Wednesday, June 13, 2012

How Businesses Fix a Broken Economy

By the end of the 1960's, the U.S. economy was beginning to experience difficulties. By the early 1970's, there was serious problem. Cengage's history textbook describes it:

Lyndon Johnson, determined to stave off defeat in Indochina without cutting Great Society programs or raising taxes, had concealed the true costs of the war, even from his own economic advisers. Nixon inherited a deteriorating (although still favorable) balance of trade and rising rate of inflation. Between 1960 and 1965, consumer prices grew an average of only about 1 percent per year; by 1968, this figure exceeded 4 percent.

The problems had more than one cause. First, total government spending had increased annually. Second, entitlement spending and social welfare spending had increased both absolutely and as a percentage of the increasing federal budget (Great Society programs). Third, although LBJ had worked to avoid major tax increases (minor revenue increases did sneak in), there had been no significant tax cut since 1964. Finally, there was a private sector cause as well: the failure of some industries to implement the full efficiency of technology.

Although most of the damage to the economy came from the government, the private sector causes warranted attention as well, because they were perhaps more quickly and easily fixable. As technology had entered into various sectors, decreasing the need to for labor, industries had failed to respond with tighter staffing. Thus, as David Brooks writes about the situation in 1972:

Forty years ago, corporate America was bloated, sluggish and losing ground to competitors in Japan and beyond. But then something astonishing happened. Financiers, private equity firms and bare-knuckled corporate executives initiated a series of reforms and transformations.

While the economic history of the 1970's is alternately dominated by damage done by the federal government and attempts by the federal government to correct its mistakes, the non-governmental side gets less attention in history books. Cengage tells us that, on the government side, harm was done when

domestic programs favored by most congressional Democrats contributed to this economic distress. Increasing the minimum wage and vigorously enforcing safety and antipollution regulations

stifled economic growth, raised prices to consumers, sapped resources out of business, and discouraged any creativity in the private sector. Eventually, even Democrat President Jimmy Carter

cut spending for some social programs, sought to reduce capital-gains taxes to encourage investment, and began deregulating various industries, beginning with the financial and transportation sectors.

In these actions, Carter agreed substantially with his predecessor President Ford, and with his successor President Reagan. Tax cuts, spending cuts, and deregulation were the common-sense measures to help the economy. To this would be added a reduction in debt and deficit as concern grew about fiscal responsibility.

Thus far the standard economic history. What has not always been made so clear, however, is the role played by business in finally getting American out of the economic doldrums. The time had arrived to fully implement the cost-saving aspects of technology, as David Brooks explains:

The process was brutal and involved streamlining and layoffs. But, at the end of it, American businesses emerged leaner, quicker and more efficient.

Business could either turn themselves around, or in some cases be taken over by new ownership and management which would help them become efficient:

Over the past several decades, these firms have scoured America looking for underperforming companies. Then they acquire them and try to force them to get better.

Economic principles often make use of inequalities, and of the changes produced when inequalities are brought toward equilibrium levels:

in any industry there is an astonishing difference in the productivity levels of leading companies and the lagging companies.

One cure is to give the management of a lagging company an incentive to work toward better productivity. New owners can

acquire bad companies and often replace management, compel executives to own more stock in their own company and reform company operations.

This was the key to turning around certain sectors and getting them out of the rut of the 1970's. Even if the government does its part - cutting taxes, spending, regulations, debts, and deficits - the private sector must also do its part, maximizing efficiency and productivity. Individuals and companies which specialize in "turning around" unprofitable businesses are often the catalyst to improving productivity.

Most of the time they succeed. Research from around the world clearly confirms that companies that have been acquired by private equity firms are more productive than comparable firms.

Sometimes this process is painful. Companies which have supported offices long after technology has made them superfluous - imagine keeping a typewriter repairman on the payroll - must face the reality that they cannot afford to pay for unneeded services.

This process involves a great deal of churn and creative destruction. It does not, on net, lead to fewer jobs. A giant study by economists from the University of Chicago, Harvard, the University of Maryland and the Census Bureau found that when private equity firms acquire a company, jobs are lost in old operations. Jobs are created in new, promising operations. The overall effect on employment is modest.

Turnaround specialists often form what are called 'private equity firms' - companies formed by groups of investors who hope to make money by improving the efficiency of lagging companies. Once productivity - and thereby profitability - have been improved, these companies can be sold by the private equity firm to other investors.

Nor is it true that private equity firms generally pile up companies with debt, loot them and then send them to the graveyard. This does happen occasionally (the tax code encourages debt), but banks would not be lending money to private equity-owned companies, decade after decade, if those companies weren't generally prosperous and creditworthy.

The majority of companies bought by turnaround specialists are able to reenter the marketplace in a profitable and competitive condition. Any private equity firm which did not succeed in reviving lagging companies would soon cease to be funded. Turnaround specialists and private equity firms are sometimes mocked in the popular press as "vultures" because instilling efficiency requires self-discipline and hard work. Lagging companies often employ underutilized or excess numbers of workers, who simply don't have enough to keep them busy.

Private equity firms are not lovable, but they forced a renaissance that revived American capitalism.

When large sectors of the economy were headed for destruction in the 1970's, it was - in part - the turnaround specialists who saved them. The process was sometimes painful, but the alternative was the annihilation of selected industry groups, a blow from which the country could not have recovered.