June 2008 Archives

Sorry I have been absent for awhile. But I have several thoughts to blog about over the coming week. To start off, here are some musing aboyt mergers and antitrust.

A fresh round of merger and acquisition headlines has brought home a clear point: Many U.S. industries are consolidating. With the prospect of fewer, and more powerful, players in many sectors, shouldn't antitrust alarm bells be going off in Washington?

The "deal flow," as financial pros like to call it, is regaining momentum after a brief credit crunch-induced hiatus. In the beleaguered airline industry, both management and Wall Street see salvation from horrendous cost pressures with mergers. The pending deal between Northwest Airlines (NWA) and Delta Air Lines (DAL) is expected to be the first in a new round of megadeals.

More earthbound industries are also joining in. The profit-starved newspaper business is seeking to slash costs and shore up profits through consolidation, too. The candy business is shrinking, with Mars purchasing rival Wrigley (WWY). And then there are the deals-that-may-be, such as Belgian brewer InBev contemplating a takeover of American icon Anheuser-Busch and Barnes & Noble (BKS) mulling a deal for its troubled adversary Borders (BGP).

Cyberspace is not immune, either. Consider the intriguing dance among Microsoft (MSFT), Yahoo! (YHOO), Google (GOOG), and famed investor Carl Icahn that could end up in a merger between Yahoo and Microsoft, an advertising deal between Yahoo and Google, some other combination, or none of the above. Stay tuned. Meanwhile, the takeover deal book is long and growing.

Does the current consolidation wave mean consumers will pay higher prices to fly, read the news, and eat a candy bar? Or to drink beer or hawk their wares on the Web? Perhaps not in each of these examples listed above, but it's a safe bet the answer could be "yes" in many consolidating industries.

So where is the Justice Dept.? Shouldn't antitrust regulators flex their muscles and start blocking deals? In many cases probably not--especially if the welcome mat stays out for international competitors. The risk that mergers will lessen competition and strengthen market power in an industry can be significantly reduced when competitors from Brazil to Shanghai to Frankfurt compete for profits and markets in a business. (Still, carrying a foreign pedigree doesn't automatically ensure adequate competition. The antitrust authorities will--and should--take a close look at the marketplace implications of combining InBev and Busch into a $100 billion revenue brewer powerhouse.)

On the surface, recent U.S. antitrust policy or, more accurately, competition, has been remarkably laissez faire, especially compared with far more interventionist European policy. Before the mid-1970s, merger litigation was commonplace and a surprising number of cases even ended up before the Supreme Court. But since the '70s, deeply influenced by industrial organization economics in general and the Chicago School of Economics in particular, trustbusters have been increasingly reluctant to intervene in the marketplace. Indeed, economists are now the crucial experts in antitrust. For instance, as of early 2008 the Justice Dept. has 60 PhD-level economists and the Federal Trade Commission has 70 PhD-level economists, according to Lawrence White, economist at New York University,

The numbers bear this out. For instance, of the 37,201 mergers or acquisitions filed with the U.S. antitrust authorities from 1991 through 2004, about 97% sailed through without much scrutiny, according to a recent paper by economists Orley Ashenfelter of Princeton University and Daniel Hoskin of the Federal Trade Commission "The Effect of Mergers on Consumer Prices: Evidence from Five Selected Case Studies"; National Bureau of Economic Research, working paper 13859).

Clearly, trustbusters have moved away from a clear-cut yes-or-no; approach. What remains is much back-channel negotiation. For instance, in the remaining 3% of deals between 1991 and 2004 that were looked at closely, some two-thirds were modified, abandoned, or blocked. "Through negotiation, companies get the benefit that they see, and antitrust authorities get rid of the downside from their perspective," says Randal Picker, professor at the University of Chicago Law School and co-author of the scholarly article "Antitrust and Regulation" (NBER working paper 12902).

In essence, there are two measures by which to judge the success or failure of antitrust policy. First, keeping quality constant, what happens to prices and, second, whether mergers encourage innovation or squash it. While both are hard to judge in the real world, the track record of prices and innovation in the U.S. economy over the past quarter century does suggest the tally has been more on the success side of the ledger.

Still, the concern about lessening competition is real, especially when it comes to the microeconomics of prices. Take the paper by Ashenfelter and Hoskin. The scholars looked at five big consumer business mergers, and they examined the impact of the deals on prices by going over retail scanner and similar data. The deals were: Procter & Gamble's (PG) purchase of Tambrands, Aurora Food's (Mrs. Butterworth) buying Kraft's Log Cabin breakfast syrup business, Pennzoil's purchase of Quaker State motor oil, General Mills' (GIS) acquisition of Ralcorp's branded cereal business, and the merger of Guinness' and Grand Metropolitan's distilled spirits businesses.

In no instance did prices drop. In four of five mergers, the companies engineered increases in some consumer prices, ranging between 3% and 7%. In one case--Aurora/Kraft--there was little effect on prices. "However, given the large amount of commerce in these industries, the implied transfer from consumers to manufacturers is substantial," they write.

But airlines are an entirely different animal from consumer products businesses. Certainly, airline management would like higher prices. (What business doesn't?) The industry has been battered by a brutal combination of $130-plus oil, steep debt burdens, and fares that often do not cover costs. A favorite guessing game on Wall Street is which airline will file for bankruptcy next or merge itself out of existence. The proposed marriage between Delta and Northwest was greeted by commentary that the era of cheap airfares was over. A 20% price hike is the number frequently bandied about.

Little wonder trustbusters might have blocked a comparable deal several years ago or at least forced the divestiture of many assets before letting it go through. However, it's a part of antitrust policy"the so-called failing firm doctrine--to let some deals go through if there is a risk that one of the firms could go under.

That said, Congress and the White House can ensure the market stays competitive and consumers don't get taken to the cleaners by making it easier for overseas airlines to own and operate in the U.S.

Many decades ago, there was a grandeur to antitrust policy. Theodore Roosevelt and his brain trust tilted against giant railroad combines, oil monopolies, and the like. Today, trustbusting is steeped in economics and it's more modest in its aims.

In a sense, trustbusters are living up to the wish of John Maynard Keynes: "If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid." But if the actions of the modern-day trustbusters are modest, the stakes--the protection of consumers from price collusion and an economy that nurtures innovation--remain high.

It's easy to get depressed about the economy with oil prices at nosebleed levels, food at the grocery store increasingly expensive and home prices continuing their downward spiral.

Still, the government came out with some good news: Productivity remains strong. During the first quarter of this year, nonfarm business productivity rose 2.6% annual rate (an upward revision from an earlier estimate of 2.2%.) Productivity has risen at a 3.3% pace the past four quarters, according to economist Ed Yardeni--the best performance since 2003.

What's more, the data shows that no evidence of a 1970s-type wage-price spiral, suggesting that the Federal Reserve still has room to manuever.

The jump in the unemployment rate from 5% to 5.5% is bad news. So is the sickening $12 spike in oil prices.

Michael Mandel at Business Weeks sees another downturn in the recession. James Hamilton, economist at the University of California, San Diego, says it's time to reassess the "potential for recent oil price increases to contribute to an economic downturn." He's definitely pessimistic..

The sharp spikes in oil prices associated with the 1973-74 oil embargo, the 1978 Iranian Revolution, the Iran-Iraq War in 1980, and the first Persian Gulf War in 1990 were each followed by an economic recession. However, when oil prices started to rise again five years ago, many of us suggested that things would be different this time, in part because the price was rising much more gradually and so should be less disruptive of consumer spending patterns. Others emphasized that, despite the price increases, oil was still cheaper than it had been historically if you took into account inflation. However, once you include the most recent data, neither of those claims would still be true.

Mark Zandi, chief economist at Moody's Economy.com is out with his latest forecast. It's gloomy. He is well worth following:

Economists and policymakers may debate whether the economy is technically in
recession, but for the average American household, there is no debate: This is a
recession. Real purchasing power is lower than it was a year ago, and household
balance sheets are worth less. With good reason, consumer confidence is as low
as it has been since the early 1980s.

Here are a couple of highlights:

The average American household's real income and net worth are down from a year ago.

Households are pinched between a harsh job market that is holding down wages and higher costs for fuel and food.

The Federal Reserve will sacrifice near-term growth for the sake of stable prices and the economy"s longer-term prospects.

Want to silence a group of colleagues at work or friends at dinner? Heap praise on speculators--and the market bubbles they help create.

Yes, you read that right. Bubbles may be anathema to many financial commentators and ordinary investors. But policymakers like central bankers should applaud speculators and welcome economic booms. And when things head south, they should concentrate their efforts on limiting the damage from the bust.

By this metric, much of the conventional criticism of former Federal Reserve Chairman Alan Greenspan for not preventing bubbles in asset markets like equities and housing from inflating during his tenure is not only misplaced, but wrong.

Bubble talk is all the rage right now, with prices of commodities soaring into the stratosphere. Case in point: The two-day 13% spike in oil prices last week, to $138.54. Sure, oil has drifted back down a bit, but it's still above $130--vastly higher than the $100 a barrel of last January, let alone the $26 of five years ago. A similar story holds with food and metals.

We've seen this kind of sustained, scary price rise and manic, speculative fever before, haven't we? And we know the outcome, right? The jaw-dropping, wealth-creating boom will end in an awe-inspiring, wealth-destroying bust.

That's what happened with real estate. House prices rose at an inflation-adjusted 4% average annual pace between 1995 and 2005, four times the yearly increase of the previous 10 years. Wall Street and mortgage bankers combined to make enormous sums available to buyers who had gradually been led to believe that a home was a "riskless" investment. Today, the economy is reeling from the bursting of the real estate bubble, and the Fed has felt compelled to take extraordinary actions to stave off financial collapse.

How about Web mania? In the years leading up to the turn of the millennium, dot-com investors thought a price-earnings ratio of 100 was conservative, 1,000 plausible, and infinity conceivable. (O.K., so maybe I'm exaggerating here. A little.) Of course, the dot-com boom turned into the dot-com bust, and the economy tanked in 2000 and 2001.

Bubbles are the most fascinating and frightening stories in finance. The dot-com and housing market bubbles are only the most recent episodes of speculative frenzies, a legendary history that includes debacles such as tulip mania, the South Sea Bubble, the Mississippi Bubble, and the Roaring '20s.

In retrospect, looking at the financial and economic carnage when a bubble goes pop, there's always the puzzle over how so many smart people could be so dumb with their money. Charles Mackay, author of the 19th-century classic Extraordinary Popular Delusions and the Madness of Crowds, captured the essential dynamic. "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

Maybe modern-day oil traders could profit from reading Mackay's book, even though it was published in 1841. Little wonder the commodity price surge has Wall Street on bubble watch and the scholarly literature of the central banking cognoscenti is full of articles on bubblenomics.

Bubble bashers dwell on the bad and ignore the good that speculative price runups can do. Speculative fevers often emerge during times of major innovations and technological change. By definition, the impact of innovation is unpredictable. What new technologies and business models will win out in a competitive market is difficult, if not impossible, to predict. A bubble is capitalism's way of rapidly transforming an economy. It's a perspective Greenspan shared and understood well.

Let's go back to the dot-com example. What's remarkable is just how quickly the Internet economy was established during that so-called era of fictitious value. "The conventional wisdom is that the period of exuberance during the boom period--especially 1999 and 2000--was a bubble," writes BusinessWeek Chief Economist Michael Mandel in his book Rational Exuberance. "It carries connotations of something fragile, which was never quite real in the first place."

But rather than a bubble, argues Mandel, the second half of the 1990s could just as easily be called an "age of exploration." "The low cost of capital enabled risk-taking people and companies to try out lots of new ideas simultaneously, and on a large enough scale that they got a fair test," he writes.

And some bubble beneficiaries ultimately stand the test of time. During the dot-com boom/crash, the online grocer Webvan went out of business but bookseller Amazon (AMZN) survived, and eventually found its way to solid profitability. Web browser pioneer Netscape essentially disappeared, but Google (GOOG) triumphed.

Put it this way: Bubble moralizers greatly underestimate the vital role of speculators and speculative markets in allocating resources toward an economy's fast-growing sectors and away from stagnant industries. "The stuff built during infrastructure bubbles--housing and telegraph wires, fiber-optic cable and railroads--doesn't get plowed under when its owners go bankrupt," writes Daniel Gross in Pop! Why Bubbles Are Great for the Economy. "It gets reused--and quickly--by entrepreneurs with new business plans, lower cost bases, and better capital structures. And when new services and businesses are rolled out over the new infrastructure, entrepreneurs can tap into the legions of users who were coaxed into the market during the bubble."

Now, let's fast-forward to today. Much of the rise in prices for oil (and food for that matter) reflects the growth of India and China. But remember all the warnings about the developed world's eagerness to invest in China, India, Vietnam, and other emerging frontiers of global capitalism, how it had all the earmarks of a bubble. The bubble worriers will eventually be proved right. Too much money is flowing into emerging markets.

But take a step back. While the "hot money" is flowing in, the investment is building ever tighter and stronger economic ties between the developed and developing economies, creating wealth at an unprecedented rate, building bridges that will strengthen in coming decades. And it's the growing economic vigor of a vastly healthier global economy that is pushing up the price of commodities. These higher prices are encouraging enormous increases in investment in alternative energy and increased agricultural production.

Meanwhile, the Fed (as well as other central banks) should continue to develop the expertise and authority to limit the downside damage to the financial system and the real economy when prices abruptly tumble. Ben Bernanke is leading the way.

Will the boom go bust? Of course it will. Fortunes will be made and lost. Investments will coin money or vanish. But much of what will remain will be real, and of lasting value. Thank you, speculators

The Little Book Big Priofits series is terrific. The books are short, well-written by Wall Street luminaries, and deal with important investment topics. I just got a review copy of David Darst's contribution: The Little Book That Saves Your Assets: What the Rich Do to Stay Wealthy in Up and Down Markets. David is a managing director at Morgan Stanley, and it all about asset allocation. When it comes to investing over a lifetime asset alocation is key, far more important than picking a good mutual fund or stock.

Hardly anyone disagrees with this statement: The nation's tax system is a mess. The U.S. tax code is riddled with far too many deductions, credits, exemptions, exclusions, phase-ins, and phase-outs. Nobel laureate Milton Friedman noted half a century ago that constant changes in the tax code discourage long-term planning by households and businesses. He was right, but that hasn't stopped Democrats and Republicans from tinkering with taxes ever since the income tax was imposed in 1913.

Perhaps it's the safest forecast in politics and economics that history will repeat itself when it comes to the tax code. It's going to get even more complex next year, since both John McCain and Barack Obama are proposing major tax initiatives.

For instance, among his proposals, McCain wants to make the 2001 and 2003 tax cuts permanent (with the exception of the estate tax repeal), phase in a two-thirds increase in the dependent exemption, and offer a voluntary alternative tax with two rates and a larger standard deduction and exemption.

Obama is more aggressive in the number of his proposed tax plans. They range from creating income-related subsidies for health insurance to refundable "Making Work Pay" credits and "Universal Mortgage" credits. He'll increase the maximum capital-gains tax to 25%. He will keep some of the 2001 and 2003 tax laws, such as the child-credit expansions and the 10%, 15%, 25%, and 28% income rates.

That breakdown of the two tax plans comes from the Tax Policy Center, a joint venture between the Urban Institute and the Brookings Institution. Its recent analysis captures the essential difference between the two tax approaches:

Senator McCain's tax cuts would primarily benefit those with very high incomes, almost all of whom would receive large tax cuts that would, on average, raise their aftertax incomes by more than twice the average for all households. Many fewer households at the bottom of the income distribution would get tax cuts, and those whose taxes fall would, on average, see their aftertax income rise much less.

In marked contrast, Senator Obama offers much larger tax breaks to low- and middle-income taxpayers and would increase taxes on high-income taxpayers. The largest tax cuts, as a share of income, would go to those at the bottom of the distribution, while taxpayers with the highest income would see their taxes rise.

For many voters, that's all the information they need to know about the candidates and taxes. But there are other ways to judge. For instance, by one critical measure--how they would deal with the omnivorous Alternative Minimum Tax--both plans are failures. The AMT was designed in the late 1960s to make sure that the very wealthiest Americans paid at least some tax. Yet because it was poorly constructed, some 3 million taxpayers now pay the AMT, and by 2010 that figure could swell to 30 million, according to William Gale, economist at the Brookings Institution.

Congress and the White House have punted for years on the AMT, largely because neither political party is sure how to replace the lost revenue. It's estimated that repealing the AMT would cost at least $800 billion over the next decade. Instead, Washington has preferred to rely on a series of "patches" to keep the dreaded tax from reaching deep down into the middle class. Both McCain and Obama plan on continuing that ignoble Washington tradition.

By the metric of simplicity, McCain edges out Obama. For one thing, he's proposing fewer tax initiatives. For another, he has embraced repealing various corporate loopholes, such as eliminating the preferential treatment of oil companies, in return for a lowering of the corporate tax rate from 35% to 25%. Nevertheless, neither candidate is embracing dramatic simplification by broadening the tax base and eliminating a wide range of deductions and credits. Both prefer to embrace tax subsidies targeted toward boosting valuable social goals, such as health-care reform. Problem is, that strategy carries a cost in complexity.

Then there are value judgments. Personally, I like McCain's idea to cut the corporate income tax rate, although I would go further and abolish it altogether. But I prefer the greater progressivity of Obama's tax approach.

That said, I'd like to propose this standard for judging tax reform. It was written more than two centuries ago by political economist Adam Smith. In Book Five of The Wealth of Nations, he proposed four maxims with regard to taxes in general. They are equality, certainty, convenience, and economy.

Smith wrote: "All nations have endeavored, to the best of their judgment, to render their taxes as equal as they could contrive; as certain, as convenient to the contributor, both in the time and in the mode of payment, and, in proportion to the revenue which they brought to the prince, as little burdensome to the people." Of course, as Smith went on to say, most nations have also fallen far short of these goals.

(I'd also add that Smith embraced progressivity: "It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.")

In other words, the centerpiece of tax reform should be simplification, reducing the interference of the government through the tax system in the financial affairs of households and business, and streamlining the progressive income tax system. Flattening the rate structure and broadening the tax base would go a long way toward improving economic efficiency and simplifying taxpayers' lives. The long-forgotten 2005 proposals by a blue chip panel appointed by the White House offered up a starting point.