it? Or do regulators know about the quant trading and are they just staying quiet?
Is this scandal anything like the mutual fund fee scam that erupted in 2003? Even if there's a fine, where does it go? What's being done to correct the vulnerabilities and systemic problems--gaps in regulation perhaps?--that led to the crisis, like the credit crash? Too many questions, with answers not easily answered.

I'd thought about the 2003 mutual fund scandal upon reading May/June version of MotherJones by James Ridgeway, titled "Who Shredded Our Safety Net?" (link)

I think that article relates to my post because the financial system adverse to change that doesn't want pensions. Better it is to identify the ways we're being ripped off, or look to solve the problems American, unregulated capitalism has caused.

I know I tried to cover too much, but the issue of fake vs. real socialism is very comprehensive, impacting social justice issues like retirement in addition to the overreliance on borrowing, the shadow banking/private credit system, and globalization.

Someone once said that there is no national interest, but only interests. In this case, the financial industry scores again, over the workers of real socialism. Except instead of denying them ownership, and forcing companies to borrow in order to expand in this case pensions were abandoned and 401(k)s offered in their place.

I guess the capitalist system really showed how vulnerable the working class are. Nowhere is this more clearer than the credit crisis, which will disproportionately impact lower income Americans. Providing adequate income in retirement needs to be a fundamental right.


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  • At 12:37 AM, Blogger jbpeebles said…

    The allegations of frontrunning at Goldman Sachs appear to have some legs. Apparently the story is based on the arrest of former Goldman Sachs executive, Sergei Aleynikov, who'd downloaded a trading platform program off GS's servers that could allow its users to reap nearly unlimited amounts of money by electronic front-running, called quant flushing.

    I'm guessing that during the course of his employment at GS Aleynikov became aware of the software then tried to make off with it, by selling it abroad, or using it with his new company. Authorities probably intervened when it became possible that someone could do as Goldman had, and make unimaginable sums of money, just like GS apparently had in its most recent quarter.

    Stories on this allegation appear to be spreading. I think the allegations fit a pattern of unchecked exploitation of regulatory shortcomings and lax enforcement.

    See the post by CoyotePrime here.


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