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Golden Parachutes, Explained

In Economy, Politics on December 18, 2008 at 1:58 am

It sounds outrageous, that some companies end up filing for bankruptcy restructuring, or even vanishing entirely, while their presidents and CEOs leave the companies with bonus severance packages of millions of dollars, a “golden parachute“.

It seems unfair to the workers, who are out of jobs, the investors and stock holders, and everyone else who gets nothing.

Why should an executive, who obviously failed everyone, whose very competence as a manager is in question, get enough money to retire on, while everyone else has to struggle a disastrous end to the venture?

It sounds terrible, that executives get huge bonuses when a company goes under, but this clause actually saves many companies in the first place.

It sounds terrible, that executives get huge bonuses when a company goes under, but this clause actually saves many companies in the first place.

 

 

Why on earth do companies offer them, in the first place? Especially the ones that are already struggling…shouldn’t they refuse to offer a big severance package when they’re likely to go under, anyway?

Well, in fact, the struggling companies don’t want to offer those packages.

What happens is that the company does know it’s struggling, and so it is looking for the best CEO it can find, someone who can save it when its last managers obviously were just making things worse. But when they call the best guy available, they run into two problems:

  • First, they can’t afford him, because they’re struggling. The money for his high salary could bankrupt them.
  • Second, he doesn’t want to risk his reputation. If the company turns out to be too far gone, he will definitely get blamed, even if he did all that was possible.

Fortunately, they can  solve both of these in one :

They can offer a lower salary now…what they and the executive agree they can afford, plus a huge severance package.

If the company is saved, then he’s earned it.

If the company goes under despite his great skill, then he gets compensated for his damaged reputation, and the pay cut he took during the time he worked there.

This means that a struggling company can hire a better executive, therefore increasing the company’s chances of surviving, if it offers a golden parachute. 

So it’s actually better for the workers, shareholders, investors, and customers if a company does offer a golden parachute. Not just struggling companies, either…because it can always improve the executive a company can hire, therefore improving the company’s future.

Now there are other, obvious benefits to having golden parachutes.

Golden parachutes also help protect companies from hostile takeovers, because the executives of the taken-over company, inevitably all fired, will cost millions to the devouring company. 

Really, any way you look at it, companies being able to offer golden parachutes is good for all involved. Including the regular employees.

Why Deflation is Bad…for You, Private Property, and Capitalism

In Economy on December 16, 2008 at 5:02 pm

Politicians and journalists are worried, right now, about a downward spiral of deflation, of the type that normally comes in an economic depression.

They are pointing to two signs we are having bad deflation…first, the falling price of commodities like oil, and the disappearance of money in this economic failure causing demand to plunge. One of those is actually good, the other is very bad.

When prices go down naturally, because of an increase in efficiency or improvement in technology, it is good for everyone. 

For example:

  • Improved efficiency makes the manufacture of computers cheaper, while more advanced computers make the old versions cost less.
  • Food used to take up most of humanity’s effort, therefore most of  a family’s cost of living, but has declined to third or fourth place as technology and efficiency allowed us to grow more with less.

The decline in oil prices, returning to only double their normal level, will cause a good kind of global price decline, because most prices are effected by the cost of the energy required to create and deliver products and services.

But, again, those specific cost reductions are not deflation.

What Are Real Deflation and Inflation?

When money deflates, people choose to just hold onto it, starving the marketplace and causing a spiral of ever more deflation

When money deflates, people choose to just hold onto it, starving the marketplace and causing a spiral of ever more deflation

In real economic terms, inflation and deflation happen when the ratio of money to economic wealth changes. If the amount of money becomes greater, in comparison to the economy, then you get inflation. Because the most common result of this is for prices to increase, we confuse the terms and call general price increases “inflation”, but actually it’s the change in ratio that is inflation.

The eleven trillion-plus dollars of capital that have purportedly vanished in the past few months represent a huge decline in money supply, causing actual deflation. This failure was caused by the inability of central authority to manage money any better in the US than it could provide shoes and food in the Soviet Union.

Prices Can Increase Without Inflation, Too

Prices can actually increase for other reasons, and that’s not really inflation. For example, when oil increased 600% in price, it drove up the cost of production, without regard for the number of dollars in the economy. This general price increase was NOT inflation.

And when prices decrease for other reasons, it’s not deflation.

Inflation is Harmful

We all know that when the ratio of money to wealth increases, causing inflation, it is bad for the economy, and especially for the poor and middle classes. This is because it usually drives up prices, and the poorer you are, the more of your wealth and well-being is in cash.

Poorer people depend on cash they have in a bank, or other savings. They are paid by employers who give them only a set rate, plus raises for special reasons like increased skill.

Wealthier people tend to have more of their wealth in assets like, stocks and real estate, that will simply increase in price, sheltering them from some of the effect if inflation. They get cost of living increases in salary every year, on top of any other raises.

Deflation is Harmful, too

But the opposite kind of damage occurs if you have deflation, and is compounded by a new problem.

First, deflation artificially drives down prices. To a person with no real assets or investments, this sounds good, because “stuff costs less”.

But it comes at a horrible price.

Deflation punishes investments that can raise people from poverty, both personal investments, and business growth

Deflation punishes investments that can raise people from poverty, both personal investments, and business growth

For example, the decline in prices includes wages. Deflation is universal, with a shortage of money everywhere, so that your income will decline, along with the price you pay for things. What good is cheaper stuff, if you also have less money?

So people with fewer assets and no investments will more or less end up breaking even. But they still lose out in the end, because they become blocked from gaining assets, trapping them in relative poverty.

For example:
 

How Deflation Traps the Poor and Middle Class

Imagine you’re buying a house. Not on a sub-prime loan, but one where your income is perfectly fit for the home you’re getting.

It’s probably a thirty year loan. So you’re going to be stuck paying on the original price of your house, for thirty years, at the original size of house payment.

Now remember that your income (in dollars) is getting smaller every year. That’s deflation.

And the price of your house, too. Each year, its is worth fewer dollars, yet your original debt is the same. And so are your payments.

Within just a few years, you are making far less money, but are stuck with the same size house payment you always had.

While you still have to pay the same percentage of of your paycheck income for food, electricity, and so on, your house payment takes up a higher percentage of that money every year.

Soon, your income has shrunken to the point where you cannot make your house payment at all. Not even if you paid your whole check to the bank every week.

And worse, you can’t simply sell his house to get out of it. The price of your house has also declined every year. Selling it now that the payment is too high won’t even pay off your remaining house debt.

Of course people would quickly learn this, and that they simply cannot buy houses, unless they are so incredibly wealthy that they can save up enough to pay cash. 

But even those wealthy people who can pay cash for a house now face the situation where buying a house is a horrible investment, because the house’s value will decline, in dollars.

It would actually be better to leave the money in a vault, and rent monthly, even for a billionaire, because the money’s value increases, while the house’s price declines. One thousand dollars will be worth more next year, if you simply stick it in your mattress, than one thousand dollars worth of house will be worth in that same year.

In fact, owning land becomes a losing proposition. With even the wealthy better-off renting, who’s going to actually be the landlord?

Deflation Attacks Economic Freedom

In fact, ALL property ownership becomes punished!

With deflation, anything you buy does not just depreciate with use and age, but declines in value every year with prices, compared to if you’d simply kept the money.

Today, you could buy that console game, or car, or collectible, and then sell it on eBay a few years from now and recoup part of the cost. But with deflation, the price you recoup is even farther from if you’d kept the cash in the first place.

Deflation Destroys Capitalism

Deflation punishes investment and property ownership, attacking capitalism at its roots

Deflation punishes investment and property ownership, attacking capitalism at its roots

In fact (and this is where the entire economy implodes from deflation), simply holding on to your money is rewarded versus ANY investment, in a deflationary economy. If you put your money in a big ol’ vault, removing it from the economy entirely, it grows in value every year. But if, instead, you buy stocks, or invest in commodities, then your money is gone, replaced with an asset that becomes worth less every year, in dollar terms.

The growth of every business, in fact, would be undone by the rate of deflation. Now from the company’s standpoint, that is fine, because its expenses decline every year by the same amount.

But from an investor’s standpoint, a company growing at 2% per year during 3% deflation would mean you lose 1% over just stuffing your money in a safe. And yet you also risk, when investing money.

Why bother investing even in a company you think might grow at 5%, when you could have a 100% safe 3% investment in a vault under your mattress? So, really, the company facing deflation is NOT fine, because it discovers that it’s far harder to get investors. In fact, the entrepreneur who would have started that company is 3% punished each year for the effort, making him that much less likely to even bother.

With investors discouraged because of deflation, it becomes harder to create wealth. Capitalism, in fact, becomes almost impossible:

  • An entrepreneur can’t get investors for his new project.
  • There’s less reason to buy stocks, so companies can’t raise capital.
  • You can’t get a loan to start a business, because your company’s income would decline every year, yet the loan payment would stay as large as ever.

With deflation, the very engines of capitalism all die out.

Speculation Defines Capitalism

It is the uncertain investment on the wild new idea that makes capitalism superior to central planning. Anyone can decide to invest in a “sure thing”: if that were good enough, socialism would work, because a government bureaucrat could declare money for the obvious solution. It’s diverse people choosing to risk money on many different wild ideas that lets the best solutions rise to the top.

But that very kind of capital investment, in a deflationary economy, is punished, because you get such a good deal by not investing in anything at all, but holding your money in a vault.

All of this, by the way, is aside from the additional destruction caused by the lack of downward price elasticity on many commodities and time-based investments. That’s much more arcane, but a key source of economic depression, that I’ll get into some other time.

For now, it’s enough to realize that prices being FORCED downward by deflation includes your pay, and the value of any investments you make, so that private property ownership, borrowing, and investing, in fact all capitalism, is crippled under deflation.

Not a Recession: A Depression

In Economy, Politics on December 5, 2008 at 9:09 pm

 Why does this economic downturn seem different than previous ones in our lifetime? Why does it seem familiar to anyone who is familiar with the economic history of 19th and early 20th centuries?

Because, up to the mid 1940s, the US tended to face economic depressions. Since then, we had not had one…until now. 

What we are suffering, today, is an economic depression.

Sure, it had been trendy, in the last decade or more, to say “we just stopped using the D word after the Great Depression”. But, once again, anyone who knows economic history realizes there’s more to it than that.

There is no official definition of an economic depression, other than the idea that they’re worse than recessions.

There isn’t really an official definition of an economic recession, either, although the pat answer is “two quarters of GPD shrinkage”. Real economists hate that definition, because it ignores more factors than it considers, to the point of being almost useless.

But we can simply examine what were called “depressions”, from 1800 through 1938, and compare them to the recessions between 1947 and 2007, and the differences are obvious.

 

Depressions, Described

 

Each depression / panic from 1819 through 1938 shared certain traits:

A shortage of money itself, leading to

  • Usually at least 2 years, as many as 23 years
  • Sudden runs on banks, causing bank failures
  • Commodity price collapse, where something generic like cotton, steel, oil, or real estate plunged in value, causing a domino effect that devastated the economy
  • A more general decline in prices across the economy
  • A collapse in capital, for example stock market collapse, once that became an important factor
  • A credit freeze, making loans and other forms of obtaining temporary money more difficult 
  • Massive business closings
  • Astonishing amounts of job loss and unemployment

Now what about the subsequent “recessions”, from 1948 through 2003? 

Recessions, Rescribed

 

Every one of them happened like this:

A dramatic raising of interest rates by the Federal Reserve, followed by

  • Usually only a few months, rarely more than a year
  • An increase in private interest rates
  • An increase in unemployment
  • Moderate to extreme price increases
  • A plunge in the stock market and moderate tightening of capital
  • Some amount of business failure

You can see examples of both recessions and depressions at the History of Economic Downturns.

What’s the Difference?

 

We face, as was normal during the days of the gold standard, massive bank runs, a credit freeze, price failures

We face, as was normal during the days of the gold standard, massive bank runs, a credit freeze, price failures

Now the most obvious difference is timespan. 

During the days of economic depressions, the downturns lasted much longer.  Always years, sometimes decades. Economic recessions generally only last months, rarely more than a year…the longest recession has not lasted as long as the shortest depression.

The second is that the trigger is slightly different.

Depressions were caused by a direct shortage of currency (money) in the economy. This, in fact, led to the other obvious differences, like runs on banks, mostly caused by a shortage of money making people worry about bank stability.

Recessions, on the other hand, have been preceded, in every single case, by the Federal Reserve raising rates, trying to make it harder to get new money. That’s very similar, but it leaves the financial sector able to compensate, however painfully, so that bank runs and commodity price failures never become “necessary”.

And that’s probably the next most important difference:

During the depressions, bank runs were almost universal, commodity price collapse was normal, the loss of huge numbers of jobs and businesses was a constant.

In the era of recessions, none of those things occurred at all. Unemployment, though miserable, was generally only a few percentage points higher, and while some businesses failed, nothing like the tens of thousands of the depression days, even though the economy was smaller back then.

Now, which are we seeing today?

Are We Depressed?

 

Let’s make a list:
  • Runs on banks, and bank failures
  • Real estate price collapse, along with some other commodities, including many metals like gold, copper, and nickel
  • The massive price inflation expected to result from high energy prices failed to materialize, representing an inability of people to pay more, even though production cost had to rise
  • A collapse in capital, for example stock market free-fall
  • A failure in credit, making loans and other forms of obtaining temporary money more difficult 
  • Massive business closings
  • A rising snowball of job loss and unemployment

Well, this does indeed sound almost exactly like a depression, not a recession. 

And, in fact, it was preceded by a money shortage, just like other depressions. In our case, the shortage was caused by high oil prices, two wars, and hundreds of billions in new foreign “aid” shipping trillions of dollars overseas, much faster than the Federal Reserve was creating new money. This meant that, while the surplus of foreign-based dollars caused its value to plunge compared to foreign money, here in the US there was less money available than usual.

Without as much money, we could not maintain the prices of some commodities, we became distrusting of banks, credit became scarce…ultimately, a new economic depression was natural. 

Why didn’t we have depressions from 1948 through 2007?

Up to the 1940s, the US had usually depended upon gold, and sometimes silver, to back its money. It claimed you could cash in a paper dollar, any time you wanted, for gold. This meant that money was, in a sense, just a glorified form of barter for a commodity.

In those days of a gold standard, if the economy grew faster than the supply of gold, this created a shortage of money, which could only grow as fast as people could dig up gold. When the economy grew faster, the relative shortage of money would eventually force banks to close, commodity prices to plunge, prices to decline, credit to freeze, and generally the economy to grind to a halt, to wait for gold to catch up.

That ended in 1946, when the US entered into the Breton Woods agreement. This was a sort of price fixing scheme, where instead of making a dollar equal to a certain amount of gold for exchange, each government just attempted to force the price of gold to remain a certain amount, compared to its money.

This happened to coincide, exactly, to the end of economic depressions. Without money being linked to the barter of a commodity that had its own separate value and supply, it did not end up in such short demand that the whole economy would fail. The recessions that did occur were from money shortages caused by the Federal Reserve, but these could be overcome, so banks never had runs, commodity prices never collapsed, et cetera.

This became even more true in the 1970s, when even the Breton Woods agreement was ended, and the price of gold became a legitimate free market price, not a fixed one.

Why are we having a depression, today?

As I noted earlier, this is the first time since the 1930s when there was a shortage of money so grave that we stopped trusting banks, could not pay for important commodities, and so on.

This is because we sent so much money overseas, out of our own reach.

The normal money we have sent abroad for decades, because we buy goods, was actually barely enough to keep up with foreign demand for dollars…but in 2001, that began to change:

The price of oil went through the roof. At its peak, we were paying 700% of oil’s natural price. This amounted to as much as one trillion dollars leaving the US to import oil, without getting anything in return (beyond what we normally got for 1/7th the amount). 

Meanwhile, we engaged in two wars, that cost hundreds of billions of dollars, much of which went to foreign countries.

And, in order to support those wars, paid hundreds of billions in new “foreign aid”, money shipped abroad with no imported wealth to offset it, at all.

This left us without enough money to simply run our own economy.

The result? Bank closings, real estate and other price failures, massive unemployment, bankrupcies, business failures…

Another economic depression.