Economy on a Roll
John Mauldin
Source: RealInvestmentAdvice.com
John Mauldin
Economy on a Roll
John Mauldin
Does Trickle-down Economics Add Up – or Is It a Drop in the Bucket?
An old term of questionable meaning is getting a new lease on life: Trickle-down economics.
And to many in media and liberal circles, it has once again emerged as the great hobgoblin of our time.
“Trump and conservatives in Congress are planning a big tax cut for millionaires and billionaires,” Robert Reich, who served as secretary of labor during the Clinton administration, wrote in Newsweek recently. “To justify it they’re using the oldest song in their playbook, claiming tax cuts on the rich will trickle down to working families in the form of stronger economic growth. Baloney. Trickle-down economics is a cruel joke.”
But what is trickle-down economics? The answer depends on who is saying it and what public opinion buttons they are trying to press. Kent Smetters, Wharton professor of business economics and public policy, says that trickle-down economics is a term created to disparage supply-side economics.
“It is just a clever negative sound bite,” says Smetters, faculty director of the Penn Wharton Budget Model (PWBM). “Detractors claim that supply-side economics is about giving tax breaks to the rich. The rich then engage in more economic behavior, such as buying more stuff or hiring more workers; that eventually ‘trickles down’ to the non-rich who get the crumbs that fall from the table.”
Many others have pointed out the folly of using the term — that no real economic model or serious school of thought stands behind what has long been a term of art at the intersection of politics and media. “I have a little bit of a hard time with the terminology and the idea of trickle-down economics,” says Wharton professor of finance Joao F. Gomes. “Although everyone in the popular press has a somewhat different characterization of what this means, this is not something we have tested or seriously theorized about as economists.”
But if there is no substance behind trickle-down — just pejorative intent — the Trump administration itself has curiously invoked the term in its zeal to sell its tax plan to the American public.
“I don’t believe that we’ve set out to create a tax cut for the wealthy. If someone’s getting a tax cut, I’m not upset that they’re getting a tax cut. I’m really not upset,” Gary Cohn, President Trump’s chief economic adviser, told CNBC recently. “We create wage inflation, which means the workers get paid more; the workers have more disposable income, the workers spend more. And we see the whole trickle-down through the economy, and that’s good for the economy.”
It’s not clear that most Americans believe that anything good will eventually trickle down to them from the still-unfinished overhaul. When asked who the Republican tax plan would help most, 76% of respondents to a December 2-5 CBS poll of 1,120 adults nationwide said it would be large corporations, with 69% saying wealthy Americans would benefit most. Just 31% named the middle class as winners, with “you and your family” trailing at 24%.
A Politically Infused Etymology
Oxford defines the particularly colorful phrase trickle down as the notion that wealth will “gradually benefit the poorest as a result of the increasing wealth of the richest.” The term’s popularization is often traced to a 1932 syndicated column by Will Rogers in which the humorist referred to money “appropriated for the top in the hopes that it would trickle down to the needy. Mr. Hoover was an engineer. He knew that water trickles down. Put it uphill and let it go and it will reach the driest little spot. But he didn’t know that money trickled up. Give it to the people at the bottom and the people at the top will have it before night, anyhow.”
“Favors for the few and prayers for the many” is what Adlai Stevenson II called it in an address to a 1954 Democratic Party rally in Detroit while stumping nationally for candidates.
A 1971 New York Times editorial referred to organized labor’s view that President Nixon was embracing “old-line ‘trickle down’ economics in the conventional Republican mold” by suggesting that “workers will benefit most by large-scale tax concessions to industry designed to spur investment in modernized plants and thus strengthen the competitive position of American business.”
And when President Ford proposed a tax overhaul in 1974, Sen. Edward M. Kennedy dismissed it as “a throwback to the trickle-down economics the nation has traditionally had to suffer under Republican Presidents.”
The phrase’s resonance today, of course, emanates from the Reagan era, and while it may have stood the test of time, longevity has not conferred clarity. Part of the problem is that “trickle down” lacks a universally understood meaning. Smetters says the idea of tax breaks for the rich eventually producing benefits to the poor has never been part of supply-side economics.
“Supply-siders believe — correctly or not — that lower taxes lifts all boats together,” he says. “Growth is not a flow of resources that cascade from rich to non-rich. In fact, many supply-siders argue that lower taxes benefit workers more than capital owners through international capital flows. Whether this argument is right or wrong is a legitimate issue. But describing this view as ‘trickle-down economics’ would be akin to supply-siders describing their detractors as communists, a label that would certainly be rejected as well.”
Semantics aside, most agree that the right kind of stimulus can be efficacious to growth. “The term ‘trickle-down economics’ doesn’t really represent a cohesive economic theory,” says Wharton professor of business economics and public policy Benjamin Lockwood. “It’s a term used, often negatively, to characterize the view that reducing taxes on the rich will benefit the non-rich.”
There are a number of reasons why tax cuts for high earners could theoretically make others better off, he says. “Economists have long emphasized that taxes don’t necessarily ‘stick’ where you levy them — for example, a tax cut on corporate profits could raise workers’ wages. And if taxes are very high, reducing them can theoretically spur economic activity enough that tax revenues actually increase, which may have been the case in the 1950s, when top income tax rates exceeded 90%.”
However, he says, there’s little evidence to suggest that this would be the case for the current GOP proposal. “Most recent estimates suggest that the majority of corporate income taxes fall on business owners and shareholders, with only a minority falling on wages. And the fiscal crisis generated by Kansas’s recent tax cuts suggests today’s tax rates aren’t high enough for such cuts to be revenue-generating.”
“How much growth will we get from this plan? It depends on final details and things we truly don’t know much about.”–Joao Gomes
The current tax bill is still a moving target, but the Penn Wharton Budget Model finds that the boost to GDP produced by the tax cuts would not be enough to pay for the tax cuts.
Lower taxes will probably add to growth. “Almost all economists accept that,” says Gomes. “How much and for how long is another question, and that’s where we disagree. There are several reasons for that. Some of us will say it is because lower taxes encourage people to work more and maybe corporations to invest more. If the tax cuts are long lived, this will raise national income for a long time. Republicans tend to start from this point.” Others will say it is because lower taxes will put money in people’s pockets and encourage spending which in turn creates jobs for a short time, even when the tax cuts are also temporary, Gomes adds. “Democrats tend to start from here. Indeed, this was the rationale for temporary cuts under President Obama. As I said, most economists agree that each of these arguments has merit. However, long-term cuts that stimulate work and investment cost more money and tend to benefit people who pay higher rates and/or capital gains taxes. These tend to be higher-income individuals.”
Do tax cuts pay for themselves, as some like to suggest?
“Almost surely not,” says Gomes. “But it is also important to say, to be absolutely fair, neither does spending on infrastructure, and that has not stopped left-wing economists from proposing it with the same fuzzy math that right-wingers support with these cuts. For an unbiased observer, there really is very little to choose between the fiscal probity of Democrats and Republicans.
“How much growth will we get from this plan? It depends on final details and things we truly don’t know much about,” Gomes continues. “Will it encourage people to work more? I would estimate yes, maybe a little but not very much. Will it encourage investment? Absolutely. Will it encourage corporations to relocate operations to the U.S.? Maybe, but the details are going to matter a lot.”
Looking for Growth in All the Right Places
The details of the tax plan are still opaque. One key unknown is the extent to which tax savings might be applied in ways that produce growth.
“Under the current tax proposal, the trickle-down economics becomes: ‘we’ll give a big cut in the corporate tax rate with the hope that those workers will benefit from the resulting new investment.’ It’s not surprising that if you tax returns on investments less there will be more investments,” says Robert P. Inman, Wharton professor of finance. “The real question becomes: How big of an effect on investment will there be, and if there is new investment in capital, will it benefit workers?
“For example, if businesses invest that in existing real estate or share buy-backs,” Inman continues, “there is probably not going to be much of an impact on employment or worker wages. However, investing in a new building or in new capital equipment will employ people and potentially increase worker productivity. In that case there will be a positive effect on employment and on worker wages.”
But how many jobs? And wages of what kind?
“I suspect most of the new machinery will be very sophisticated, high-tech, investment. If so, the trickle down, the wage premium for those at the lower ends of the income distribution, will be rather modest. The trickle-down will probably stop at [jobs paying] about $50,000.”
Inman recalls the effects of President George W. Bush’s 2004-2005 overseas corporate profits repatriation program. “The idea was that it would lead to a big influx of cash on the investment side, but what corporations ended up doing was buying back shares. That was an investment, but an investment that didn’t create any jobs.”
Of the new tax plan’s repatriation of earnings — about $2.5 trillion sitting offshore — that would be automatically brought home and taxed at a special rate, Smetters says it’s likely that some of it will translate into higher dividends, some into stock repurchases and some of it will be invested. “We don’t think the investment channel is going to be nearly as big as some people will say, and the reason why is that there are already some ways of clever financing,” he recently said in a separate Knowledge@Wharton interview.
Inman does believe that lowering the corporate tax rate makes sense, but that it needs to happen along with closing loopholes. “Close the loopholes, then see how much money you have and lower the tax rate accordingly,” he suggests.
On the question of whether the GOP’s plan will increase income and wealth inequality, a lot depends on what the exact changes to the estate tax end up being, says Gomes. “Still, from an inequality standpoint it would be great to see the elimination of the state and local tax and home mortgage deductions, which are mostly gifts to the top 20% of the income distribution. Eliminating these deductions while cutting tax rates is also the sort of ‘revenue neutral’ change that most economists would applaud.”
One aspect of this debate that is under-emphasized, says Lockwood, is the potential for other types of targeted tax cuts to generate beneficial spillovers. These are benefits that could bubble up from low earners, or flow sideways from middle earners, rather than trickling down from the top.
“In fact, there is evidence that cutting taxes, or targeting spending, on specific middle-class professions, including teaching and basic research, would have quite large beneficial spillovers,” he says. In a recent paper co-authored with Charles G. Nathanson of Northwestern University and E. Glen Weyl of Microsoft Research and Yale University, Lockwood writes that some professions have “spillovers” — that the social value of an individual’s work can be much higher, or much lower, than that individual’s compensation.
“Some spillovers are quite large,” they write in a Harvard Business Review piece about the paper “Taxation and the Allocation of Talent,” published in the Journal of Political Economy.
“Given how much good teachers raise the eventual incomes of their students, we calculate that spillovers from teachers are twice as large as the salaries teachers are paid. The benefits from medical research are even larger, amounting to over one-fifth of total income in the U.S. “On the other hand, some sectors involve ‘zero sum’ endeavors, in which profits come at the expense of other market participants. Examples include excessive litigation or financial traders trying to beat the market.”
They examine two potential types of tax policies. In one, raising top tax rates would, in theory, encourage workers to choose lower-paying jobs, compelling some to gravitate toward more socially valuable professions. In the other, the government would tax or subsidize some professions more than others.
The first approach would do little to spur economic growth, they conclude. The second could boost growth dramatically. Rather than advocating a rewrite of tax code with different rates for different jobs, the authors recommend a rewards system that would raise salaries and award merit pay.
Of growth stimulators in the current GOP tax proposal, Gomes says one aspect that is appealing is the expensing of investment. Firms will be allowed to deduct all investment expenses from their corporate taxes immediately, instead of slowly over time. “This change more than any others should encourage them to invest and boost our economy in the short and long runs. It’s a clever idea that economists have been advocating for years on the left and the right,” he says.
What he likes least: The fact that the plan is unlikely to pay for itself. “We should be raising revenues elsewhere to offset the cost of [many] good ideas. We are adding to the burden of the federal debt when we should be reducing it. Admittedly it’s not a lot relative to GDP, and the bond market is not concerned about the government’s ability to repay higher debt. But it goes in the wrong direction.”
Gomes says “there are several good ideas in the plan. The main problems might be the overall cost and the lack of phase-in for some of the changes that are likely to be very disruptive.”
It is, however, a complex plan, he says, and “obviously Republicans exaggerate its virtues and Democrats the defects. The truth is in the middle.”
Fluidic imagery aside, change is coming. Says Inman: “There is no economist who doesn’t agree that if you give somebody money, it’s going to have effects elsewhere in the economy. The only issue is how do those effects play out, and who are the beneficiaries?
For conservatives, he notes, “trickle-down is a flood, and for liberals it’s a drip.”
Fake Tax Reform
By: Peter Schiff
After supposedly chomping on the bit for years to pass meaningful tax reform, Republicans are now set to blow an historic opportunity. Whatever version of the Bill that emerges from the House and Senate Conference Committee (which will be signed by President Trump faster than he can down a Filet o’Fish), will be far less than the Republicans envisioned when they finally captured the White House and both Congressional Chambers in 2016. But from what I have seen of the particulars, the revisions to the tax code will offer a marginal, although temporary, win for low income individuals, a major slap for moderately successful wage earners and home owners, (especially in the high tax Blue States) and a huge victory for the extremely wealthy and certain categories of business owners. While it is certain that the plan will add to the growing deficit, its immediate economic and political impact is hard to predict.
For generations, taxpayers and politicians alike lambasted our overly complex tax code for its myriad of economic distorting loopholes that seemed to produce nothing except employment for legions of accountants and tax lawyers adept at gaming the system. As a result, talk about tax reform has always included proposals to make the system simpler, fairer, and more transparent. But on that front, the Republican proposals fail miserably. Trump and Congress will hail this achievement as being a major victory for the American people. But the true winner will be the swamp that Trump promised to drain.
Unlike Ronald Reagan, who passed tax reform in 1986 by striking a deal with Democrat House Speaker Tip O'Neill, Trump and Congressional Republicans faced no particular need to compromise. If Reagan had the benefits enjoyed by Trump, Ryan and McConnell, his tax cuts would have been paired with significant spending cuts and perhaps a balanced budget. But to get O’Neill (and his whopping 71 seat House majority) to go along, Reagan's ideals of fiscal prudence and smaller government had to be set aside. But Trump is no Reagan, and today’s Republican Party has about as much commitment to shrinking the size of government as did the Democrats in the 1980s.
Taxes are the price we pay for government. If Republicans want to reduce the tax burden, they need to make government less expensive. Tax cuts without spending cuts is the Republican version of a free lunch. But if government spending is not paid for with tax revenue, alternate sources must be found that will ultimately prove more costly than the forgone tax revenue.
Despite endless campaign rhetoric to the contrary, the Republican Party is no longer the party of limited government, fiscal responsibility, Federalism, the Constitution, sound money, or any of the principals that they typically espouse while stumping for office or raising money. Instead of reducing the size of government, thereby lightening the burden on taxpayers and limiting the economic drag caused by government, Republicans have chosen the easy course of tax cuts, replete with overly optimistic assumptions and gimmicks meant to disguise their true impact on future deficits. Adding insult to injury, they leave in place an even more complex tax code, replete with even more loopholes, that limits individual freedom and undermines economic growth.
True reform would have eliminated the income tax completely, or at a minimum, replaced it with a flat tax. It would have abolished the corporate income tax, payroll taxes, and the estate and gift taxes, and replaced them with a tax system based on consumption rather than production. Such a system would encourage savings rather than debt accumulation, and would restore some semblance of sanity to a system increasingly dependent on borrowing. Real reform would have included entitlement reform, as well as across the board reductions in government spending. Entire agencies and departments would have been eliminated, making government smaller and less expensive. These are the types of changes that are needed to head off a possible looming debt crisis and put the country back on a path to achieve real economic growth, not the phony financial gains we have seen in the past generation.
But instead, Republicans crafted a plan that would cut taxes for some while raising taxes for others.
The political genius of the plan can be found in the elimination of state and local tax deductions that will raise taxes predominantly on higher wage earners in Democrat controlled states with high taxes.
This move was a political freebie for Republicans, as it largely spares their constituents from tax hikes, but prevents Democrats from protecting theirs because to do so would require them to argue against raising taxes on the "wealthy." It may also trigger a fiscal crisis in largely Democrat states as high earners, who provide an outsize share of state tax revenue, consider pulling up stakes for lower tax jurisdictions. But Republicans did not leave well enough alone.
The taxes raised on rich Democrats will not nearly be enough to pay for the cuts they offer business owners, passive investors, and corporations. The balance will be "paid for" by borrowing. In addition, high tax states may be forced to scramble to adjust their tax policies in an attempt to forestall defections of the wealthy. To do so, they may shift taxes to businesses (for which state taxes will still be deductible from federal taxes). The businesses in turn, can pass these costs onto their employees in the form of lower wages and their customers in the form of higher prices.
Republicans, of course, argue that the economic growth that will be generated by lowering the corporate tax rate from 35% to 20% will generate enough new tax revenue to offset what is lost.
While that idea is sound in theory, nothing about our current situation would suggest that a growth surge is around the corner, with or without corporate tax cuts.
We are already in the ninth year of a supposed economic expansion. Over the last century, these expansions (the time between recessions) have lasted, on average, about five and a quarter years. So, already our current “expansion” has lasted nearly twice the average. Also, this expansion has been extraordinarily weak, with growth averaging around 2% since 2009. This is far below the 3% to 4% rate seen in prior recoveries. (data from the National Bureau of Economic Research and Bureau of Labor Statistics) It is also clear that this tepid number has relied heavily on surging asset prices in stocks, real estate, and bonds. But all three of those markets could easily reverse course.
The stock market has surged to all-time highs based on the expected likelihood that tax reform would be passed early in the Trump Administration. When this hope becomes reality, it may be that we will get a “buy the rumor, sell the fact” decline, especially if the final package is not all that investors hoped it would be. The real estate market may actually suffer under the new rules as high-end properties become more expensive to own and less attractive to buy given the limits on property tax and mortgage deductions. On the lower end of the market, the expansion of the standard deduction could mean far fewer will receive a tax benefit from buying modestly priced homes, thereby mitigating the advantages of buying over renting. (It is no accident that some of the biggest objections to the new proposals have come from real estate industry groups). And lastly, the bond market faces no shortage of headwinds. With the Fed threatening to sell much of its $4.5 Trillion holdings of Treasury and Mortgage bonds, the likelihood of falling bond prices and rising yields looms large. (In the past three months, 10-year Treasury yields have increased 30 basis points). Even the tax bill’s supporters acknowledge that it will increase the deficit significantly in the near term, thereby requiring the Treasury to sell more bonds to fill the gap. The extra supply could put downward pressure on bond prices and raise yields on the long end, creating losses in the bond market and raising borrowing costs for government, businesses and consumers.
For these reasons, it is logical to assume that the current tax proposals will have a more modest economic impact than the Tax Cuts of 1986 or even the Bush tax cuts of 2001. It is important to note that the Bush tax cuts occurred while the economy was already in recession, a time where economists could at least plausibly argue that fiscal stimulus was needed. But by putting these cuts through now, while the economy is still expanding (at least on paper), by the time the next recession arrives, the fiscal bullets will have already been fired.
Assuming that the hoped for economic growth does not materialize, the money borrowed now must eventually be repaid. Deficit spending means that today’s tax cuts merely sow the seeds for tomorrow’s tax hikes. But since taxpayers will not only be on the hook for the money borrowed, but the added interest associated with that debt, the future tax hikes could be larger than today’s cuts.
Of course, instead of raising future taxes to repay the money borrowed to fund today’s cuts, a cooperative Federal Reserve could simply print the money needed to buy the additional Treasury debt. But this does not mean we get all this government for free. The cost will come in the form of higher consumer prices as a new round of monetary expansion could cause a continuing drop in the dollar. So Americans may end up with more after tax dollars in their paychecks, but the reduced value of those dollars means they will actually be able to afford to buy less stuff. Just because it appears consumers dodged this bullet during the first three phases of Quantitative Easing does not mean that we will be as lucky with additional rounds.
Two Myths About Automation
BARRY EICHENGREEN
BERKELEY – Robots, machine learning, and artificial intelligence promise to change fundamentally the nature of work. Everyone knows this. Or at least they think they do.
Specifically, they think they know two things. First, more jobs than ever are threatened. “Forrester Predicts that AI-enabled Automation will Eliminate 9% of US Jobs in 2018,” declares one headline. “McKinsey: One-third of US workers could be jobless by 2030 due to automation,” seconds another.
Reports like these leave the impression that technological progress and job destruction are accelerating dramatically. But there is no evidence of either trend. In reality, total factor productivity, the best summary measure of the pace of technical change, has been stagnating since 2005 in the United States and across the advanced-country world.
Moreover, as the economist Timothy Taylor recently pointed out, the rate of change of the occupational structure, defined as the absolute value of jobs added in growing occupations and jobs lost in declining occupations, has been slowing, not accelerating, since the 1980s. This is not to deny that the occupational structure is changing. But it calls into question the widely held view that the pace of change is quickening.
The second thing everyone thinks they know is that previously safe jobs are now at risk. Once upon a time, it was possible to argue that robots would displace workers engaged in routine tasks, but not the highly skilled and educated – not the doctors, lawyers and, dare one say, professors. In particular, machines, it was said, are not capable of tasks in which empathy, compassion, intuition, interpersonal interaction, and communication are central.
Now, however, these distinctions are breaking down. Amazon’s Alexa can communicate.
Crowd-sourcing, together with one’s digital history, can intuit buying habits. Artificial intelligence can be used to read x-rays and diagnose medical conditions. As a result, all jobs, even those of doctors, lawyers, and professors, are being transformed.
But transformed is not the same as threatened. Machines, it is true, are already more efficient than legal associates at searching for precedents. But an attorney attuned to the personality of her client still plays an indispensable role in advising someone contemplating a messy divorce whether to negotiate, mediate, or go to court. Likewise, an attorney’s knowledge of the personalities of the principals in a civil suit or a criminal case can be combined with big data and analytics when the time comes for jury selection. The job is changing, not disappearing.
These observations point to what is really happening in the labor market. It’s not that nurses’ aides are being replaced by health-care robots; rather, what nurses’ aides do is being redefined.
And what they do will continue to be redefined as those robots’ capabilities evolve from getting patients out of bed to giving physical therapy sessions and providing emotional succor to the depressed and disabled.
At one level, this is good news for those concerned about the prospects of incumbent workers: there will continue to be demand for workers in existing occupations. Not all nurses’ aides will have to become software engineers. The knowledge they acquire on the job – of how one interacts with patients, how one recognizes their moods, and how one acknowledges their needs – will remain pertinent and valued. They will use that knowledge to guide and cooperate with their robotic colleagues.
Thus, the coming technological transformation won’t entail occupational shifts on the scale of the Industrial Revolution, with its wholesale redistribution of labor between the agricultural and industrial sectors. After all, the vast majority of Americans already work in the service sector. But it will be more important than ever for people of all ages to update their skills and renew their training continuously, given how their occupations will continue to be reshaped by technology.
In countries like Germany, workers in a variety of sectors receive training as apprentices and then over the course of their working lives. Companies invest and reinvest in their workers, because the latter can insist on it, possessing as they do a seat in the boardroom as a result of the 1951 Codetermination Law. Employers’ associations join with strong trade unions to organize and run training schemes at the sectoral level. The schemes are effective, in part, because the federal government sets standards for training programs and issues uniform curricula for trainees.
In the US, board membership for workers’ representatives, strong unions, and government regulation of private-sector training are not part of the prevailing institutional formula. As a result firms treat their workers as disposable parts, rather than investing in them. And government does nothing about it.
So here’s an idea. Instead of a “tax reform” that allows firms to expense their capital outlays immediately, why not give companies tax credits for the cost of providing lifelong learning to their employees?
Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is Hall of Mirrors:The Great Depression, the Great Recession, and the Uses – and Misuses – of History.
2007 All Over Again, Part 7: Borrowers Start Scamming Desperate Lenders
Yield-Starved Investors Giving In to the Demands of Bond Sellers
(Wall Street Journal) – Demand for leveraged loans is allowing private-equity firms to water down legal safeguards for investors Hellman & Friedman LLC and other investors sought last month to borrow money in the bond market to finance a takeover.
The U.S. private-equity firm offered a yield of about 3%, but few of the protections once considered routine.
Still, the investors bought.
Rampant demand for leveraged loans is allowing private-equity firms to water down legal safeguards for investors. Many lawyers and bankers increasingly worry that such changes could result in higher losses for investors during the next downturn, as creditors find themselves with less protection.
Terms on loans from Hellman & Friedman’s takeover of Denmark’s Nets A/S allowed greater flexibility for the borrower to take on more debt, extract cash from the company and even restrict who owns the loans. That, though, is no longer unusual in the loan market.
In the financing of a previous takeover of Nets in 2014, a separate group of private equity borrowers had to prove that debt at the Danish payments company wasn’t rising too quickly. Such a requirement wasn’t present this time.
The move to more borrower-friendly terms has come in both the U.S. and Europe.
But the most dramatic shift has been in Europe, where the imbalance between loan supply and demand is most acute.
Investors are clamoring for leveraged loans as years of low interest rates and central banks’ bond buying have pushed down returns elsewhere. Trillions of dollars of sovereign debt, primarily in Europe, continue to sport negative yields, meaning investors pay to lend governments money.
With “far too much cash trying to find too few homes,” private-equity firms “can be more aggressive and lenders will take it,” said Adam Freeman, a partner at Linklaters LLP.
Some of the year’s largest leveraged buyouts in Europe have either removed covenants and legal protections, or allowed the borrower to control who buys its debt.
That included Bain Capital and Cinven’s takeover of German drugmaker Stada Arzneimittel AG, Lone Star LP’s acquisition of German building materials maker Xella Group, as well as the takeover of Nets A/S.
Analysts say that along with low borrowing costs, the weakening of deal terms has helped boost the appeal of loans to private-equity firms. In Europe, around 88% of the debt funding for leveraged buyouts came from loans this year, according to S&P Global Market Intelligence’s LCD unit, up from 73% in 2015. Meanwhile, 81% of loans in Europe this year have been “covenant-lite,” meaning they lack many standard investor protections, up from 21% in 2013, according to LCD.
Among the first changes was the stripping out of so-called financial-maintenance covenants, which are investors’ main defense against borrowers taking on too much debt. They require quarterly tests of a company’s leverage level, allowing lenders to force the firm into default if it rises too high.
Other borrower-friendly terms include stringent loan-to-own clauses, which limit investors’ ability to sell to distressed debt funds. Recent loans have placed restrictions against such firms as Elliot Capital Management, Apollo Global Management and Cerberus Capital Management.
Bankers warn that such provisions, along with so-called white lists that detail which funds can buy the loan, could hurt liquidity if investors can’t unload loans in troubled companies to the sort of funds that specialize in taking on this risk.
This is just what happens when central banks push interest rates way down while flooding the market with new currency. Lenders find themselves with too much money to lend and borrowers can, as a result, can write their own tickets. With eventually disastrous results.
When things get tough, as they always do after a long debt binge, the private equity borrowers will suck as much money out of their captive companies as possible, while layering on new debt at unfavorable terms. Then they’ll let those companies default and hand off the near-worthless carcasses to creditors.
You have to feel sorry (and, yes, a bit of disgust) for the victims of this recurring scam. Pension funds, for instance, are saddled by their political masters with unrealistically high return assumptions of 7% – 8%, which are unattainable in a world where long-term bonds yield next to nothing. So the prospect of even an extra percentage point of yield is tantalizing for pension fund managers whose jobs are on the line if they can’t do the impossible.
A personal aside: My first serious finance job was as a junk bond analyst with a high-yield mutual fund, and my days boiled down to reading bond covenants and answering the question, “how can they screw us?” The assumption was that if the borrowers could screw us they would, and we wanted to see it coming.
But with bubbles of today’s magnitude, seeing it coming isn’t much help for either the owners of this increasingly toxic paper or the economy as a whole.
For India and China, Southeast Asia Is a Battleground
By Kamran Bokhari