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December 31, 2007 | www.post-gazette.com
Dr. Christina Fong, research scientist at Carnegie Mellon University, does research on people's charitable impulses.
Christina Fong grew up near Purdue University, where she met many poor Indiana residents who believed strongly in the free enterprise system, even if it wasn't benefiting them very much.
Then, every other summer, she would spend six weeks in her mother's native Sweden, meeting wealthy Swedes who happily supported the heavy taxes on the rich that financed that nation's expansive social welfare system.
It gave the Carnegie Mellon University researcher a lifelong question to pursue: Why do people support economic systems that seem to be against their self-interest?
In Sweden, many affluent residents endorse the country's lofty taxes, even though it takes citizens until the first week in August to pay their collective annual tax burden, compared with the end of April in the United States.
On the other hand, many low-income Americans oppose stiff taxes on the wealthy, even if it would mean greater benefits for them.
That enigma has been a driving force for Dr. Fong, a professor in the Department of Social and Decision Sciences at Carnegie Mellon.
"Why do we see these poor people in Indiana who don't buy into an egalitarian system and these rich people in Sweden who support it?" she asked. "That's a big puzzle in economics."
She and her colleagues have found that the split between rich and poor people on these issues is less lopsided than many might imagine.
As expected, a 1998 Gallup poll found that a majority of people making less than $30,000 a year felt the rich should be heavily taxed, while a majority of those making more than $50,000 a year felt they should not.
- Position: Research scientist, Department of Social and Decision Sciences, Carnegie Mellon University
- Age: 39
- Residence: Mount Washington
- Education: Bachelor's in economics, University of Michigan, 1990. Ph.D., economics, University of Massachusetts, 2000.
- Previous positions: Visiting scholar, Washington University, 1999-2000; Pre-doctoral fellow, University of Arizona, 1998; consultant, Inter-American Development Bank, Washington, D.C., 1995-96; Research intern, University of Massachusetts, 1993; Economist, U.S. Bureau of Labor Statistics, Washington D.C., 1990-92.
- Publications: Twelve papers for professional journals and book chapters.
But surprisingly, nearly 35 percent of the poorer residents opposed heavy taxes for the wealthy, while a quarter of the affluent supported such taxes.
In a similar vein, a 1995 study by the research organization Public Agenda showed that welfare recipients shared almost the same negative attitudes toward welfare as other people did.
For instance, 57 percent of non-welfare respondents and 62 percent of welfare recipients said welfare "encourages people to be lazy," while 60 percent of non-welfare people and 64 percent of welfare clients said it "encourages people to have kids out of wedlock."
In several studies in recent years, Dr. Fong has found that for many people, achieving fairness in an economic system is almost as important as how much money they make.
The experiments she and others have done show that "income doesn't matter as much as we think it should."
"If only income mattered and beliefs about fairness didn't matter at all, then you should expect to see the world that traditional economists expect you to see, which is that poor people demand redistribution [of tax revenue] and rich people oppose it.
"The fact that we don't see that requires some explanation, and a big part of the explanation is that these beliefs about fairness matter a lot. So if you're poor but you think that the rich people really deserve to be rich, then you'll accept having less."
Much of Americans' beliefs revolve around whether they think the free-market economy is fair -- "in other words, people who work hard get more and people who don't get less" -- or whether they think it is basically unfair, so that "people are working really hard and not getting enough compensation."
In one recent study, Dr. Fong and Giacomo Corneo at the Free University of Berlin used economic equations to calculate that both those groups would give up about 20 percent of their annual income to achieve a world that they thought was fair.
In other words, people who think the free market is unjust would give up a fifth of their income to switch from a laissez-faire economy to one where the government reduces the gap between the rich and poor. But those who feel that private enterprise is fair would give up an equal amount of their income to switch from an economy where the government redistributes money to the poor, to one where the free market rules.
Other studies show that people will spend real money to ensure fairness.
In one unpublished experiment she has just finished with Felix Oberholzer at Harvard Business School, Dr. Fong gave people $10 each and said they could split it any way they wanted between themselves and public housing residents they were paired with.
But then she added a twist. All the public housing residents in the study had indicated they were held back in life either by drug abuse or by a disability, and the experimental subjects were offered the chance to spend $1 to find out which reason had been cited by the residents they were matched with.
About a third of the subjects spent the dollar, Dr. Fong said. And while you might think such curiosity would make them the less generous group, the opposite was true.
On average, she said, people who didn't seek information about their public housing residents gave them about $2 and kept about $8. Those who paid to find out about their residents gave them about $2.60 and kept the remaining $6.40.
The averages obscured a more intriguing finding, though. Those who discovered they had "worthy" residents, who said a disability had held them back, gave the residents about $4.55, and kept just $4.45 for themselves. Those who found that their residents cited drug abuse as an impediment kept $8.38 and gave the residents only 62 cents.
It turned out, then, that the people who were more generous on average also were extremely interested in finding out whether their charity recipients deserved to be helped, while those who were more selfish on average didn't care as much about how worthy the recipients were.
"Selfish people don't need the information" about recipients, she said, "because they're just not going to give [as much], but the people who want to give are only going to give if the person is deemed worthy."
While feelings about fairness influence charitable giving, another study Dr. Fong published earlier this year with Erzo Luttmer of Harvard University shows that racial and ethnic identity also plays a role in the United States.
In that study, people were shown a video about victims of Hurricane Katrina and then could decide how to split $100 between themselves and Habitat for Humanity chapters in the communities they had learned about.
Some of the videos people watched showed mostly white residents and some showed mostly black residents. In addition, the people in the experiment had previously filled out surveys showing how closely they identified with their own racial or ethnic group.
The bottom line: Whites who said they felt "close" or "very close" to their ethnic or racial group on average gave $17 less to blacks than whites, but whites who said they were "not very close" or "not close at all" to their group gave $13 more to blacks than to whites.
The lessons from this experiment are not just about race, Dr. Fong said, but about the importance of our opinions about the people receiving any kind of assistance.
While many people still have negative attitudes toward welfare, despite the reforms made over the past decade, they generally have positive feelings toward Social Security.
Both those programs have white and black recipients, Dr. Fong said, but with welfare, many people feel the recipients aren't deserving, but have opposite opinions about Social Security because most recipients paid into the system when they worked.
In America, she said, one way to tap into this basic sense of fairness is to bring up the subject of the working poor.
"If they're perceived as being really hard-working and having reached that state despite their hard work, that's the point at which people are willing to step in and say either I as an individual or we as a society have to do something for this person.
"People don't necessarily think a low-income worker should be as rich as [Microsoft billionaire] Bill Gates, even though he might be working as hard as Bill Gates, but they do have some sense of when things have gone too far."
ZNet South Asia
Almost two years ago, Ajay Kapur, a prominent global strategist of the Citigroup and his two associates, Niall Macleod and Narendra Singh, came out with a paper "Plutonomy: Buying Luxury, Explaining Global Imbalances." If the formulations contained in this paper are correct, they will have far reaching implications, upsetting long-standing understandings of economists all over the world.
Ajay Kapur and his associates assert that world is getting divided into two blocs, namely, the Plutonomy and the rest. The term 'Plutonomy' is derived from, Plutus, the Greek god of wealth. America, Britain and Canada are the key Plutonomies, powered mainly by the wealthy. In Plutonomies, the rich dominate the economy as they account for most of the consumption expenditures, savings, current account deficits, etc. Obviously, in the Plutonomies, economic growth is powered by the wealthy. The rest of the population does not have much of a role in the economy.
Kapur and his associates claim: "Plutonomies have occurred before in sixteenth century Spain, in seventeenth century Holland, the Gilded Ages and Roaring Twenties in the U.S." Common drivers of Plutonomy in each case have been "Disruptive technology-driven productivity gains, creative financial innovation, capitalist-friendly cooperative governments, an international dimension of immigrants and overseas conquests invigorating wealth creation, the rule of law, and patenting inventions." These conditions benefit the rich and educated of the time because only they are in a position to exploit them. Income inequality has been a prominent feature of Plutonomy. In the present day world Plutonomies are given birth to and sustained by revolution in information and communications technology, financialization, globalization and friendly governments and their policies.
In a Plutonomy, consumers do not have their nationality. Thus there is no U.S. consumer or British consumer. Globalization has converted the entire world into a single integrated market. "There are rich consumers, few in number, but disproportionate in the gigantic slice of income and consumption they take. There are the rest, the "non-rich", the multitudinous many, but only accounting for surprisingly small bites of the national pie. Consensus analyses that not tease out the profound plutonomy on spending power, debt loads, savings rates (and hence current account deficits), oil price impacts etc., i.e., focus on the "average" consumer flawed from the start… Since consumption accounts for 65% of the world economy, and consumer staples and discretionary sectors for the MSCIAC World Index, understanding how the plutonomy impacts consumer is key for equity market participants."
Kapur & Co. assert that Plutonomy is not going to go away but will get stronger and stronger, "its membership swelling from globalized enclaves in the emerging world, we think a "plutonomy basket" of stocks should continue to do well These toys for the wealthy have pricing power, and staying power."
The share of the wealthy in the national income has been increasing. The top 1% of households in America, i.e., about one million households accounted for around 20% of overall U.S. income in 2000, slightly lower than the share of income of the bottom 60% of households put together. In other words, about one million households on the top and the bottom 60% households had almost equal share in the national pie. The top one per cent of households accounted for 40 per cent of financial net worth, more than the bottom 95 per cent of households put together.
Kapur & Co. assert: "We posit that the drivers of plutonomy in the U.S. (the UK and Canada) are likely to strengthen, entrenching and buttressing plutonomy where it exists. The six drivers of the current plutonomy: (1) an ongoing technology/biotechnology revolution, (2) capitalist friendly governments and tax regimes, (3) globalization that re-arranges global supply chains with mobile well-capitalized elites and immigrants, (4) greater financial complexity and innovation, (5) the rule of law, and (6) patent protection are well ensconced in the U.S., the UK and Canada. They are also gaining strength in the emerging world." Further, "Eastern Europe is embracing many of these attributes, as are China, India, and Russia."
When the top, say one per cent of households in a country see their share of income rise sharply, a Plutonomy emerges. This is witnessed often in times of frenetic technology/financial innovation driven wealth waves, accompanied by asset booms, equity and/or property. Feeling wealthier, the rich decide to consume a part of their capital gains right away. In other words, they save less from their income, the well-known wealth effect.
They claim that the rich have become the dominant drivers of demand in many economies. They have started dominating income, wealth and spending. According to a recent article by George Ip "Income Inequality Gap Widens" (The Wall Street Journal, October 12, 2007): the richest Americans have been cornering greater and greater share of the national income. The wealthiest one per cent of Americans earned 21.2 per cent of national income in 2005 while they earned 19 per cent in 2004 and 20.8 per cent in 2000. On the other hand the bottom 50 per cent earned 12.8 per cent of national income that was less than 13.4 per cent in 2004 and 13 per cent in 2000.
Since the wealthy appropriate most of the national income, the pattern of production is fashioned to meet their demand. It is estimated that America's richest half-per cent consume, on an average, goods and services worth $650 billion a year. In a Plutonomy like America, "the wealthy account for a greater share of national wealth, spending, profits and economic growth … the top 20 per cent of income earners account for as much as 70 per cent of consumption in the United States. Like it or not… spending by the rich was propping up the economy, even as the middle and lower classes were struggling." Further, "In this new plutonomy, with "rich" consumers and "everyone else," companies that serve the rich are prospering. From department stores to hotels to automakers to homebuilders, businesses in every industry was adapting to an increasingly hour-glass-shaped economy, selling to the status-seeking rich, and the penny-pinching middle and lower middle classes."
The Plutonomy thesis presented by Ajay Kapur & Co. implies that there will be no "realization crisis" nor will there be any need for the Keynesian prescription of an active role of the state in augmenting the volume of effective demand. In other words, no public works and welfare activities are to be undertaken wherever Plutonomy is in ascendancy. "New Deal" of Roosevelt has become irrelevant. The same is the fate of William H. Beveridge's recommendations for creating a welfare state. Mahatma Gandhi, Nehru, and Indira Gandhi (with her slogan of 'Garibi Hatao') are to become irrelevant. Present day slogans like 'Congress ka Hath Aam Adami ke Sath' and 'the inclusive growth' are nothing but hollow ones.
Karl Marx was the first to point out that capitalism was bound to face "realization crisis", i.e., capitalists might not realize the value inherent in commodities because they might find the total volume of demand falling short of the volume of supply. Thus capitalists would not be able to sell the entire volume of output. This could be due to anarchy of production and productivity increasing much faster than the wages.
Karl Marx's claim was outright dismissed by the ruling orthodoxy because till 1929 it continued to stick to the dictum "supply creates its own demand," based on the law of markets put forth by the French economist Jean-Baptiste Say (1767-1832) in a book published in France in 1803 (translated into English as "A Treatise on Political Economy, or the production, distribution and consumption of wealth," and published from Philadelphia in 1855).
Say held that there could be no demand without supply. The power to purchase could get augmented only by more and more production. Hence there could be no problem of unsold commodities. If everything was normal and there was no interference by the government, trade unions and other quarters in the functioning of market, it would clear. In other words, economy would be self-regulating, provided all prices, including wages were flexible enough. A free market economy was always supposed to maintain full employment. Hence there would be no glut. This approach collapsed in 1929 when the Great Depression set in. This was the most severe and prolonged General Crisis in the history of capitalism.
Keynes tore this orthodoxy to pieces. Contrary to the assertion of Say's followers there was mass involuntary unemployment because the realization crisis had forced the factories to down their shutters and lay off the workers. This deepened the crisis further. Keynes demonstrated that Say was wrong when he believed that there was only transaction demand for money. In fact, there were precautionary and speculative demands for money. Because of this people might not spend all their earnings on buying goods and services. The greater this leakage, the greater was the impending fear of the phenomenon of unsold commodities. He analyzed the factors behind these two motives.
Keynes suggested an active role for the state in order to augment and maintain the volume of demand to enable the market to clear and ward off the danger of realization crisis. From this arose the strategy of welfare state. In the course of time, state assumed the responsibility of creating employment opportunities and poverty reduction.
This thinking remained prominent, in spite of onslaughts by Mises, Hayek and the Chicago school, led by Milton Friedman, but the process of its burial began with the rise of Thatcher-Reagan line of thinking, the collapse of the Soviet Union and the Washington consensus-based globalization, thrust indiscriminately on the entire world. Now, it appears, the danger of realization crisis emanating from a general crisis of capitalism is almost forgotten. Extolling the virtues of consumerism and 'shop till you fall dead' appear to be the instrument for raising the volume of effective demand. There is, however, a catch, more so in developing countries, where the seeds of plutonomy will take a long time to germinate. The overwhelming mass of people lack employment opportunities and income to survive, but they have the power to unseat the government, notwithstanding all the propaganda about glowing future. Didn't Keynes say, in the long run we all will be dead, so what is relevant is the present and immediate future?
Thursday, October 11, 2007 WASHINGTON
Enough, already, with compassion for society's middle and lower orders. There currently is a sympathy deficit regarding the very rich. Or so the rich might argue because they bear the heavy burden of spending enough to keep today's plutonomy humming.
Furthermore, they are getting diminishing psychological returns on their spending now that luxury brands are becoming democratized. When there are 379 Louis Vuitton and 227 Gucci stores, who cares?
Citigroup's Ajay Kapur applies the term "plutonomy" to, primarily, the United States, although Britain, Canada and Australia also qualify. He notes that America's richest 1 percent of households own more than half the nation's stocks and control more wealth ($16 trillion) than the bottom 90 percent. When the richest 20 percent account for almost 60 percent of consumption, you see why rising oil prices have had so little effect on consumption.
Kapur's theory is that "wealth waves" develop in epochs characterized by, among other things, disruptive technology-driven productivity gains and creative financial innovations that "involve great complexity exploited best by the rich and educated of the time." For the canny, daring and inventive, these are the best of times -- and vast rewards to such people might serve the rapid propulsion of society to greater wealth.
But it is increasingly expensive to be rich. The Forbes CLEW index (the Cost of Living Extremely Well) -- yes, there is such a thing -- has been rising much faster than the banal CPI (consumer price index). At the end of 2006, there were 9.5 million millionaires worldwide, which helps to explain the boom in the "bling indexes" -- stocks such as Christian Dior and Richemont (Cartier and Chloe, among other brands), which are up 247 percent and 337 percent respectively since 2002, according to Fortune magazine. Citicorp's "plutonomy basket" of stocks (Sotheby's, Bulgari, Hermes, etc.) has generated an annualized return of 17.8 percent since 1985.
This is the outer symptom of a fascinating psychological phenomenon: Envy increases while -- and perhaps even faster than -- wealth does. When affluence in the material economy guarantees that a large majority can take for granted things that a few generations ago were luxuries for a small minority (a nice home, nice vacations, a second home, college education, comfortable retirement), the "positional economy" becomes more important.
Positional goods and services are inherently minority enjoyments. These are enjoyments -- "elite" education, "exclusive" vacations or properties -- available only to persons with sufficient wealth to pursue the satisfaction of "positional competition." Time was, certain clothes, luggage, wristwatches, handbags, automobiles, etc., sufficed. But with so much money sloshing around the world, too many people can purchase them. Too many, in the sense that the value of acquiring a "positional good" is linked to the fact that all but a few people cannot acquire it.
That used to be guaranteed because supplies of many positional goods were inelastic -- they were made by a small class of European craftsmen. But when they are mass-produced in developing nations, they cannot long remain such goods. When 40 percent of all Japanese -- and, Fortune reports, 94.3 percent of Japanese women in their 20s -- own a Louis Vuitton item, its positional value vanishes.
James Twitchell, University of Florida professor of English and advertising, writing in the Wilson Quarterly, says this "lux populi" is "the Twinkiefication of deluxe." Now that Ralph Lauren is selling house paint, can Polo radial tires be far behind? When a yacht manufacturer advertises a $20 million craft -- in a newspaper, for Pete's sake; the Financial Times, but still -- cachet is a casualty.
As Adam Smith wrote in "The Wealth of Nations," for most rich people "the chief enjoyment of riches consists in the parade of riches, which in their eye is never so complete as when they appear to possess those decisive marks of opulence which nobody can possess but themselves." Hennessy understands the logic of trophy assets: It is selling a limited batch of 100 bottles of cognac for $200,000 a bottle.
There is some good news lurking amid the vulgarity. Americans' saving habits are better than they seem because the very rich, consuming more than their current earnings, have a negative savings rate.
Furthermore, because the merely affluent are diminishing the ability of the very rich to derive pleasure from positional goods, philanthropy might become the final form of positional competition. Perhaps that is why so many colleges and universities (more than 20, according to Twitchell) are currently conducting multi billion-dollar pledge campaigns. When rising consumption of luxuries produces declining enjoyment of vast wealth, giving it away might be the best revenge.
George F. Will is a columnist for The Washington Post and Newsweek. He can be reached at email@example.com.
It's well known that the rich have an outsized influence on the economy.
The nation's top 1% of households own more than half the nation's stocks, according to the Federal Reserve. They also control more than $16 trillion in wealth - more than the bottom 90%.
Yet a new body of research from Citigroup suggests that the rich have other, more-surprising impacts on the economy.
Ajay Kapur, global strategist at Citigroup, and his research team came up with the term "Plutonomy" in 2005 to describe a country that is defined by massive income and wealth inequality. According to their definition, the U.S. is a Plutonomy, along with the U.K., Canada and Australia.
In a series of research notes over the past year, Kapur and his team explained that Plutonomies have three basic characteristics.
1. They are all created by "disruptive technology-driven productivity gains, creative financial innovation, capitalist friendly cooperative governments, immigrants…the rule of law and patenting inventions. Often these wealth waves involve great complexity exploited best by the rich and educated of the time."
2. There is no "average" consumer in Plutonomies. There is only the rich "and everyone else." The rich account for a disproportionate chunk of the economy, while the non-rich account for "surprisingly small bites of the national pie." Kapur estimates that in 2005, the richest 20% may have been responsible for 60% of total spending.
3. Plutonomies are likely to grow in the future, fed by capitalist-friendly governments, more technology-driven productivity and globalization.
Kapur says that once we understand the Plutonomy, we can solve some of the recent mysteries of the American economy. For instance, some economists have been puzzled (especially last year) about why wild swings in oil prices have had only muted effects on consumer spending.
Kapur's explanation: the Plutonomy. Since the rich don't care about higher oil prices, and they dominate spending, higher oil prices don't matter as much to total consumer spending.
The Plutonomy also could explain larger "imbalances" such as the national debt level. The rich are so comfortably rich, Kapur explains, that they have started spending higher shares of their incomes on luxuries. They borrow much larger amounts than the "average consumer," so they have an exaggerated impact on the nation's debt levels and savings rates. Yet because the rich still have plenty of wealth and healthy balance sheets, their borrowing shouldn't be a cause for concern.
In other words, much of the nation's lower savings rate is due to borrowing by the rich. So we should worry less about the "over-stretched" average consumer.
Finally, the Plutonomy helps explain why companies that serve the rich are posting some of the strongest growth and profits these days.
"The Plutonomy is here, is going to get stronger, its membership swelling" he wrote in one research note. "Toys for the wealthy have pricing power, and staying power."
To prove his point, he created a "Plutonomy Basket" of stocks, filled with companies that sell to the rich. The auction house Sotheby's is on the list, along with fashion houses Bulgari, Burberry and Hermes, hotelier Four Seasons, private-banker Julius Baer and jeweler Tiffany's. Kapur says the basket has risen an average of 17% a year over the past year, outperforming the MSCI World Index.
Of course, Kapur says there are risks to the Plutonomy, including war, inflation, financial crises, the end of the technological revolution and populist political pressure. Yet he maintains that the "the rich are likely to keep getting even richer, and enjoy an even greater share of the wealth pie over the coming years."
All of which means that, like it or not, inequality isn't going away and may become even more pronounced in the coming years. The best way for companies and businesspeople to survive in Plutonomies, Kapur implies, is to disregard the "mass" consumer and focus on the increasingly rich market of the rich.
A tough message - but one worth considering.
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The wealth of the world's super-rich soared last year at the fastest rate for seven years. The rise in riches was accompanied by a surge in charitable giving to $285bn - believed to be a record.
The downside for the super-rich was that the cost of their favourite luxury products and activities rose at nearly twice the average rate for goods and services.
The 11th annual study of 71 countries by investment bank Merrill Lynch and consultancy firm, Capgemini found that buoyant economic growth across the world pushed the riches of "high net worth individuals" (HNWI) up by a hefty 11.4% last year. The dramatic increase took the total prosperity of the world to $37.2 trillion - equivalent to 15 times the annual output of the UK economy.
High-net worth individuals are those with $1m (£500,000) to invest in financial assets excluding first homes. Ultra high-net worth individuals have $30m at their disposal.
Britain had the fourth biggest number of the world's wealthiest, with a total of 484,580 high-net worth individuals, up 8.1% from 2005. Only the US, Japan and Germany have more. Britain is home to 16.7% of Europe's super-rich.
Part of the rise in world wealth last year came from booming stock markets. The Dow Jones world index, for example, increased by a solid 16.4%.
The boost in cash held by the world's millionaires and billionaires gave way to a surge in philanthropy, the report said. Rich individuals donated 7% of their wealth to charity, while the ultra-rich donated more than 10% to these causes. This charitable giving amounted to more than $285bn globally. Warren Buffett, the world's second-richest man, added to the trend last year when he donated 85% of the $45bn earned from his lifetime of investments to a foundation established by Microsoft's Bill Gates and his wife Melinda.
"Philanthropy is central to what wealth managers are having to do; it cannot be ignored," said Nick Tucker, a Merrill Lynch executive director and co-author of the report. "New wealth especially are keen on this."
Environmental and socially responsible investing were no longer niche categories. Nearly half of all British investment firms invest more than 10% of the assets under their management in socially responsible projects, a rise of 20% from 2004.
The report predicted that global wealth was expected to grow by 6.8% each year until 2011, pushing the total amount to $51.6 trillion, though Mr Tucker warned that a slowing world economy may put a brake on the soaring expansion of wealth over the coming years.
"With many central banks tightening monetary policy, the period of high liquidity that has stimulated recent growth may soon come to an end. The growth rates of Asia and Latin America are expected to ease back as global demand slows. The dual risks of rising energy prices and geopolitical conflicts are a continued threat, adding a level of uncertainty to our current forecasts."
Britain in particular was facing slowing growth, and therefore a lower generation of wealth, as a result of higher inflation and low household savings rates this year.
There were 9.5 million HNWIs last year, according to the report - a rise of 8.3% from 2005. Europe saw its wealth increase at the sharpest rate since 2000, with a rise of 7.8% to $10 trillion. The performance of financial markets in eastern Europe in particular was a key driver in this, Mr Tucker said. Ultra-HNWIs also rapidly increased by 11.3% to 94,970 last year.
The largest share of the growth in the world's higher net worth population came from Singapore and India, where numbers rose by 21.2% and 20.5% on the year respectively. This continued the rise of a new elite of super-rich individuals in developing nations as their economies expanded, in the case of India and China at rates more than triple that of the UK.
Many of these emerging economies, which included Russia, were gaining strength from domestic private consumption, competitive services and manufacturing sectors.
Wealth generated in Latin America, the Middle East and Russia was buoyed up by high commodity and oil prices.
"The globalisation of wealth creation has accelerated," said Chris Gant, head of wealth management at Capgemini Financial Services. "If 2005 was characterised by a flow of investment to international funds from HNWIs, 2006 ushered in a new era whereby emerging economies leaped ahead with direct foreign investment, strong domestic demand and hefty stock market gains."
The report found that as the rich got richer, the demand for luxury products increased, making them more expensive. The Cost of Living Extremely Well Index (CLEWI) measured the cost of a basket of 42 luxury goods and services, including designer handbags, tuition at Harvard University and filet mignon.
Last year, this index rose nearly twice as fast as the cost of everyday consumer products. The CLEWI rose at 7% while the consumer price index increased by 4%.
The world's millionaires nevertheless devoted about a quarter of their "investments of passion" to yachts and private jets, dubbed "mobile mansions," and a fifth to art.
April 21st, 2007 | patrick.net
One of the topics that has kept coming up over the 2 years of this blog's existence is wealth and income disparity. It's pretty obvious from a number of different sources and metrics that –after heading down for several generations– it's been going up over the past 35 years or so in the U.S. In fact the U.S. is now closer to China or Iran in terms of wealth distribution (as measured by the Gini Coefficient) than Canada or Western Europe.
Some of the regulars here (myself included) view this as an alarming trend, with some disturbing implications, such as:
- A gradually shrinking middle class (however one chooses to define that), and increasingly bifurcated economy/society.
- Less overall economic/social mobility (fewer opportunities for ambitious, intelligent poor people to join the ranks of the middle class, or move from middle to wealthy class).
- Potential for greater social/political unrest, as wealth disparity approaches Third-world levels (What good is it to be "middle class" or wealthy, if it means having to live in a heavily fortified compound that you cannot leave without bringing along a small private army to protect you, a-la Mexico or Colombia?).
- The devolution of our economy, from "free market" capitalism, based (at least somewhat) on the concepts of rule-of-law, meritocracy, competition and personal responsibility, to one based more on kleptocracy, plutocracy, corruption, and political connections.
- The growing phenomenon of "Privatize Profits, Socialize Risks", where politically well connected big businesses and de-facto cartels attempt to insulate themselves from competition, and seek to transfer the consequences of their own bad financial decisions to taxpayers, via federal laws, subsidies and bailouts.
Some of our Patrick.net regulars appear to think this may be a symptom of an inevitable mega-trend that no amount of social engineering or tax redistribution can stop. Some even consider the emergence of a large, prosperous middle class as a historical aberration, that we are now in the process of "correcting". Peter P has often commented that, "no matter how you redistribute wealth, it always ends up in the same hands". And there may be validity to this view: consider the spectacular rise and fall of Communism in the Twentieth Century. There is also the notion that our economy has progressed to the point where wealth disparity is unlikely to lead to the kinds of social/political unrest it has in the past (French, Russian Revolutions, etc.), because for the most part, citizens' basic physical needs are still being met. A.k.a., the "bread and circuses" argument (see Maslow's hierarchy of needs).
The big questions for me are:
- Is the decline of the middle class and bifurcation of the U.S. economy an inevitable result of macro-economic and historical forces beyond our ability to influence (such as global wage arbitrage and the transition from being an industrial power to a primarily service-based economy)?
- Is it theoretically possible to reverse this trend through social/economic policies, and if so, how? Is Different Sean-style socialism the only way? (see "How does one regulate 'well'?")
- If such reforms are theoretically possible, are they practically feasible? (i.e., is it realistic to assume political opposition from entrenched special interests can ever be overcome?)
"The rich are different from you and me," wrote Fitzgerald and I suppose they are, but the differences – they wax and wane with the economic tides. Gilded ages come, go, and are reborn on the monsoon cloudbursts of seemingly intangible forces such as globalization, innovation, and favorable tax policy. For the rich to be truly rich and multiply their numbers, they need help. Adept surfers they may be, but like all riders, the wealthy need a seventh wave that allows them to preen their skills and declare themselves masters of their own universe, if only for a moment in time. That the golden glazed surfboards of the 21st century seem unique with their decals of "private equity" and "hedge finance" is mostly a mirage. Wealth has always gravitated towards those that take risk with other people's money but especially so when taxes are low. The rich are different – but they are not necessarily society's paragons. It is in fact society's wind and its current willingness to nurture the rich that fills their sails.
What farce, then, to give credence to current debate as to whether private equity and hedge fund managers will be properly incented if Congress moves to raise their taxes up to levels paid by the majority of America's middle class. What pretense to assert, as did Kenneth Griffin, recipient last year of more than $1 billion in compensation as manager of the Citadel Investment Group, that "the (current) income distribution has to stand. If the tax became too high, as a matter of principle I would not be working this hard." Right. In the same breath he tells, Louis Uchitelle of The New York Times that the get-rich crowd "soon discover that wealth is not a particularly satisfying outcome." The team at Citadel, he claims, "loves the problems they work on and the challenges inherent to their business." Oh what a delicate/tangled web we weave sir. Far better to admit, as has Warren Buffett, that the tax rates of the wealthiest Americans average nearly 15% while those of their salaried and therefore less incented assistants just outside their offices are nearly twice that. Far better to recognize, as does Chart 1, that only twice before during the last century has such a high percentage of national income (5%) gone to the top .01% of American families. Far better to understand, to quote Buffett, that "society should place an initial emphasis on abundance but then should continuously strive to redistribute the abundance more equitably."
Buffett's comments basically frame the debate: when is enough, enough? Granted, American style capitalism has fostered and encouraged innovation and globalization which are the fundamental building blocks of wealth. That is the abundance that Buffett speaks to – the creation of enough. But when the fruits of society's labor become maldistributed, when the rich get richer and the middle and lower classes struggle to keep their heads above water as is clearly the case today, then the system ultimately breaks down; boats do not rise equally with the tide; the center cannot hold.
Of course the wealthy fire back in cloying self-justification, stressing their charitable and philanthropic pursuits, suggesting that they can more efficiently redistribute wealth than can the society that provided the basis for their riches in the first place. Perhaps. But with exceptions (and plaudits) for the Gates and Buffetts of the mega-rich, the inefficiencies of wealth redistribution by the Forbes 400 mega-rich and their wannabes are perhaps as egregious and wasteful as any government agency, if not more. Trust funds for the kids, inheritances for the grandkids, multiple vacation homes, private planes, multi-million dollar birthday bashes and ego-rich donations to local art museums and concert halls are but a few of the ways that rich people waste money – and I must admit, I am guilty of at least one of these on this admittedly short list of sins. I have, however, avoided the last one. When millions of people are dying from AIDS and malaria in Africa, it is hard to justify the umpteenth society gala held for the benefit of a performing arts center or an art museum. A thirty million dollar gift for a concert hall is not philanthropy, it is a Napoleonic coronation.
So when is enough, enough? Now is the time, long overdue in fact, to admit that for the rich, for the mega-rich of this country, that enough is never enough, and it is therefore incumbent upon government to rectify today's imbalances. "The way our society equalizes incomes" argues ex-American Airlines CEO Bob Crandall, "is through much higher taxes than we have today. There is no other way." Well said, Bob. Enough said, Bob. Because enough, when it comes to the gilded 21st century rich, has clearly become too much.
If gluttony describes the acquisitive reach of the mega-rich, then the same gastronomical metaphor applies to today's state of the credit markets. Stuffed! Both borrowers and lenders may have bitten off more than they can chew, and even those that swallow their hot dogs whole – Nathan's Famous Coney Island style – are having a serious bout of indigestion. Several hundred billion dollars of bank loans and high yield debt wait in the wings to take out the private equity and leveraged buyout deals that have helped propel stocks to Dow 14,000. And lenders…mmmmm, how do we say this…don't seem to have much of an appetite anymore. Six weeks ago the high yield debt market was humming the Campbell's soup theme and now, it's begging for a truckload of Rolaids. Yields have risen by 100 to 150 basis points in response as shown in Chart 2.
Some wonder what squelched the hunger of potential lenders so abruptly, while in the same breath suggesting that the subprime crisis is "isolated" and not contagious to other markets or even the overall economy. Not so, and the sudden liquidity crisis in the high yield debt market is just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the U.S. economy. The fact is that several weeks ago, Moody's and Standard & Poor's finally got it into gear, downgrading hundreds of subprime issues and threatening more to come. "Isolationists" would wonder what that has to do with the corporate debt market. Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in subprime housing space, they claim. Unfortunately that does not appear to be the case.
The holiday season was very joyous on Wall Street. CEOs and lots of others took home some of the biggest checks ever.
I like a $50 million bonus as much as the next guy (although the most I can recall getting was $1,000), but those huge paydays beg a larger social and economic question: Does income inequality matter?
Mind the Gap
I'm not asking if we should care about the well-being of our poorest citizens. We should. This is a more subtle question: Should we care about the size of the gap between the rich and poor?
If we succeed in raising the incomes of the poor, does it matter if incomes at the top are rising even faster, making us a more unequal society overall?
By coincidence, I was in Brazil in December while those giant Wall Street bonuses were being handed out. Brazil has one of the largest gaps between rich and poor on the planet. Having experienced that gap firsthand -- from the slums run by drug traffickers at one end to the lovely apartments with bulletproof doors at the other -- I'm convinced that income inequality does matter.
If the gap between rich and poor gets too large, and if those at the bottom feel they have no meaningful route to the riches at the top, then the fabric of society will fray, or even come unraveled entirely.
Violence Literally Doesn't Pay
Life gets pretty scary -- no matter how much money you've got -- when a segment of society decides that they're no longer going to play by the rules.
Shortly before I arrived in Brazil, a British tour bus was hijacked and robbed in broad daylight on the way from Rio's international airport to a ritzy beach area. While I was there, two Supreme Court justices were carjacked on the same road.
Overall, the murder rate in Brazil is five times that of New York City. As in the United States, much of that violence is poor-on-poor, although the toll redounds everywhere. The New York Times reported recently on a World Bank study concluding that if Brazil had the much lower homicide rate of Costa Rica, Brazil's GDP would have been three to eight percent higher in the 1990s.
As one economist explained in the article, "You have money spent on guarding stuff rather than making stuff." And when international investors look around the globe, they choose safer places.
The Gini Out of the Bottle
Is this violence a direct result of income inequality? Almost certainly not. Brazil has a history of slavery and colonization that was far more brutal than the U.S. It would require a team of sociologists, historians, economists, and criminologists to explain the roots of violence in Brazil. Based on my knowledge of academics, I don't think they would come to a conclusion anyway.
Still, one can't spend time in Brazil without wondering about income inequality at home. Let's take a look at some numbers.
The most convenient statistic for measuring income inequality is called a Gini coefficient, which measures a country's distribution of income from 0 (absolute equality, with each person sharing the same amount of wealth) to 1 (absolute inequality, with one person controlling all of the nation's wealth).
Here's what that statistic looks like for a handful of countries, including contemporary and historic figures for the U.S.:
A Reason to Get Up in the Morning
- Japan: .25
- Sweden: .25
- India: .33
- The United States 1970: .39
- The United States 2005: .47 (Note that a small fraction of the increase over time is due to a change in the methodology for calculating the Gini coefficient; still, income inequality has climbed steadily by this measure over the past four decades.)
- Brazil: .58
So what? Obviously income inequality is just one statistic; it doesn't reflect the size of the pie, only how it's divided. The Soviet Union was a very equal place -- equally poor.
In fact, there are some really good things about income inequality, namely that it motivates risk, hard work, and innovation. I'm sure Wall Street bankers are motivated by a love of their work -- but a $50 million bonus can also help you get out of bed in the morning.
As a matter of fact, high salaries motivate not only the people who get them, but also the people who would like to get them in the future -- a phenomenon that economists refer to as a "tournament effect."
Thus, a $50 million bonus for a Wall Street CEO also inspires that ambitious guy in the mailroom to get out of bed if he thinks he's got a shot at being CEO someday. Even my undergraduate economics students work harder because they need good grades in order to get coveted investment banking jobs.
A Bigger Pie, or a Bigger Slice?
What's the problem, then? I think there are at least two reasons to be cognizant of income inequality in the U.S.:
Name Your Poison
- Is there still really a path from rags to riches? I've spent enough time in inner-city schools to wonder if we're really providing an opportunity for the motivated and gifted to make their way from the projects to Wall Street.
Yes, it happens -- you can watch Will Smith do it at your local multiplex in The Pursuit of Happyness, which is inspired by a true story. But how often does it not happen?
I'm convinced that part of what's going on in Brazil is that the socioeconomic ladder is broken. There's no real path from favela to bulletproof apartment, and some people with guns have decided that they don't want to play by the rules made by the people in those apartments.
Income inequality doesn't motivate anything good when there's no hope of sharing in the pot of gold.
- There's a very interesting strain of economic research showing that our sense of well-being is determined more by our relative wealth than by our absolute wealth.
In other words, we care less about how much money we have than we do about how much money we have relative to everyone else. In a fascinating survey, Cornell economist Robert Frank found that a majority of Americans would prefer to earn $100,000 while everyone else earns $85,000, rather than earning $110,000 while everyone else earns $200,000.
Think about it: People would prefer to have less stuff, as long as they have more stuff than the neighbors.
The point -- and this is still a nascent field -- is that a nation may be collectively better off (using some abstract measure of well-being) with a smaller, more evenly divided pie than with a larger pie that's sliced less equitably. Reasonable people can and should argue about that.
What's clear, however, is that one key difference between poverty in 1900 and poverty in 2007 is that even the poorest households -- in Brazil or the U.S. or anywhere else -- can turn on the television and see how the other half lives. It's one thing to be poor; it's another to be continually reminded exactly how poor you are.
At a minimum, we should question whether a bigger pie is always better.
There's no right answer as to how society ought to look. That's a matter of personal philosophy. Indeed, I still find a thought experiment proposed by philosopher John Rawls as relevant as anything that economics can offer.
Rawls argued that decisions about economic justice should be made behind a "veil of ignorance." How would you want the world to look if you were going to be born tomorrow but didn't know the economic station into which you would be born?
If you were going to be born somewhere in America tomorrow -- in the projects of Chicago or perhaps into one of those families that brought home $50 million this bonus season -- what would you want the economic landscape to look like today?
Would you want a distribution of income that looked more like Sweden's, or Brazil's? It's worth thinking about.
By Jessica Holzer
Despite having a hardscrabble farmer and an avowed socialist in their ranks, the incoming class of senators does little to shake the Senate's image as a millionaires' club.
Bob Corker, senator-elect from Tennessee, boasts an estimated $64 million to $236 million fortune, according to the financial disclosure he filed to the Senate. Claire McCaskill, the senator-to-be from Missouri, has a portfolio worth roughly $13 million to $29 million.
And Sheldon Whitehouse, who ousted the fifth-richest member of the Senate, Lincoln Chaffee of Rhode Island, is hardly hurting for cash himself: He has $4 million to $14 million parked in various trusts and funds.
All told, at least half of the ten men and women joining the Senate next year are millionaires, with Corker and McCaskill shoo-ins to number among the ten richest senators. That rarefied club includes Sen. John Kerry, D-Mass., who Roll Call newspaper ranks as the richest senator, with an estimated net worth of $750 million. Sen. Herb Kohl, D-Wisc., comes in second, with an estimated fortune of $243.15 million.
The wealth of the incoming class will hardly raise eyebrows in the Senate, where about half of the current 100 members are also millionaires and the average net worth is $8.9 million, according to an analysis by the Center for Responsive Politics in Washington. By contrast, less than 1% of the U.S. population has a net worth of $1 million or more.
In 2006, senators were paid an annual salary of $165,200.
Though the affluence of today's Senate might seem staggering, it is hardly out of the ordinary for Congress' elite upper chamber.
"Overall, senators have historically been wealthier," says Donald Ritchie, a Senate historian.
The peak of Senate wealth probably came in the late 19th and early 20th centuries, when wealthy businessmen like George Hearst, the father of newspaperman William Randolph Hearst, and Simon Guggenheim were members.
Though millionaires are far more common today thanks to inflation, lots of members in the 19th century Senate would have been multimillionaires in today's dollars, insists Ritchie. Back in 1900, $100,000 was roughly equivalent to $1 million today.
So glaring was the affluence of the turn-of-the century Senate that it prompted a series of muckraking articles in 1906 called the "The Treason of the Senate." That led to the 17th Amendment, which instituted the direct election of senators in 1913. Previously, they were chosen by state legislatures.
It is difficult to pinpoint a senator's precise worth because they are required to disclose only the ranges of dollar values into which their assets fall, rather than an exact figure. Therefore, it's unclear for example whether Amy Klobuchar, Minnesota's senator-elect, is a millionaire: She reported assets of $325,000 and $1.4 million.
There seems to be a presumption that more equality equates with lower growth. For example, while discussing policies Democrats might pursue to reduce inequality, David Wessel asks today in the Wall Street Journal:
What can Democrats do to resist inequality in a way that doesn't choke off economic growth? Can government slice the economic apple more evenly without shrinking it?
And later adds:
Republicans as prominent as Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke recently have warned ... of risks posed by widening inequality. But many conservatives fear taxing the rich in response would reduce incentives for innovation, entrepreneurship and education -- and thus reduce economic growth to the detriment of all. Their counsel: Try to lift incomes of the poor and middle class, and don't worry if the rich do even better.
That is, growth must not be reduced even if it means we must accept widening inequality. However, it hasn't been established that more equality is harmful to economic growth, so I don't accept the presumption that lower economic growth is a necessary consequence of higher equality (and even if it were the case that efficiency and growth are reduced, there may be equity considerations that justify promoting more equality, i.e. the standard efficiency-equity tradeoff and related arguments).
Richard Freeman and Alexander Gelber recently looked into the question of how effort varies with inequality:
Optimal Inequality/Optimal Incentives: Evidence from a Tournament, by Richard B. Freeman and Alexander M. Gelber, NBER WP 12588, October 2006 [open link]: Abstract This paper examines performance in a tournament setting with different levels of inequality in rewards... We find that that total tournament output depends on inequality according to an inverse U shaped function: We reward subjects based on the number of mazes they can solve, and the number of solved mazes is lowest when payments are independent of the participants' performance; rises to a maximum at a medium level of inequality; then falls at the highest level of inequality. ...
Thus, it is not at all clear that moving from high to moderate levels of inequality reduces economic incentives and economic growth.
The Ubiquitous Leveraged Buyout (LBO): Management Buyout or Management Sellout?
My objective in this article is to discuss certain elements of the leveraged buyout (LBO), sometimes referred to as taking a corporation private. In this practice, the company's management and other private investors buy out (hence "buyout") all the other shareholders, almost entirely with borrowed funds (hence "leveraged").
I am mindful, however, of the sage journalistic advice that suggests that the writer should capture the interest of the readers very early on by establishing the essentiality of the topic, its impact, or, at the very least, sharing provocative examples that highlight its salience. In no particular order, try these:
Related Results: bribing management in taking private
A recent special report by Fortune (1989) educates us with regard to "How Ross Johnson Blew the Buyout." F. Ross Johnson, of course, was the CEO of RJR Nabisco who put his company into play by proposing to take it private via the leveraged buyout. Among other things, it has been suggested that his bid (initially $75 per share, ultimately $109 by Kohlberg, Kravis, and Roberts [KKR]) was preposterously low. The compensation package for Johnson and a few (very few) managerial colleagues was judged by most observers to be outrageously high. Beyond that, certain of Johnson's strategies (for lack of a better word) led to a fair amount of enmity between himself and the special committee of outside directors enchartered to decide the final fate and ultimate ownership of RJR.
There is apparently some substance to these reports. At a minimum, there is an unusual amount of consistency among many observers that the RJR leveraged buyout did illustrate some excesses that can be associated with such a play. Perhaps, but permit me a quibble.
If we rely on these reports in their entirety, we might be led to believe that F. Ross Johnson lost. He lost his job, presumably one of great status and reward, as the CEO of a Fortune 500 company. He lost to KKR, for it is KKR who now own and operate RJR. He may have lost some reputation. The word "greed" crops up repeatedly in some descriptions of this LBO. Beyond that, his professional competence has been questioned. It has been alleged, for example, that he was totally outmaneuvered by KKR. Taken in the aggregate, a grim picture and humiliating loss.
Maybe. Maybe not. We may want to consider one other factor before we decide whether or not Mr. Johnson "lost." It turns out that Mr. Johnson set another record of sorts with his departure from RJR--the largest golden parachute in history. A recent Business Week (1989) reports that F. Ross Johnson, former CEO of RJR, walked away from this embarrassing loss with "separation pay" of more than $53 million.
I will be among the very first to concede that wealth, as well as winning or losing, is in the proverbial eye of the beholder. I must say, however, that I find it difficult to brand anyone a "loser" who after the fray walks away with $53.8 million. That really does sound like a safe landing. Mr. Johnson deliberately put the company in play; nearly all observers feel that he lost. Even so, it has to be reported that the consolation prize in this tournament is most impressive.
Rand V. Araskog, Chairperson of ITT Corporation, has recently written a book, The ITT Wars: A CEO Speaks Out on Takeovers. Araskog reports that in 1983, Jay Pritzker and Philip Anschutz were interested in gaining control of ITT through a leveraged buyout. The actual financial details are of little consequence here. Suffice it to say that the "deal" would have involved several transactions. Among other things, ITT's senior management would be given a 10 percent stake in the new company. This stake would have garnered Araskog some $30 million or so. Araskog explains in this book that he perceived this $30 million windfall to be little more than a gargantuan bribe.
Just A Family Affair
Richard P. Simmons took a specialty steel unit of what is now Allegheny International private in 1980. To his credit, this company has done very well. Two years ago, this same company was once again taken public. Stock was sold and has also done well.
CEO Simmons requested that the board of directors approve an investment of corporate money into a LBO fund. There is nothing manifestly wrong with that. LBO funds are designed to allow companies (like KKR) to raise money to take companies private. Obviously, one invests in such a fund in the hope that these ventures will be profitable and provide an attractive return on the investment. Mr. Simmons evidently believed that corporate funds invested in such a vehicle was a prudent use of these assets.
So far, so good. This LBO fund has three general partners. The problem is that one of these three partners is Brian Simmons, the son of Richard P. Simmons, CEO of Allegheny Ludlum.
THE LBO AND ETHICS
That there may be some potential for ethical issues to arise in LBO transactions will come as no surprise to anyone. Certainly, I do not presume to suggest that the prior examples are representative of all LBO transactions. Indeed, I fervently hope that only a modest few would have the character of those cited. Still, since 1981 (the LBO was relatively infrequent prior to that) more than 1,550 public companies have gone private, nearly as many as are listed on the New York Stock Exchange. I will argue that there are a number of factors common to every one of these LBO transactions that are most troubling. In fact, they raise the issue of whether current management of any publicly traded company should be party to an LBO. These issues include, but are not limited to:
- An Obvious Conflict of Interest
- What is the Incentive for an LBO?
- The Ultimate in Inside Information
- The Quality of Privileged Information
- Full Disclosure
- Life After the LBO
- The Final Irony: Going Public Again
An Obvious Conflict of Interest
The CEO of a publicly traded corporation has a fiduciary responsibility to shareholders. This responsibility is rather simply described: It requires that the interests of the stockholder be considered prior to, ahead of, and superior to the self-interest of the manager at all times and in all circumstances. Clearly, that sets an omnibus and challenging standard.
Obviously, it is in the interest of the shareholders to have the value of their common stock at as high a level as possible. This is particularly evident when the stockholder may have some immediate interest in selling the stock. Just as obviously, it is in the interests of the potential buyer of the stock to have the price set somewhat lower. Most of us would be inclined to purchase stock when we believe that the stock is undervalued, when we think we are getting a "good buy." The value of this stock is going to increase. Accordingly, we'll buy some of it at its currently undervalued price.
More specifically for these purposes, CEOs as managers should seek to place as high a value as possible on the common stock of the corporation. CEOs, as rational individuals, who are acting in their capacity as principals in an LBO, can have no such incentive. On the contrary, it is in their obvious interests to have the common stock valued somewhat lower.
What Is The Incentive For An LBO?
Why would any manager be interested in being involved in a LBO? Maybe, in one of the great understatements in recent memory, they believe there may be a few dollars in it. Maybe, more benignly, they believe that the company could be run a bit more efficiently. Suppose that an officer (or group of officers) of the corporation believes that certain assets could be redeployed, divisions divested, products launched, and so forth. Is there not a mature argument that these individuals are legally, as well as ethically, bound to identify and execute these strategies for the benefit of the stockholders?
It would seem that there are any number of dynamics that underscore such concerns. One, when is the last time that the board of directors accepted the first offer and conditions when a management group proposed a buyout? On the contrary, it is commonplace that the board finds the first offer to be insufficient (the RJR event is a classic case, among hundreds of others). In other words, the management group typically provides a low-ball offer, much the same that you might do when making an offer on a new home. The obvious difference in that you do not have a fiduciary responsibility to the seller of the home.
It is also considered to be textbook procedure for the board of directors to immediately market the corporation to all suitors when faced with a LBO offer. The object of this is to invite "competition," to be certain that a "fair" price is put on the assets and so forth. What do you suppose this exercise is all about? Is it possible that there are some folks who are not altogether confident that the current management would act in the absolute best interests of their constituency short of these strategies?
Moreover, it is considered de rigueur to appoint a group of outside directors (because they are purportedly independent, a questionable assumption) to review and make the final recommendation concerning the management proposal. Why do we do this? Do we do it because we can count on the LBO group to provide us with a "fair" price from the onset?
Also, it is typical to solicit the opinion of investment banks to determine the "fair market" price of such a transaction. Once again, why is this necessary? Do we not trust the very managers who serve as fiduciaries of the shareholders? There must be some doubt in someone's mind.
We can all agree that some notion of the "fair price" of the company should be set. What is less clear is that the management involved in the bid should set it. Moreover, it is not as though this number can be independently and easily arrived at to the satisfaction of all observers. On the contrary, in one bidding war for Stokely Van Camp, three different investment advisors provided an opinion, sometimes referred to as a fairness letter, to three prospective buyers, all at different values ranging from a low of $50 to a high of $75 per share. If it is true that this "true value" is apparently subject to some debate, many would be quite disturbed if individuals with rather substantial self-interests are serious parties to establishing the price.
The Ultimate in Inside Information
The most cursory examination of the leading business and financial periodicals over the past several years would suggest some near crisis regarding inside information. Fundamentally, it is a violation of federal securities law for insiders (for example, company officers, members of the board) to profit from any transaction inspired by certain knowledge not available to stockholders generally. Suppose, for example, that a CEO knew that on Tuesday he would report the lowest dividend in the company's history. When this information is public, it would probably result in at least a short-term reduction in the value of the company's common stock. This CEO could not, then, legally sell shares in his company short on Monday. In short selling, of course, you hope that the price of the stock will fall.
The CEO has made a good bet, too good. He is almost certain that the price will fall. The problem is he knows that because he is privy to information not generally available to others. Under SEC rule 10b-5, he cannot act in this manner: It is patently illegal. If prosecuted, he would at a minimum forfeit any and all profits derived as a function of this transaction. Beyond that, he would be subject to criminal penalties as well.
If trading on inside information for a few thousand shares (one share, for that matter) is in violation of federal securities law, then how can the LBO be conducted in anything resembling good faith? Who on the planet has more pertinent information about the strengths, weaknesses, threats, and opportunities facing an organization that its management?
More directly, if it is illegal to profit on the basis of "inside" information with just a few shares of the company's stock, how can we profit on the basis of the ultimate stock purchase, the company in its entirety? Frankly, I find it incredible that the standing management of a company does not have access to information available neither to its stockholders nor, most certainly, to the public at large.
The Quality of Privileged
One of the chief arguments often used in defense of the LBO is that there is no monopoly of the right to offer to buy. It is true that management-led groups, or groups with substantive management interests, can propose an LBO. It is also argued that excesses in this area are unlikely. Suppose, for example, that the management-involved group makes an offer below a reasonable estimate of the market value for a company. It is only reasonable to expect that some other suitor would enter the bidding, provide a more responsible bid and carry the day. In fact, it has been suggested:
Once anyone initiates an LBO, the directors should put the company up for auction. And they should make sure that all serious bidders have access to all the information needed to make an offer (Business Week December 1988, p. 30).
It seems that there are two pertinent issues here. One concerns whether it is indeed possible for any other bidder to have the quality of information available to it that is enjoyed by the management-involved team. Once again, who could possibly have the wealth of information available to the current management team? It is hard to contemplate a scenario wherein the management team would not have a substantive edge with regard to the quality of information.
Beyond that, however, we may face an interesting catch-22. As the prior quote indicates, it is sensible to put the company to auction (presumably to encourage some competition and a check on the reasonableness of the management offer) and provide access to all the information needed to make the offer (possibly to reduce the management information edge.) Surely, much of the information that would be "needed to make an [informed?] offer" would be proprietary. Before suitors could make an informed bid, wouldn't they need information regarding state of development of new products, pending lawsuits and settlements, illness of key executives, and so forth? After all, the current executives are privy to this information.
It is not immediately clear that the interests of the stockholders are met by divulging this information to "outsiders" irrespective of the LBO. Would such information be considered "inside information" by SEC standards? Would the bidding companies, then, be constrained from relying on this information for purposes of profit? I think that there is an excellent argument that such companies would be so constrained. If, however, it would be illegal for such a company to profit by such information, how could we allow the current officers of the corporation to profit by the same information?
Management-involved groups cannot take a publicly traded company private at their own initiative. Among other things, they will need the "permission" of the shareholders. Naturally, this is accomplished through the proxy process. Benjamin Stein, a lawyer and economist, has raised a fascinating question regarding this issue. Essentially, the proxy material to a stockholder must include full disclosure of any material fact involving the action. In theory, the stockholder reads the proxy material, becomes acquainted with the major aspects of it, and votes either to approve the LBO or otherwise. The Supreme Court has ruled that there must be such full disclosure of any fact "if there is a substantial likelihood that a reasonable stockholder would consider it important in deciding how to vote."
This leads Mr. Stein to a persuasive point:
But insiders never disclose the crucial fact that they plan to make vastly more from the corporate assets than they pay the stockholders for them. I am a stockholder in a few companies in a small way, and I hope I am reasonable. I consider it extremely important if management plans to make $50 from something it paid me $1 for, and it would assuredly make a difference in how I voted (Stein 1985, p. 170).
Why would CEOs and other highranking officers of prestigious firms risk their security and their reputations if the opportunity for reward was not correspondingly great? Do you think that such information should be disclosed to the stockholders to better inform their vote?
Let's assume that by whatever means the LBO has been approved. What now? The period after the LBO raises even more troubling issues.
Life After the LBO
Not all LBOs are successful, as Revco and Freuhauf could attest. Even so, it has recently been recently reported that the profit margins for LBO companies were 40 percent higher than their industries' median two years after the buyout. It would seem reasonable, then, to conclude that many of these LBOs do very well. As might be expected, there has been some speculation about why this might be the case.
Consider this. Tadd Seitz ran a profitable division of ITT. This company was divested in an LBO by ITT in 1986. Mr. Seitz continued to run the new company. According to some, when under the control of ITT, is overhead was too high, inventories too large, and management a bit relaxed with respect to wooing new clientele. These, and other "problems" were addressed and the company has prospered. That, however, is not the issue. The better question is why wait until the company was private to make these rather elementary moves. Why were these strategies not employed for the benefit of the initial shareholders?
This is by no means an uncommon scenario. Time after time LBO companies divest poorly performing subunits, drastically reduce administrative overhead, pare the workforce, renegotiate contracts, and moderate executive perquisites (for example, executive jets, first class accommodations), among a host of other initiatives. E. E. Bergsman of McKinsey & Co. adds some interesting perspective to this: "These LBOs are so immensely successful because they are better managed" (Business Week June 1988).
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