Executive Times






2008 Book Reviews


The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity by Robert Kuttner








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Robert Kuttner’s new book, The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity, proposes a restoration of democracy and greater regulation of markets to temper capitalism with government intervention. Kuttner argues that the dominance of politics by big money has disenfranchised ordinary citizens, who have not benefitted from the recent decades of prosperity nearly as much as the very wealthy. He calls for citizens to vote out the moneyed interests and vote in an approach to managed capitalism that spreads wealth throughout America. Here’s an excerpt, from the end of Chapter 4, “Financial Engineering and Systemic Risks,” pp. 126-129:


The latest wave of asset rearrangement is fueled by four realities. First, in the aftermath of the stock market bust of 2000, investors are hungry for the supernormal yields they briefly enjoyed in the bubble of the 99os. Money from quasi-public institutions such as university endowments and pension funds, as well as individual investors, has been pouring into hedge funds and private-equity funds. Second, a climate of low interest rates makes these deals irresistible, especially since the interest is tax-deductible. Regulatory laxity is a third factor, and the use of hedge funds or private-equity firms evades even the minimal regula­tion required of normal mergers and acquisitions. Finally, these deals are relentlessly promoted by other middlemen—commercial banks and investment bankers, which make money off the fees.

This trend invites several big questions. How could financial markets be so inefficient that insiders could find literally billions of spare dollars to exploit in a single deal, by cashing in the difference between the price that the stock market places on a company and their own valuation of the underlying assets? This practice, known as risk arbitrage, has been around for decades—Robert Rubin made his money as a "risk arb"—but it has never been so central to financial markets.

And is the stock market really so undervalued? In the 1970s and 1980s, when the movement to deregulate financial markets gathered force, we heard a lot about a core postulate of conservative Chicago School economics: the Efficient Market Hypothesis. Supposedly, mar­kets were efficient by definition. Whatever the market deemed to be the price of a stock was its true value. Therefore, regulators should leave markets alone. Today, the same Chicago School economists, who once touted the efficiency of stock market pricing, are apologists for private-equity deals that supposedly take advantage of the same stock market's inefficiency—its apparent failure to price shares accurately. But both claims can't be true. Either way, the markets are not as efficient as they're cracked up to be.

And what about the stock market itself ? In principle, stock markets exist to connect entrepreneurs with investors. There is a legitimate mid­dleman function in underwriting new securities: taking the risk of evalu­ating an entrepreneur, floating a new issue of stock, pricing it, and selling it to the investing public. Investment bankers can make fortunes performing that role. But what is so seriously the matter with the stock market that a whole new layer of essentially parasitic middlemen is nec­essary to carry out the ordinary functions of capital markets?

It would make more sense to expose the stock market to greater pub­lic scrutiny and increase its efficiency directly—and to get rid of the incentives that allow windfall gains to the new middlemen. Some private-equity firms do add value, especially when they supply equity capital and when they hold stock and improve the management of a firm for the medium or long term. But public policy needs to change the current incentives that reward the short-term acquisition of sound corporations and allow middlemen to strip them of assets. Specifically, the interest on the borrowed money that underwrites leveraged buyouts should not be tax-deductible. Deal makers who take entire companies private only to take them public again in a short period of time should be subject to a windfall profits tax. New owners of a firm acquired mostly with bor­rowed money should be prohibited from voting themselves extraordi­nary dividends. There should be limits on the transactions fees paid to middlemen. And, in the case of a company with assets over a set amount, say $50 million, exactly the same public disclosures should be required, whether the owners are the general shareholding public or private-equity firms and hedge funds.

You can bet that this proposal, like the reining in of hedge funds, is nowhere on the public regulatory agenda. But that is just a mark of the degree to which regulatory policy has been captured by Wall Street.

Wouldn't such a proposal gum up the efficiency of markets? On the contrary, it would take a lot of the profit out of deals aimed mainly at the enrichment of middlemen. It would put pressure on companies to improve their performance organically. It is bizarre to use the highly leveraged sale and resale of entire companies as the preferred way of holding their managers accountable. Taking some of the profit out of these superheated buyouts would also redirect more investment capital and entrepreneurial, zeal to the creation of real wealth rather than the manipulation and rearrangement of paper.

Defenders of private equity make three arguments. First, they con­tend, there are many badly managed companies. By grasping the poten­tial for changes in how an enterprise is run, private-equity owners can pay above-market prices, unlock hidden value, reap just rewards, and improve the efficiency of the economy. Back when private equity was a small niche, this picture described at least some private-equity owners; and there are still some private-equity firms that buy and hold for the long term. But today the norm is becoming a strategy of stripping assets for quick return. The new wave of private-equity funds do not get involved in the details of running firms. They are the antithesis of care­ful management.

A second oft-heard argument is that private-equity purchasers of companies "must have" some special proprietary knowledge or skill; otherwise, they would not pay above-market prices. And to compel additional disclosures would destroy their ability to bring new economic efficiencies to the company, and by extension to the economy. But today's private-equity players increasingly are using a generic cookbook: borrow a lot of money, take the company private, pull out windfall dividends, and sell off the remaining assets. There are few genuine management secrets worth protecting.

This brings us to the trump card in the defense. Obviously, say apol­ogists for private equity, the whole process would not work if private-equity owners could not find buyers. And if buyers are willing to pay more than the private-equity owners' own previous purchase price, then by definition private equity "must have" added value. But take a closer look. If the whole deal is financed with tax-deductible borrowed money, and private-equity owners make windfall gains by paying themselves exorbitant special dividends, then a private-equity firm can actually sell the company, or its pieces, for less than its own acquisition price and still come out way ahead.

In a rising stock market, with low interest rates, private-equity owners can make exorbitant short-term gains by putting up a small amount of equity and borrowing the rest. Their windfall is the difference between the return on total capital, which need only be normal, and the return on equity—even if they bring no additional management expertise. But in a down market, or a period of rising interest costs, the magic of leverage goes into reverse. So private-equity fever brings risks both to sound enterprises and to the economy as a whole.

There have been times in American history when regulators have stepped in precisely to throw a little "sand in the gears" of financial spec­ulation, as the Nobel laureate in economics James Tobin famously put it. Tobin was no wild-eyed radical. He was a member of the Council of Economic Advisers under President Kennedy. Tobin made his sand-in-­the-gears comment in the course of proposing a special tax on short-term financial transactions, aimed at discouraging so much speculative activity. The Tobin Tax was never enacted, but it won the support of other mainstream economists such as Lawrence Summers, the former Treasury secretary and before that the chief economist of the Inter­national Monetary Fund. The whole series of post-1929 reforms was aimed at making either illegal or unprofitable entire categories of specu­lative financial transactions. All of these, from stock pools to evasions of margin requirements to insider trading, have been reborn in the finan­cial engineering of the current era.

The addition of a new layer of middlemen and the dysfunctional operation of corporate governance and capital markets are two sides of the same coin. If corporate executives were more effectively accountable to boards of directors and directors more accountable to shareholders, the system would not need private-equity firms and hedge funds to claim that they were rendering managers more responsible and markets more efficient by buying and selling entire companies with tax-deductible bor­rowed money.

Unfortunately, serious reforms of financial markets are nowhere on the horizon. Instead, in the deregulated climate, new abuses and risks continue to proliferate.


The mood in the citizenry might just be ripe for considering many of the ideas on the pages of The Squandering of America. We may not like adult supervision, but recognize that in some sectors, it’s required.


Steve Hopkins, February 21, 2008



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The recommendation rating for this book appeared

 in the March 2008 issue of Executive Times


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