The Fed, conversely, has maximized the weak tools it has available right now for helping these families. Maybe we should give the Fed more and better tools for future recessions—but it’s not useful to get mad at the Fed for failing to do things it can’t do right now.

This is not to say the Fed is a force for good always and everywhere. There really are times when the Fed intervenes on the side of corporate interests in what is essentially a distributive conflict between labor and capital. (By “capital” I’m including the corporate managers who serve as corporate agents and whose rewards trade off pretty sharply against typical workers’ pay.) Usually the Fed’s intervention on behalf of capital occurs when it cuts economic expansions short by raising interest rates in the name of controlling inflation, robbing typical workers of the leverage to secure faster wage growth that really tight labor markets could give them. As we have often written, these actions by the Fed have been hugely consequential, contributing significantly to the disastrously slow wage growth for the bottom 80% of the U.S. workforce for most of the last 40 years.

However, lots of recent evidence suggests that the Fed—now recognizing how distributionally important these past episodes have been—is genuinely concerned about avoiding the kind of prematurely contractionary policies that curtail employment possibilities for traditionally disadvantaged groups and hamstring typical workers’ wage growth. This has been a huge progressive win.

Today’s Fed intervention is not part of a capital–labor conflict

By lending to and buying the debt of private businesses in response to the coronavirus crisis, the Fed is not wading into a capital–labor conflict on the wrong side. Instead, it is wading into a conflict between nonfinancial capital and financial predators.

Take the case of a notably unsympathetic nonfinancial corporation: Carnival Corp., operator of Carnival Cruise Lines. In a recent article generally critical of the Fed’s actions, The American Prospect’s David Dayen tells a story about how Carnival needed bridge financing to survive the shutdown in the cruise industry caused by the coronavirus:

Carnival was flirting with a consortium of hedge funds on a high-interest loan above 15 percent. These vulture funds, including Apollo Global Management and Elliott Management, specialize in distressed debt, squeezing governments and businesses with no alternatives. If Carnival couldn’t repay the loan, the hedge funds would be primed to take ownership.

But the March 23 announcement, signaling a Fed backstop to all comers, suddenly gave Carnival new options. Within days, it had secured $5.75 billion in loans, including a $4 billion bond issuance at 11.5 percent interest, and a $1.75 billion bond at an even smaller 5.75 percent rate that could be converted into Carnival stock.

To boil this down: Hedge funder predators were looking to exploit a nonfinancial corporation that needed loans as it faced distress caused by a global pandemic and economic crisis, and the Fed intervened and offered the nonfinancial corporation a better deal. From my perspective, there are no presumptive good guys in distributive conflicts between nonfinancial capital and financial predators. But it’s not obvious to me why we should shove more firms like Carnival closer to bankruptcy—and threaten to extinguish even more jobs than have already been destroyed—just to allow hedge fund vultures to reap the benefits of having their predatory loans be Carnival’s only option.

The Fed was actually founded in 1913 precisely to serve as a public lender of last resort that could give nonfinancial businesses an option for obtaining loans for survival without throwing themselves on the mercy of Wall Street. In very real terms, the Fed was created so that J.P. Morgan (the person, not the bank) wouldn’t get to decide who did and did not survive financial panics, and wouldn’t get to decide the price of this survival. The Fed experiment as a public service to break the power of private financial capital has not gone without a hitch in the century-plus since its founding, but, during the crisis, it seems to me that it’s mostly going how one would want.

Rising stock prices are not proof that the Fed’s actions are malign or misguided

It is often pointed out that share prices of nonfinancial corporations rose after the Fed announced its lending programs. Given that most stock is owned by the already wealthy, this seems like prima facie evidence that the Fed’s actions have helped the rich, no? Yes, but, while wealthy households own most of any companies’ stock right now, they also will be the buyers of that stock eventually, and so policy actions that raise stock prices reduce the future rate of return. In short, the real distributive conflict between a lower and higher share price for Carnival isn’t really between rich and poor (who will never own this stock), it’s between today’s rich and tomorrow’s rich. Further, as a spillover potential benefit, the more generous loan terms offered by the Fed (relative to other sources of capital) will likely keep many companies in business and avert layoffs of typical workers.

The Fed can do more at the margins—but its existing tools are too weak to provide the help typical families need—it’s up to Congress and the president now

I’ve already noted that Carnival is hardly a sympathetic company. It has a terrible record on labor and environmental standards and bungled its obligation to provide safe accommodations for its passengers during the coronavirus pandemic. It may well be the case that all of this means Carnival shouldn’t exist as a company. But policing these things is a job for labor, environmental, and health authorities, not the Fed. The proper tool for doing this policing is transparent and consistently enforced regulation, not decisions—made on the fly during a meltdown of the economy—that the company should not get access to financial support being widely offered to other firms.

This theme that the Fed can’t be held responsible for all aspects of economic policy is an important moral of this story. It is absolutely true that we as a country have not yet done nearly enough to ensure that human misery and economic suffering are minimized in the wake of this recession and after. But this is on Congress and the president. They have the tools—fiscal policy measures such as stimulus spending—that can provide relief and recovery at scale and targeted toward typical families. In moments like this, the Fed’s official tools really can only keep financial predators from exploiting the vulnerability of nonfinancial corporations and provide a very modest across-the-board stimulus to economic activity once it starts again.

Has the Fed utterly maximized the modest help it can provide? Not quite yet. It should lower interest rates on loans offered to state and local governments, extend these loans’ maturities, and make them more broadly available to cities and counties. Unofficially, Fed leaders can jawbone Congress to be better—and they’ve largely been doing this.

The Fed has shown more concern and intelligence than other branches of the economy policymaking apparatus for more than a decade now. Because of this, and because the Fed is not hobbled by the filibuster or other things that hamstring fiscal policy, it is not surprising that many want the Fed to be in charge of crisis response generally. And when the Fed doesn’t do things that many think (rightly) should be part of this general crisis response, people get mad. But this is not the Fed’s fault. The Fed lacks the legal and logistical capability of delivering aid more directly to households. Would it be nice if the Fed one day had this capability? Sure. But Fed leaders don’t have it today. And in the meantime, it’s better that they use the frustratingly weak and indirect tools they have available to them rather than do nothing.

The Honorable Patrick McHenry
Ranking Member
Committee on Financial Services
United States House of Representatives
2004 Rayburn House Office Building
Washington, D.C. 20515

Dear Chairwoman Waters, Ranking Member McHenry, and Members of the Committee:

In advance of tomorrow’s hearing, “America for Sale? An Examination of the Practices of Private Funds,” I am submitting written testimony in support of the “Stop Wall Street Looting Act of 2019,” a comprehensive bill aimed at stemming abusive practices employed by some private equity firms to line their pockets at the expense of workers, institutional investors, creditors, and others with stakes in the companies they acquire—and too often destroy. As I told Senator Elizabeth Warren in an earlier letter, the legislation will not hinder those private equity firms that prosper by delivering efficiency gains to underperforming companies in their portfolios. Instead, it will simply remove tax and other incentives that allow some firms to realize large gains by inflicting even larger losses on other stakeholders. This type of negative sum strategy is pursued too often in the private equity industry and requires a legislative and regulatory response.

Private equity’s rocky history. Investment firms engaging in leveraged buyouts first caught the public’s attention in the 1980s with the hostile takeovers of high-profile companies such as RJR Nabisco, whose acquisition and subsequent collapse became the subject of a bestselling book and HBO movie, Barbarians at the Gate.1 Bad publicity about failed deals put a damper on leveraged buyouts in the 1990s, but the same business model, now known as private equity, made a comeback in the early 2000s and rebounded after the Great Recession. According to the private equity industry lobby, investment has more than doubled over the past 10 years, with $3.4 trillion invested between 2013 and 2018 and 5.8 million Americans employed in private-equity-backed businesses.2

Abetted by short memories, deregulation, and low interest rates, private equity firms have trained their sights on companies with assets that can be easily sold off if necessary, such as store chains with real estate holdings. This has left in their wake what hearing witness Eileen Appelbaum has described as a “retail apocalypse”—in which profitable companies such as Toys “R” Us are saddled with debt and stripped of assets before filing for bankruptcy.3 While toy, apparel, grocery, and other chains acquired by private equity undoubtedly face competition from online and big box retailers, their ability to adapt to meet these challenges has been hamstrung by debt service and payments to private equity partners in the form of fees and special dividends.

In a series of studies, economist Steven J. Davis and various co-authors find that though portfolio companies tended to be strong performers before their acquisition by private equity firms, job losses at these companies increased significantly (relative to similar companies) after their acquisition, often after establishments were shuttered.4

In the most recent working paper, Steven J. Davis, John Haltiwanger, Kyle Handley, Ben Lipsius, Josh Lerner, and Javier Miranda examine two-year outcomes of private equity buyouts occurring between 1980 to 2013, finding that employment in target firms fell by 4.4 percentage points relative to comparable firms not backed by private equity, netting out gains and losses from post-buyout acquisitions and divestitures. The effect varied by type of buyout, with public-to-private deals showing larger losses.5

Not surprisingly given these job losses, the authors found that real revenue per worker increased in firms targeted by private equity relative to comparable firms. However, it is not clear to what extent, if any, these productivity gains reflected a more efficient deployment of workers or similar operational efficiencies as opposed to simply squeezing more work out of fewer workers. The latter tactic may not be sustainable if it leads to increased worker turnover or a declining reputation among customers. In any case, growth in revenue per worker, as opposed to revenue per hour worked, is an imperfect way to measure productivity growth since it may simply reflect longer work hours.

The authors also found that workers did not share in the gains from these supposed productivity improvements. Even after restricting the sample to establishments that were still in operation two years after the buyout, earnings per worker fell by 1.7% at target companies relative to comparable firms. This likely understates wage losses for ordinary workers, since average compensation includes compensation of managers, who are often given raises and retention bonuses after buyouts. The measure is also based on earnings per worker rather than hourly pay.

What are the purported benefits of private equity? Proponents say private equity can play a constructive role in the economy by streamlining and, if necessary, breaking up underperforming companies—what economist Joseph Schumpeter has famously called “creative destruction.”6 In this view, private equity addresses the problem of empire-building CEOs whose interests are not closely aligned with those of shareholders because their pay and prestige reflects the company’s size rather than its performance. Solutions to this agency problem involve giving investors more control or managers a greater stake in profit maximization. With private equity, the result is a highly leveraged and multilayered business model that blurs the line between owners and managers.

How does private equity function in the real world? While leverage and direct control by equity investors can impose discipline on bloated companies, much of what private equity firms do is simply destructive—absent the “creative” part. Private equity firms often engage in what economists call “rent-seeking,” or unproductive behavior designed to take advantage of loopholes in the tax code, banking and securities laws, and bankruptcy provisions, rather than creating value through efficiency gains.

Private equity firms have rigged the system so that they share in the upside risk but minimize losses from bad bets—a “heads we win, tails you lose” strategy enabled by a tax system that encourages equity investors to load companies up with debt. If a portfolio company thrives despite being saddled with debt, it can be resold at a profit. If not, private equity partners recoup some or all of their minimal investment by selling assets and siphoning off cash through fees and debt-funded dividends.7

Meanwhile, suppliers and other creditors are kept in the dark if the company slides toward insolvency. The biggest victims are often workers, who risk losing not only their jobs, but also back wages, pension benefits, and severance pay, in bankruptcy proceedings tilted in favor of creditors with more political clout. Consumers are also harmed as companies they like are driven out of business, market concentration increases, and they are left with worthless gift cards and unfulfilled orders.

Banks, bondholders, limited partners, and other investors may suffer immense losses while private equity’s general partners emerge unscathed from bad deals. As one observer has noted, private equity is engaging in the systemic abuse of limited liability.8 Private equity firms were behind the largest commercial real estate default in U.S. history, the result of their vastly overpaying for the Stuyvesant Town and Peter Cooper Village apartment complexes in Manhattan. Underlying this bad gamble was a projection that income would triple in five years, based in part on a strategy of improperly converting rent-stabilized units. When the deal went sour, the private equity partners lost only a tiny equity stake in the deal, while other investors lost billions.9

While some of the risk is borne by wealthy investors who can afford to suffer losses, ordinary Americans are indirectly exposed, notably workers whose pension funds are among the largest investors in private equity funds. The scale and riskiness of private equity transactions has also increased our economy’s vulnerability to financial crisis, especially as leverage has increased while standards have declined.10

Private equity markets itself to pension funds and other limited partners with the promise of outsize returns. However, these claims are based on cherry-picked statistics, manipulated earnings, and ignored risk. While early investors and insiders in some of the best-performing funds may prosper, more objective research finds that most investors do not achieve higher risk-adjusted returns to compensate for illiquidity and lack of transparency, so even non-risk-averse institutional investors would fare better by investing in, say, small cap index funds.11

In addition to shifting risk, private equity general partners also shift the tax burden to others through tax-avoidance strategies. The best known of these is classifying their compensation as lightly taxed “carried interest.”12 While the revenue losses are hard to estimate because they depend on assumptions about how this income might be taxed if the loophole were closed, estimates have ranged from $18 billion annually to 10 times that amount.13

In short, private equity partners often prosper at the expense of others—investors, suppliers, creditors, workers, consumers, and taxpayers—rather than managing portfolio companies more efficiently in ways that foster economic growth. Even when private equity management appears to bring about efficiency improvements, these are typically short-term gains that come at the expense of the long-run health of the company and the economy.

Private equity is not in it for the long term. The industry and its backers tout the supposed productivity gains from reduced staffing levels in retail and other industries. However, there is little reason to believe that managers in highly competitive industries such as retail were complacent about labor costs before private equity came on the scene. Rather, private equity overseers may have reduced staffing below sustainable levels in order to boost short-term profits, ignoring employee turnover, customer complaints, and even worse outcomes. For example, the Washington Post reported that after private equity firm Carlyle bought nursing home company HCR ManorCare, serious health code violations—including violations placing patients in immediate jeopardy or causing actual harm—rose by 29% annually before the company filed for bankruptcy.14

Short-termism helps explain why private equity is often drawn to industries where reputations matter, such as health care and journalism, since this is where the gap between short-term and long-term profits is often greatest. Because there is often a delay between the cost savings achieved by layoffs and the reputational impact of poor service and deteriorating quality, private equity can enrich itself by stripping a brand of reputational value the same way it strips target companies of other real and intangible assets—whether brick-and-mortar stores or creditors’ trust.

Thus, for example, before private equity recognized the opportunity to make outsize profits, most medical providers were reluctant to engage in surprise medical billing, whereby vulnerable patients—often those experiencing medical emergencies—are presented with extortionate bills by out-of-network providers, such as ambulance services or anesthesiologists. This practice is not just terrible public relations, it is likely to eventually be shut down by regulators. It makes no business sense for a hospital or other health care provider with community roots and a long-term outlook to engage in such practices, but it makes sense as a get-rich-quick scheme for private equity.15

Similarly, private equity takeovers have gutted media companies around the country, including local newspapers such as The Denver Post, leading magazines such as Sports Illustrated, and popular websites such as Deadspin.16 While industry consolidation cannot all be blamed on private equity, private equity’s attempt to drain any remaining profits from media companies that produce original content, which are already competing with social media behemoths for scarce advertising dollars, has sped up the process. Admittedly, the targeted media companies may not have been maximizing profits—publishers have balanced a public and a business purpose long before the concept of a “B Corporation” was formalized. However, it is difficult to imagine how our economy, democracy, and culture benefit when media companies focus single-mindedly on short-term profits.

Imperviousness to bad publicity and lust for short-term profits also explains private equity’s entrée into the residential real estate market, which has been abetted by preferential tax treatment. The Washington Post reported that Cerberus Capital Management, the largest owner of single-family homes in the Memphis area, filed for eviction at twice the rate of other home property managers in the area and threatened renters with removal at the highest rate among the area’s large management firms.17 These are not isolated incidents. The problem is large and worldwide, to the point where the United Nations’ Special Rapporteur on adequate housing singled out private-equity firm Blackstone Group for exploiting tenants, wreaking havoc on communities, and contributing to a global housing crisis.18

Such practices not only harm those communities that are directly impacted, but they may heighten systemic risks in the broader economy.19 The most recent study by Davis et al. finds that private equity deals that occur amid easy credit conditions appear to be more driven by private returns from financial engineering—leveraged buyouts and buybacks—as opposed to operational improvements, a pattern that could exacerbate cyclical swings in economic activity.20

A comprehensive solution is at hand. The Stop Wall Street Looting Act will not outlaw private equity partnerships, but rather will force them to do what they already claim to be doing—restructuring underperforming companies to make them more productive. It does this through a number of provisions aimed at removing the tax and other incentives that encourage private equity firms to gamble with other people’s money, loot and destroy productive resources, and enrich themselves at the expense of other stakeholders.

To this end, the bill

• holds those who have ultimate decision-making authority responsible for damages and debts, including employee back pay and benefits;
• limits or prohibits the looting of assets through fees and capital distributions;
• reduces the incentive for risk-taking by prohibiting interest on excessive debt obligations from being tax-deductible;
• limits enhancement of executive compensation, and prioritizes unpaid wages, severance pay, contributions to employee benefit plans, and damages from violations of labor and employment laws, during bankruptcy proceedings;
• directs bankruptcy courts to give substantial weight to the effect on employees in directing the sale of company properties;
• puts consumers with unredeemed gift cards or undelivered services just behind employees in bankruptcy proceedings, along with people who purchased, leased, or rented property from the company;
• closes the carried interest loophole that gives preferential tax treatment to private equity partners’ income;
• protects outside investors by requiring detailed disclosure of fees and returns, as well as the performance of past funds, including the outcomes for target firms;
• clarifies that fund managers have a fiduciary duty to pension plans whose assets they manage;
• prohibits giving favorable treatment to certain limited partners;
• requires managers of collateralized debt obligations to retain a share of the risk according to the credit risk retention requirements in the Dodd-Frank Act; and
• provides effective enforcement mechanisms to ensure compliance with these provisions.

Industry response. The Stop Wall Street Looting Act tackles a business model based on rent-seeking and extracting short-term profits at the expense of long-term value. It should not deter private equity partners who have a genuine expertise in identifying undervalued companies and managing them better. Because the legislation focuses on removing incentives to engage in socially undesirable business practices, it is not surprising that the industry’s response has largely avoided defending these incentives and practices, relying instead on exaggerated claims of the industry’s economic importance.

The industry lobby claims private equity supports millions of jobs and invests trillions in struggling companies, as if these workers and resources would otherwise remain idle.21 Not content to claim credit for jobs in companies wholly owned by private equity, the lobby commissioned a report from Ernst & Young that inflated that number by including all jobs in companies where the industry has partial ownership. Likewise, the Ernst & Young report inflated workers’ average earnings by including the private equity partners’ sky-high compensation in the average. Perhaps most absurdly, the report credited the industry with an estimate of taxes paid based on “the historical relationship between federal, state, and local tax collections (by tax type) to economic activity,” rather than on what the famously tax-dodging industry actually paid.22

Conclusion. A telling aspect of the private equity business model is that risks and rewards are not evenly distributed among investors. While private equity managers invest little of their own money, they capture a disproportionate share of gains through layers of fees and other opaque arrangements. Meanwhile, other insiders make private side deals, leaving less connected investors, such as pension funds, with the dregs. If the private equity business model were truly about using expertise to identify undervalued companies and manage them better, we would expect the partners to invest more of their own money. Instead, outside investors, such as pension funds, are brought in to bear more of the risk and reap less of the profit.

Rather than promoting efficient market outcomes, private equity often thrives on identifying, creating, and perpetuating tax and regulatory loopholes that distort economic incentives, perverting our political system in the process. If the Vikings had had public relations teams, they would have claimed to be making better use of the resources of the fishing villages they pillaged. Private equity often leaves a similar trail of destruction—looting productive resources rather than salvaging unproductive ones. This bill addresses serious problems with the private equity business model, without getting in the way of firms that actually do produce allocative or operational efficiencies that strengthen the U.S. economy.

Sincerely,
Thea Lee
Economic Policy Institute

Notes

1. Brian Burrough and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (New York: HarperCollins, 2008).

2. American Investment Council, “2018 Top States and Districts,” April 29, 2019.

3. Eileen Appelbaum, “Recession or Not, There Will Be Pain; Coping with Corporate Bonds,” Working Economics Blog (Economic Policy Institute), May 30, 2019.

4. Research summarized by Eileen Appelbaum and Rosemary Batt in chapter 7 of their authoritative 2014 book, Private Equity at Work: When Wall Street Manages Main Street (New York: Russell Sage Foundation).

5. Steven J. Davis et al., “The Economic Effects of Private Equity Buyouts,” Becker-Friedman Institute Working Paper no. 2019-122, October 2019, downloadable at https://bfi.uchicago.edu/wp-content/uploads/BFI_WP_2019122.pdf.

6. David Haarmeyer, “Private Equity Capitalism’s Misunderstood Entrepreneurs and Catalysts for Value Creation,” The Independent Review, Fall 2008.

7. Nabila Ahmed and Sridhar Natarajan, “Private Equity Wins Even When It Loses, Thanks to Debt Markets,” Bloomberg, March 20, 2017.

8. Jonathan Ford, “Elizabeth Warren Is Right to Worry About Private Equity Looting,” Financial Times, July 28, 2019.

9. Eileen Appelbaum and Rosemary Batt, Private Equity at Work: When Wall Street Manages Main Street (New York: Russell Sage Foundation, 2014), 44–45; Gabriel Sherman, “Clash of the Utopias,” New York Magazine, February 1, 2009; Charles V. Bagli, “Worry at Stuyvesant Town as Foreclosure Draws Near,” New York Times, February 15, 2010.

10. Trista Kelley, “Former Fed Chair Janet Yellen Just Joined the Chorus of Warnings About $1.6 Trillion ‘Leveraged Loan’ Market,” Business Insider, October 25, 2018; Kristen Haunss, “UPDATE 1-Leveraged Loan Credit Risk Warrants Attention, Regulators Testify,” Reuters, May 15, 2019.

11. For an overview of the research, see chapter 6 in Eileen Appelbaum and Rosemary Batt, Private Equity at Work: When Wall Street Manages Main Street (New York: Russell Sage Foundation, 2014). More recent research in this vein includes Brian Boyer, Taylor D. Nadauld, Keith P. Vorkink, and Michael S. Weisbach, “Private Equity Indices Based on Secondary Market Transactions,” NBER Working Paper no. 25207, November 2018; Gregory W. Brown, Oleg R. Gredil, and Steven N. Kaplan, “Do Private Equity Funds Manipulate Reported Returns?” Journal of Financial Economics 132, no. 2 (May 2019); Morten Sorensen, Neng Wang, and Jinqiang Yang, “Valuing Private Equity,” Review of Financial Studies 27, no. 7 (2014); Berl A. Sensoy, Yingdi Wang, and Michael S. Weisbach, “Limited Partner Performance and the Maturing of the Private Equity Industry,” Journal of Financial Economics 112, no. 3.

12. Young Ran Kim, “Carried Interest and Beyond: The Nature of Private Equity Investment and Its International Tax Implications,” Virginia Tax Review 37, no. 3 (2018).

13. Victor Fleischer, “How a Carried Interest Tax Could Raise $180 Billion,” New York Times, June 5, 2015.

14. Peter Whoriskey and Dan Keating, “Overdoses, Bedsores, Broken Bones: What Happened When a Private-Equity Firm Sought to Care for Society’s Most Vulnerable,” Washington Post, November 25, 2018.

15. Eileen Appelbaum and Rosemary Batt, “Private Equity and Surprise Medical Billing,” Institute for New Economic Thinking, September 4, 2019; Eileen Appelbaum and Rosemary Batt, “Private Equity Buyouts, Surprise Medical Bills, and Rising Health Costs: It’s About Market Power and Money,” American Prospect, September 9, 2019; Lovisa Gustafsson, Shanoo Seervai, and David Blumenthal, “The Role of Private Equity in Driving Up Health Care Prices,” Harvard Business Review, October 29, 2019; Olivia Webb, “Private Equity Chases Ambulances: Investment Firms Have Bought Up Emergency Medical Service Companies, Squeezing Soaring Profits from Vulnerable Patients,” American Prospect, October 3, 2019.

16. Kim Kelly, “This Is a Horror Story: How Private Equity Vampires Are Killing Everything,” Nation, November 10, 2019; Robert Kuttner and Hildy Zenger, “Saving the Free Press from Private Equity,” American Prospect, December 27, 2017; Alex Shephard, “Finance Is Killing the News,” New Republic, April 18, 2018.

17. Todd C. Frankel and Dan Keating, “Eviction Filings and Code Complaints: What Happened When a Private Equity Firm Became One City’s Biggest Homeowner,” Washington Post, December 25, 2018.

18. Surya Deva and Leilani Farha, Letter to Blackstone CEO Stephen A. Schwarzman, March 22, 2019 (https://www.ohchr.org/Documents/Issues/Housing/Financialization/OL_OTH_17_2019.pdf); Patrick Butler and Dominic Rushe, “UN Accuses Blackstone Group of Contributing to Global Housing Crisis,” Guardian, March 26, 2019.

19. ACCE Institute, Americans for Financial Reform, and Public Advocates, Wall Street Landlords Turn American Dream into a Nightmare, 2018; Julia Gordon, “The Dark Side of Single-Family Rental,” Shelterforce, July 30, 2018. Elora Raymond, Richard Duckworth, Ben Miller, Michael Lucas, and Shiraj Pokharel, “Corporate Landlords, Institutional Investors, and Displacement: Eviction Rates in Single-Family Rentals,” Federal Reserve Bank of Atlanta, Community & Economic Development Discussion Paper no. 04-16, December 2016; Alana Semuels, “When Wall Street Is Your Landlord,” Atlantic, February 13, 2019.

20. Steven J. Davis et al., “The Economic Effects of Private Equity Buyouts,” Becker-Friedman Institute Working Paper no. 2019-122, October 2019, downloadable at https://bfi.uchicago.edu/wp-content/uploads/BFI_WP_2019122.pdf.

21. American Investment Council, “Private Equity Invests Across America, Supports Jobs, and Strengthens Pensions” (press release), July 19, 2019.

22. American Investment Council, “What They Are Saying: New EY Report Reveals Private Equity’s Significant and Positive Economic Impact” (press release), October 22, 2019; Eileen Appelbaum, “Lobbying Arm of Private Equity Industry Pays E&Y for Misleading Report on PE’s Economic Contributions,” CEPR Blog, October 23, 2019; Ernst & Young, Economic Contribution of the US Private Equity Sector in 2018: Prepared for the American Investment Council, October 2019.

Dear Senator Warren,

I am writing to express support for the “Stop Wall Street Looting Act of 2019,” a comprehensive bill aimed at stemming abusive practices employed by some private equity firms to line their pockets at the expense of workers, institutional investors, creditors, and others with stakes in the companies they acquire—and too often destroy. The legislation will not hinder those private equity firms that prosper by delivering efficiency gains to underperforming companies in their portfolios. Instead, it will simply remove tax and other incentives that allow some firms to realize large gains by inflicting even larger losses on other stakeholders. This type of negative sum strategy is pursued too often in the private equity industry and requires a legislative and regulatory response.

Private equity’s rocky history. Investment firms engaging in leveraged buyouts first caught the public’s attention in the 1980s with the hostile takeovers of high-profile companies such as RJR Nabisco, whose acquisition and subsequent collapse became the subject of a bestselling book and HBO movie, Barbarians at the Gate.1 Bad publicity about failed deals put a damper on leveraged buyouts in the 1990s, but the same business model, now known as private equity, made a comeback in the early 2000s and rebounded after the Great Recession. According to the private equity industry lobby, investment has more than doubled over the past 10 years, with $3.4 trillion invested between 2013 and 2018 and 5.8 million Americans employed in private equity-backed businesses.2

Abetted by short memories, deregulation, and low interest rates, private equity firms have trained their sights on companies with assets that can be easily sold off if necessary, such as store chains with real estate holdings. This has left in their wake what economist Eileen Appelbaum has described as a “retail apocalypse”—in which profitable companies such as Toys “R” Us are saddled with debt and stripped of assets before filing for bankruptcy.3 While toy, apparel, grocery, and other chains acquired by private equity undoubtedly face competition from online and big box retailers, their ability to adapt to meet these challenges has been hamstrung by debt service and payments to private equity partners in the form of fees and special dividends.

Economist Steven J. Davis and co-authors have found that though portfolio companies tend to be strong performers before their acquisition by private equity firms, job losses at these companies increase significantly (relative to similar companies) after their acquisition, often after establishments are shuttered.4 In their most recent working paper, Davis et al. find that when private equity firms acquire public companies, employment falls by 13 percent relative to peers, although the effect depends on the type of buyout (companies that were already privately held fared better).5

What is the role of private equity? Proponents say private equity can play a constructive role in the economy by streamlining and, if necessary, breaking up underperforming companies—what economist Joseph Schumpeter famously called “creative destruction.”6 In this view, private equity addresses the problem of empire-building CEOs whose interests are not closely aligned with those of shareholders because their pay and prestige reflects the company’s size rather than its performance. Solutions to this agency problem involve giving investors more control or managers a greater stake in profit maximization. With private equity, the result is a highly leveraged and multilayered business model that blurs the line between owners and managers.

How does private equity function in the real world? While leverage and direct control by equity investors can impose discipline on bloated companies, much of what private equity firms do is simply destructive—absent the “creative” part. Private equity firms often engage in what economists call “rent-seeking,” or unproductive behavior designed to take advantage of loopholes in the tax code, banking and securities laws, and bankruptcy provisions, rather than creating value through efficiency gains.

Private equity firms have rigged the system so that they share in the upside risk but minimize losses from bad bets—a “heads we win, tails you lose” strategy enabled by a tax system that encourages equity investors to load companies up with debt. If a portfolio company thrives despite being saddled with debt, it can be resold at a profit. If not, private equity partners recoup some or all of their minimal investment by selling assets and siphoning off cash through fees and debt-funded dividends.7 Meanwhile, suppliers and other creditors are kept in the dark if the company slides toward insolvency. The biggest victims are often workers, who risk losing not only their jobs, but also back wages, pension benefits, and severance pay, in bankruptcy proceedings tilted in favor of creditors with more political clout. Consumers are also harmed as companies they like are driven out of business, market concentration increases, and they are left with worthless gift cards and unfulfilled orders.

Banks, bondholders, limited partners, and other investors may suffer immense losses while private equity’s general partners emerge unscathed from bad deals. Private equity firms were behind the largest commercial real estate default in U.S. history, the result of their vastly overpaying for the Stuyvesant Town and Peter Cooper Village apartment complexes in Manhattan. Underlying this bad gamble was a projection that income would triple in five years, based in part on a strategy of improperly converting rent-stabilized units. When the deal went sour, the private equity partners lost only a tiny equity stake in the deal, while other investors lost billions.8

While some of the risk is borne by wealthy investors who can afford to suffer losses, ordinary Americans are indirectly exposed, notably workers whose pension funds are among the largest investors in private equity funds. The scale and riskiness of private equity transactions has also increased our economy’s vulnerability to financial crisis, especially as leverage has increased while standards have declined.9

Private equity markets itself to pension funds and other limited partners with the promise of outsize returns. However, these claims are based on cherry-picked statistics, manipulated earnings, and ignored risk. While early investors and insiders in some of the best-performing funds may prosper, more objective research finds that most investors do not achieve higher risk-adjusted returns to compensate for illiquidity and lack of transparency, so even non-risk-averse institutional investors would fare better by investing in, say, small cap index funds.10

In addition to shifting risk, private equity general partners also shift the tax burden to others through tax-avoidance strategies. The best known of these is classifying their compensation as lightly-taxed “carried interest.”11 While the revenue losses are hard to estimate because they depend on assumptions about how this income might be taxed if the loophole were closed, estimates have ranged from $18 billion annually to 10 times that amount.12

A comprehensive solution is at hand. The Stop Wall Street Looting Act will not outlaw private equity partnerships, but rather will force them to do what they already claim to be doing—restructuring underperforming companies to make them more productive. It does this through a number of provisions aimed at removing the tax and other incentives that encourage private equity firms to gamble with other people’s money, loot and destroy productive resources, and enrich themselves at the expense of other stakeholders.

To this end, the bill:

• holds those who have ultimate decision-making authority responsible for damages and debts, including employee back pay and benefits;
• limits or prohibits the looting of assets through fees and capital distributions;
• reduces the incentive for risk-taking by prohibiting interest on excessive debt obligations from being tax-deductible;
• limits enhancement of executive compensation, and prioritizes unpaid wages, severance pay, contributions to employee benefit plans, and damages from violations of labor and employment laws, during bankruptcy proceedings;
• directs bankruptcy courts to give substantial weight to the effect on employees in directing the sale of company properties;
• puts consumers with unredeemed gift cards or undelivered services just behind employees in bankruptcy proceedings, along with people who purchased, leased, or rented property from the company;
• closes the carried interest loophole that gives preferential tax treatment to private equity partners’ income;
• protects outside investors by requiring detailed disclosure of fees and returns, as well as the performance of past funds, including the outcomes for target firms;
• clarifies that fund managers have a fiduciary duty to pension plans whose assets they manage;
• prohibits giving favorable treatment to certain limited partners;
• requires managers of collateralized debt obligations to retain a share of the risk according to the credit risk retention requirements in the Dodd-Frank Act; and
• provides effective enforcement mechanisms to ensure compliance with these provisions.

Conclusion. A telling aspect of the private equity business model is that risks and rewards are not evenly distributed among investors. While private equity managers invest little of their own money, they capture a disproportionate share of gains through layers of fees and other opaque arrangements. Meanwhile, other insiders make private side deals, leaving less connected investors, such as pension funds, with the dregs. If the private equity business model were truly about using expertise to identify undervalued companies and manage them better, we would expect the partners to invest more of their own money. Instead, outside investors, such as pension funds, are brought in to bear more of the risk and reap less of the profit.

Rather than promoting efficient market outcomes, private equity often thrives on identifying, creating, and perpetuating tax and regulatory loopholes that distort economic incentives, perverting our political system in the process. If the Vikings had had public relations teams, they would have claimed to be making better use of the resources of the fishing villages they pillaged. Private equity often leaves a similar trail of destruction—looting productive resources rather than salvaging unproductive ones. This bill addresses serious problems with the private equity business model, without getting in the way of firms that actually do produce allocative or operational efficiencies that strengthen the U.S. economy.

Sincerely,

Thea Lee
President
Economic Policy Institute

Notes

1. Brian Burrough and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (New York: HarperCollins, 2008).

2. American Investment Council, “2018 Top States and Districts,” April 29, 2019.

3. Eileen Appelbaum, “Recession or Not, There Will Be Pain; Coping with Corporate Bonds,” Working Economics Blog (Economic Policy Institute), May 30, 2019.

4. Research summarized by Eileen Appelbaum and Rosemary Batt in chapter 7 of their authoritative 2014 book, Private Equity at Work: When Wall Street Manages Main Street (New York: Russell Sage Foundation).

5. Steven J. Davis, John Haltiwanger, Kyle Handley, Ben Lipsius, Josh Lerner, and Javier Miranda, “The Social Impact of Private Equity over the Economic Cycle,” working paper presented at the American Economics Association Annual Meeting, January 6, 2019, downloadable at https://www.aeaweb.org/conference/2019/preliminary/paper/5nsZRYTz.

6. David Haarmeyer, “Private Equity Capitalism’s Misunderstood Entrepreneurs and Catalysts for Value Creation,” The Independent Review, Fall 2008.

7. Nabila Ahmed and Sridhar Natarajan, “Private Equity Wins Even When It Loses, Thanks to Debt Markets,” Bloomberg, March 20, 2017.

8. Eileen Appelbaum and Rosemary Batt, Private Equity at Work: When Wall Street Manages Main Street (New York: Russell Sage Foundation, 2014), pp. 44–45; Gabriel Sherman, “Clash of the Utopias,” New York Magazine, February 1, 2009; Charles V. Bagli, “Worry at Stuyvesant Town as Foreclosure Draws Near,” New York Times, February 15, 2010.

9. Trista Kelley, “Former Fed Chair Janet Yellen Just Joined the Chorus of Warnings About $1.6 Trillion ‘Leveraged Loan’ Market,” Business Insider, October 25, 2018; Kristen Haunss, “UPDATE 1-Leveraged Loan Credit Risk Warrants Attention, Regulators Testify,” Reuters, May 15, 2019.

10. For an overview of the research, See chapter 6 in Eileen Appelbaum and Rosemary Batt, Private Equity at Work: When Wall Street Manages Main Street (New York: Russell Sage Foundation, 2014). More recent research in this vein includes Brian Boyer, Taylor D. Nadauld, Keith P. Vorkink, and Michael S. Weisbach, “Private Equity Indices Based on Secondary Market Transactions,” NBER Working Paper no. 25207, November 2018; Gregory W. Brown, Oleg R. Gredil, and Steven N. Kaplan, “Do Private Equity Funds Manipulate Reported Returns?” Journal of Financial Economics 132, no. 2 (May 2019); Morten Sorensen, Neng Wang, and Jinqiang Yang “Valuing Private Equity,” Review of Financial Studies 27, no. 7 (2014); Berl A. Sensoy, Yingdi Wang, and Michael S. Weisbach. 2014. “Limited Partner Performance and the Maturing of the Private EquityIindustry,” Journal of Financial Economics 112, no. 3.

11. Young Ran Kim, “Carried Interest and Beyond: The Nature of Private Equity Investment and Its International Tax Implications,” Virginia Tax Review 37, no. 3 (2018).

12. Victor Fleischer, “How a Carried Interest Tax Could Raise $180 Billion,” New York Times, June 5, 2015.

My assessment of the underlying health of the U.S. economy hasn’t really changed over the past week, even as the stock market has declined pretty spectacularly in recent days. Why this equanimity?

A couple of things. First, stock market movements significantly change the wealth of only a small sliver of the U.S. population. Roughly 90 percent of stocks are held by the wealthiest 10 percent of the population. This means that the spending power of the vast majority of American households isn’t significantly affected by changes in stock prices.

Second, while stocks were pretty expensive in the past week, it doesn’t seem to me that there was an obvious market-wide bubble that would mean these declines were inevitable and will be enduring. Yes, some sectors and stocks (tech and “sharing economy” stocks) do look awfully bubbly. But when graded on things like price/earnings ratios—especially given today’s very low interest rates—the market overall looks expensive but not like an obvious bubble. What all this means is that recent stock market declines are most likely to redistribute wealth from today’s stock owners to tomorrow’s stock owners (who are buying up cheap stocks today).

All in all, the stock market is a terrible gauge of overall economy-wide health, so even large swings in it by themselves do not provide much of a signal for how to assess this broader health.

Of course, what about the root causes of the market’s slide—fears over China’s growth and fears that the Fed might raise interest rates soon? Do these developments mean we should worry about future growth? Yes, but we have known about these issues for a while and smart observers had already baked them into their assessment of the economy’s health. Further, the fears over the Chinese slowdown’s impact on the U.S. economy seem overblown to me. Yes, China is a large economy. But it’s actually not the large a market for U.S. exports. Exports to China in 2014 were $123 billion. Let’s say a combination of a Chinese growth slowdown and further Chinese depreciation of their currency cut these exports in half next year (a pretty extreme supposition)—this would cut 0.3 percent off of U.S. growth next year. Not nothing, but hardly enough to spur the kind of freak out we’ve seen in recent days. Note that this is a smaller effect than the drag that would be created if Congress fails to undo the spending caps in the Budget Control Act that will bind next year—and yet nobody would think a full-on stock market meltdown would be a reasonable response to that debate.

The Fed’s actions are, of course, another matter. If the Fed begins the process of raising short-term interest rates this fall, it will be abandoning yet another policy tool they’ve used to boost growth in recent years (they stopped outright purchases of long-term bonds at the end of 2014). This despite the fact that unemployment remains elevated relative to pre-Great Recession levels, prime-age employment rates have recovered barely half of the fall they experienced during the recession and early recovery, wage growth has been stuck at an anemic 2-2.5 percent growth since the recovery began, and overall price inflation is coming in significantly lower than even the Fed’s conservative 2 percent target.

A premature rate hike would be bad for the economy, and September is way premature. In fact, absent an absolute explosion of wage and employment growth, anytime in 2015 is premature.

Does the recent stock market decline make it more likely the Fed holds off? Probably not. The Fed really shouldn’t be reacting to bad financial market days in setting interest rates. But, the Fed should hold off regardless. A September rate hike was a bad idea a week ago, and remains a bad idea today.

For those who think that the U.S. economy remains too weak and needs as much policy support as it can get, this seems like a pretty good choice. Both Summers and Yellen have consistently argued in the past couple of years that the primary problem facing the U.S. economy currently is slack demand.

I’d argue, however, that Yellen is the clearly correct choice for the job right now.

For one, she has been far ahead of the policymakers’ curve when it comes to diagnosing macroeconomic trouble. Recently released minutes from Federal Reserve Open Market Committee meetings in December 2007 show that Yellen was nearly alone in warning that a recession was imminent—a warning that proved correct.

For another, it’s hard to imagine somebody more qualified and better-groomed for the job. She has served as Chair of the White House’s Council of Economic Advisers, has had previous stints on the Fed’s Board of Governors, has run the San Francisco Federal Reserve, and has been Vice-Chair of the Federal Reserve since 2010.

Most importantly, however, is that the Fed is the linchpin for financial regulation in the U.S. economy. Yellen has clearly shown that she has learned valuable lessons from the housing bubble-led Great Recession—reversing her earlier adherence to the near-consensus view that central banks should not pre-emptively burst asset market bubbles, because the bar for meddling in (presumably efficient) financial markets should be set very high and “cleaning up” after bubbles would never be that hard. She now acknowledges that this was too facile an approach to bubbles. Changing one’s position based on new facts—particularly when it involves pushing back against powerful sectors like finance—is admirable and sadly rare for policymakers. It should be rewarded.

EPI has been describing these trends for years. In fact, you might consider our flagship publication, The State of Working America, as a sort of modern-day Gatsby, in charts. The prose may not be as artful as Fitzgerald’s, but the economic descriptions are equally alarming.

The Great Gatsby’s protagonist, Nick Carroway, is drawn to New York by the promise of riches to be made on Wall Street. Indeed, the premium to working in the financial sector at that time was better than ever… until recently. As Figure A shows, at the beginning of the Great Depression, earnings per worker in the financial industry peaked at nearly 1.8 times the earnings per worker of all other private sector workers. After the Depression and the regulation that followed, earnings per worker in finance fell back roughly into line with the rest of the private sector. Beginning in the late 1970s, however, earnings per worker in finance again began to take off. By the onset of the Great Recession, they exceeded 1.8 times the earnings per worker of all other private sector workers. With such striking disparities in compensation, who wouldn’t be attracted to the green light of finance?

The depictions of economic inequality in Gatsby are stark. We catch a glimpse of two worlds, one filled with emerald green lawns and another where coal dust has choked out any sign of color. In 1922, when Gatsby was set, the richest 5.0 percent—the Tom and Daisy Buchannan class—captured a whopping 31.9 percent of all U.S. income (Figure B). That explains the front yard polo and the endless strings of pearls. The picture today is no less bleak, however. The top 5.0 percent of earners in 2010 took home 35.7 percent of all income.

While this share has increased slightly since 1922, it hasn’t simply ticked upwards slowly. There was a period of more equitable growth, stretching from the end of WWII to 1979, during which time overall inequality went down. Unfortunately, since then, either through deliberate policies that favor the top or a lack of policy action to protect the middle class, we’ve created a second Gatsby era.

At one point in the story, Tom Buchanan, the archetypal, old-money blue-blood from “East Egg,” expresses his disdain for the newly-rich residents of “West Egg” where Gatsby resides. Implicit in Buchanan’s contempt is the recognition that income can be fleeting and, thus, is not nearly as important as wealth. Wealth, i.e., the sum of one’s assets (houses, stocks, bonds, marble statues) minus one’s debts, is more enduring; it can be passed on to heirs, creating the dynastic family wealth that his character typifies. In 2010, the top 5.0 percent owned an astonishing 63.1 percent share of all wealth in America. Meanwhile, the entire bottom 90 percent held only 23.3 percent of all wealth. In fact, more than 1 in 5 households (22.5%) actually have zero or negative wealth, meaning their debt matches or exceeds their assets.

The picture gets even more disturbing when you examine wealth by racial group. In 2010, the median white household had wealth valued at $97,000. That is over 20 times the average wealth of black households, which stood at $4,900 in 2010.

The danger with such high concentrations of wealth is that it likely reduces a society’s economic mobility (pdf). When a shrinking portion of the population can afford access to good schools, to decent health care, and to homes in good neighborhoods, then the opportunity to better one’s lot in life begins to become concentrated as well. Jay Gatsby made it (as a bootlegger, mind you), but the reality for most Americans is that they will never venture far from the socio-economic status into which they were born. Studies have shown that a child born into a family in the bottom fifth of the wealth distribution has only a 7 percent chance of reaching to top fifth of the wealth distribution. Conversely, 36 percent of children born into the top fifth of the wealth distribution will remain there as adults, and 60 percent will remain at least in the top two fifths of the wealth distribution.

Economists quantify mobility with a metric called the intergenerational elasticity (IGE), which essentially describes how much of a child’s long-run earnings can be explained by the long-run earnings of their parents—the higher the IGE, the less mobile the society. Figure C shows what CEA Chairman Alan Krueger appropriately called “the Great Gatsby curve” (pdf). On the vertical axis is the IGE and on the horizontal axis, the Gini coefficient (a frequently-used measure of inequality). As the figure shows, countries that have higher levels of income inequality also exhibit a larger IGE, meaning lower mobility. (For more, read the mobility chapter in the State of Working America.)

It is easy to romanticize the exuberance of the Jazz Age. (Luhrmann’s Gatsby throws quite the party.) But we should remember that the excesses and disparities of the 1920s precipitated the greatest economic catastrophe in modern history, a disaster alleviated only by the massive stimulus of WWII. Let this latest incarnation of Gatsby be a wake-up call to the economic reality of 2013. We, as a country, must decide whether we will build an economy where growth is shared by all, or let policies of austerity, tax cuts for the wealthy, and inadequate regulation of Wall Street continue to feed growing inequality. We know too well how that story ends.

(Animation taken from The Great Gatsby trailer)

References:

Bivens, Josh. 2011. Failure by Design: The Story behind America’s Broken Economy. An Economic Policy Institute book. Ithaca, N.Y.: Cornell, University Press.

Corak, Miles. 2012. “Inequality from generation to generation: the United States in Comparison”. University of Ottawa. http://milescorak.files.wordpress.com/2012/01/inequality-from-generation-to-generation-the-united-states-in-comparison-v3.pdf

Mishel, Lawrence, Josh Bivens, Elise Gould, and Heidi Shierholz. 2012. The State of Working America, 12^th Edition. An Economic Policy Institute book. Ithaca, N.Y.: Cornell, University Press.

First, all the bad ideas about the so-called “fiscal cliff”:

1. The problem posed by the “fiscal cliff” is one of too much debt
2. The “cliff” is a big monolith that we either go over or we don’t
3. The “cliff” is mostly about the upper-income Bush tax cuts
4. The economy goes over the “cliff” on Jan. 1
5. The debt ceiling is one of the issues that must be resolved in debates about the “cliff”
6. Resolving the “cliff” requires a deal on long-term debt reduction
7. Financial markets will punish us for not striking a grand bargain to defuse the “cliff”

1. You can’t tax the rich enough to make a dent in the deficit
2. Raising the Medicare eligibility age is a good idea for deficit reduction
3. Switching to a “chained” consumer price index to calculate the Social Security cost-of-living-adjustment (COLA) is a technical improvement
4. Contractionary fiscal policy might actually not be contractionary
5. Only defense spending and tax cuts provide a boost to the economy
6. We’ll “turn into Greece” if we don’t reduce deficits

1. The economy’s real problem is a skills gap
2. The Federal Reserve is risking inflation in its efforts to help the U.S. economy 

The problem posed by the “fiscal cliff” is one of too much debt

Most casual observers of the budget debate (i.e., most Americans) know that self-appointed experts in the Beltway think budget deficits must be “brought under control” and that the nation is headed towards a “fiscal cliff.” So they’d be forgiven for thinking the problem posed by the fiscal cliff is one of too much debt. But, they’re wrong – the problem posed by the “fiscal cliff” is that public debt will begin rising too slowly, and the rise in taxes and (especially) cutbacks in spending will lead to purchasing power leaking out of the economy and slowing our already-insufficient economic recovery. Want to solve the actually-pressing problem posed by the cliff? Spend more.

The “cliff” is a big monolith that we either go over or we don’t

The “fiscal cliff” is, as we’ve noted, a terrible metaphor. Primarily because it implies that the problem at hand is a monolith that is either slid down or not. But the “fiscal cliff” (or as we call it, the “fiscal obstacle course,” or even “à la carte austerity”) is actually just a bundle of separable tax increases and spending cuts that are scheduled to be triggered on the first of the year. And they don’t need to be turned “off” or “on” as a group, Congress could allow the least-damaging components of the à la carte austerity to take effect as scheduled while deferring the more damaging components.

The “cliff” is mostly about the upper-income Bush tax cuts

The fate of the upper-income Bush-era tax cuts (for married couples with income more than $250,000 and single filers with income more than $200,000) is undoubtedly politically contentious and has gotten the most press attention. But in terms of slowing or boosting economic recovery in coming years, the fate of the upper-income Bush tax cuts (along with recent estate tax cuts) will have the smallest effect of any component of the coming “à la carte austerity.” In fact, the scheduled expiration of extended unemployment insurance benefits would have more than four times the economic impact that reversing the upper-income tax cuts would have, while costing about half as much.

The economy goes over the “cliff” on Jan. 1

The second reason the “cliff” metaphor is so bad is that it implies that the scheduled tax increases and spending cuts will, if left unaddressed by Jan. 1, instantly plunge the economy into recession. This is not true. If nothing is done for the first half of 2013 to counteract these contractionary measures, then the economy would indeed re-enter recession. But, with the clear exception of the unemployment insurance expirations, the impact of this fiscal restraint will be a mild (if cumulating) drag on economic growth. To be clear, the economy needs no such drag – but people should not panic into accepting bad long-term changes in policy in exchange for alleviating the danger of the cliff in coming weeks because they think Jan. 1 (or 2, or 15…) is a firm deadline. 

The debt ceiling is one of the issues that must be resolved in debates about the “cliff”

The debt ceiling isn’t a component of the “fiscal cliff” per se, but is often treated as just one more plank of fiscal policymaking that needs negotiated over. But just the existence of a statutory debt limit is terrible economic policy and the debt ceiling should be abolished, as it has become nothing but a tool for a party (in this case, the GOP) to extract policy concessions by threatening economic collapse. This policy is perhaps most similar to the Doomsday Device in Dr. Strangelove, in which a device which would trigger nuclear holocaust was created to, ironically, promote peace and stability.  The logic of the debt ceiling is equally suspect. Its flaws are numerous: it threatens the economy with collapse, weakens democratic accountability, increases the deficit, is likely unconstitutional, is completely unnecessary, and doesn’t even measure the right debt. It serves no purpose other than to scare policymakers into making desperate decisions to avoid the coming catastrophe, a situation that inevitably leads to rushed and poorly thought-out policy. In this sense, the debt ceiling is unique on this list for not only being bad policy itself but also perpetuating bad policymaking. It should be eliminated—or at least defanged—using any means necessary.

Resolving the “cliff” requires a deal on long-term debt reduction

Most policymakers realize that the immediate, concrete fiscal policy danger is that deficits will fall too quickly in the next couple of years, dragging on economic recovery. But for some reason, they remain determined to not solve this problem without also solving a theoretical, non-imminent problem of projected budget deficits far in the future (when the economy has returned to full-employment) being too large. “Stimulus now and deficit reduction later” is the mantra for this approach, which seeks a “grand bargain” to resolve the “fiscal cliff.” It’s important to realize that we’ve already locked-in substantial amounts of “deficit reduction later” in the form of the Affordable Care Act (ACA, or health reform), the largest long-run deficit reduction legislation in history. Going forward, resolving the problem of contractionary fiscal policy just requires making it less contractionary, and this is pretty simple.

Financial markets will punish us for not striking a grand bargain to defuse the “cliff”

Every now and then, those interested in maximizing the hype of the “cliff” in order to push their favored fiscal policies will try to push back on the “not a cliff” evidence-mongering. They like to claim that while the fiscal contraction is not “cliff-like” in its primary Keynesian effect of putting a slow leak in the economy’s spending power as taxes rise and public spending falls, it will be made “cliff-like” because of (cue ominous music) the “response of financial markets.” They’re not entirely wrong – but it’s not bond markets that will punish us for failing to rein in future budget deficits. Remember, the entire problem of the “fiscal cliff” is that budget deficits are going to be reined in too quickly. Instead, the problem will be stock markets falling as market participants correctly fear that an economic slowdown will occur if these deficits are reined in too quickly. It’s really important to know just what financial markets really are and aren’t “telling us” in coming weeks. 

You can’t tax the rich enough to make a dent in the deficit

One myth perpetuated particularly inside the Beltway by the crowd of “very serious people” is that taxing the rich just does not produce enough revenue to make a real dent in future deficits. This is just wrong: The share of total income claimed by the very rich is now large enough and the average federal tax rate they pay is now low enough (relative to historic benchmarks) that just returning top rates to previous levels would raise significant amounts of revenue. Further, raising rates is not the only progressive revenue option. Trust us, we have done the math on this, and, progressive revenue raising can get you wherever you need to be to close long-run budget gaps, especially if you’re willing to be smart in containing health costs as well. 

Raising the Medicare eligibility age is a good idea for deficit reduction

This idea, proffered in talks over the “fiscal cliff,” is bad in many, many ways. The simplest thing to note, however, is that it is simply a cost-shift, not a cost-reducer. That is, the federal government will pay a bit less for health care if this is implemented, but this just means that state and local governments, businesses, or households will pay more. This may be clever budget accounting, but it’s stupid economics. Worse, we know that Medicare does a better job of managing costs than the private sector, so this particular cost-shift will also cause these same costs to grow. The fact that it’s considered serious economic policy to worsen the problem of health care cost growth just to move which balance sheet these future costs show up on is the clearest signal we can get that our budget debate is unhinged from reasonable economics.

Switching to a “chained” consumer price index to calculate the Social Security cost-of-living-adjustment (COLA) is a technical improvement

This idea, also proffered in talks over the “fiscal cliff,” claims that using an arguably-better method (“chain-weighting”) for constructing the overall consumer price index for urban consumers (the CPI-U) would, if it replaced the current Social Security COLA, be a better representation of actual changes in the cost-of-living of the Social Security population. This is not true, and the reason why is simple: The basket of goods consumed by older households is different than that used to construct the “chained” CPI-U, so we have no idea at all if this chained index is actually capturing changes in their cost-of-living or not. A serious effort to improve the Social Security COLA would be to actually measure changes in the cost of the consumption basket purchased by older households and apply “chain-weighting” to this. But because this cannot be guaranteed ex-ante to result in cuts to Social Security beneficiaries, it’s not thought to be a useful thing to suggest in budget debates.

Contractionary fiscal policy might actually not be contractionary

Oh, wait. This was more from 2011. And it was wrong then. In 2012, we all agreed that Keynesians are right, that the economy needs more spending, and that having budget deficits wind down too quickly would be a bad thing, right? 

Only defense spending and tax cuts provide a boost to the economy

GOP members of Congress have generally come around to the view that Keynesian measures to boost demand are necessary in weak economies like today. However, they somehow seem to think that only tax cuts and defense spending provide such Keynesian boosts to growth. Yet research shows that tax cuts are among the weakest forms of fiscal support. And, ongoing cuts in useful non-defense public investments —like clean technology spending—will have sucked as much fiscal support out of the economy by the end of 2013 as the scheduled defense “sequesters” in that year will, if they came to pass.

We’ll “turn into Greece” if we don’t reduce deficits

The real lessons from the Eurozone crisis are pretty simple. First, countries without control over their own currency can be forced by financial markets into crises, even if their underlying fundamentals were fine. Countries with their own currencies cannot be. Second, when you have a choice, do not choose austerity. And the U.S. certainly has the option to not choose austerity.

The economy’s real problem is a skills gap

We often hear the claim that one of the reasons unemployment remains so high in this recovery is that though employers have job openings, they can’t find workers with the education and skills they need. This is wrong—the reason unemployment is high right now is because demand for workers is depressed. The unemployed currently outnumber job openings by more than 3-to-1. Further, if employers’ inability to find suitable workers were a significant part of today’s unemployment problem, you would expect to find labor shortages in some sectors. But unemployed workers dramatically outnumber job openings in every sector. Further, unemployment is significantly elevated in all major occupations relative to before the recession started. Even further, unemployment is not just elevated for worker in all major industries and occupations, it is also elevated for workers in all education groups. It is true that workers with high levels of education have much lower unemployment rates than other workers, but there has been a dramatic drop in demand for workers with even the highest levels of education. Workers with a college degree or more still have unemployment rates that are roughly twice as high as they were before the recession began. The low demand for workers across industries, occupations and education levels underscores the fact that it is not the right workers we are lacking, it is simply enough demand for work that is lagging. 

The Federal Reserve is risking inflation in its efforts to help the U.S. economy

In the second half of 2012, the Federal Reserve announced its third round of “quantitative easing” – purchases of long-term assets in an effort to lower interest rates, to allow refinancing to free up disposable income for households, and to increase inflationary expectations. Much as happened after the first two rounds of easing, critics argued that the Fed was risking a breakout of runaway inflation by too-aggressively looking to boost the economy. This is wrong; all the risks in the economy right now are in the other direction—disinflation and too-slow growth rather than inflation and economic overheating. Further, given the overhang of private debt that is the legacy of the burst housing bubble, an increase in inflation would actually boost the economy and help households “de-leverage” more quickly. In short, arguing that the Fed is risking excessive inflationwith its current policies is arguing that you think unemployment should be higher. Period.

Specifically, one would hope and expect the lame duck Senate to do nothing to compromise the authority of independent agencies like the SEC and the Consumer Financial Protection Bureau as they implement the Dodd-Frank reforms of Wall Street and the financial sector. Nonetheless, as New York Times editorial writer Teresa Tritch warns, the Senate Homeland Security and Government Affairs Committee might quickly take up and approve legislation to diminish the independence of these important agencies and many others, including the Consumer Product Safety Commission and the National Labor Relations Board.

The legislation in question, S. 3468, the Independent Agency Regulatory Analysis Act, would compel every independent agency to submit its regulatory proposals to the Office of Information and Regulatory Affairs (OIRA) in the Office of Management and Budget. This would give the political appointee who heads the office in this and future administrations the ability to delay or block agency rules which the White House finds politically inconvenient, thus subverting the purpose of having made the agencies independent in the first place.

Realizing the danger OIRA review would pose to their ability to carry out their mission, the heads of six critical financial agencies, including Mary Schapiro at the SEC and Ben Bernanke at the Federal Reserve, wrote to Chairman Joe Lieberman and ranking member Susan Collins to caution them against marking up the bill. Caution is particularly called for because no hearing has been held on the proposal, and it appears no one has fully thought through its implications for the broad range of agencies to which it would apply.

The association of state securities regulators (which by its very nature is bipartisan) also sent a letter to Lieberman and Collins opposing S. 3468. They fear that OIRA’s history of delaying agency rulemakings will be repeated with the Wall Street reforms and “could have profound, chilling effects on the ability of independent regulatory agencies to adopt rules that effectively protect the investing public.” They point to OIRA’s intervention in matters such as a health standard to protect against silicosis, an egregious example of OIRA ignoring the expert knowledge that is supposed to guide rulemaking:

“In January 2012, 300 scientists, physicians and public health experts sent President Obama a letter urging him to direct OIRA to complete its review of proposed crystalline silica regulations proposed by the Occupational Hazard Safety Administration (OSHA). At that point, OIRA had already been reviewing the proposed rule for nearly a year, despite the fact that EO 12866 limits OIRA’s authority for such review to a four-month maximum. As of October, 2012, OIRA’s review of OSHA’s proposed crystalline silica rules remains pending.”

Some of S. 3468’s supporters say they are interested only in improving the economic analyses performed by the various independent agencies. That might be a worthy goal, though there is little evidence that better economic analyses would have changed rules in any significant way. But the cost in terms of lost independence, rulemaking delays, and opportunities for mischievous lobbying by regulated entities surely outweighs any benefit of potentially improved analysis, or suggests that other ways to improve such analysis should be explored.

At minimum, all these issues deserve a full assessment that the lame duck session would not provide. S. 3468 is potentially dangerous legislation that should not even begin to be considered without appropriate hearings in the Senate where experts and affected communities on both sides can present their views, and where the many agencies that would be influenced can explore the impact of the bill on their statutes and mission.

First, it’s useful to point out that even with the “401(k) revolution,” a surprisingly small share of households ever held any significant amount of stocks. As the figure shows, at its peak in 2001, just more than half (51.9 percent) of U.S. households held any stock, including stocks held in retirement plans like 401(k)s. Furthermore, many of that 51.9 percent held very small amounts—just over a third (37.8 percent) had total stock holdings of $10,000 or more. (Read this snapshot for more on the “democratization of the stock market” that never actually happened.) And even those modest shares have since lost ground. By 2010, less than half (46.9 percent) of all households had any stock holdings, and less than a third (31.1 percent) had stock holdings of $10,000 or more.

The strong rebound in stocks since 2009 amidst persistently high unemployment highlights the disconnect between Wall Street’s financial markets and most people. The stock market simply has little or no direct financial importance to the majority of U.S. households. Since 1989, the top fifth of households consistently held about 90 percent of stock wealth, leaving approximately 10 percent for the bottom four-fifths of households. If you want to assess how the economy is performing for most households in this country, don’t look to the stock market, look to the labor market, and measures of job opportunities like employment and wage growth.

The timing of France’s HFT tax is quite apropos given Knight Capital Group’s near-fatal $440 million trading loss from a software glitch triggering a wave of unintended trades (a cash lifeline from outside investors kept the firm afloat while severely diluting existing shares). Citing computer errors marring Facebook’s NASDAQ IPO, the Associated Press  observed this week that, “Problems such as the one Knight caused last week have been occurring more regularly as the stock market’s trading systems come under increasing pressure from traders using huge computer systems.”

Indeed, remember the 2010 flash crash? In a bizarre spectacle on May 6 of that year, the Dow Jones Industrial Average—already down 4 percent for the day—abruptly plunged another 5-6 percent in a matter of minutes, hitting a floor down 992.6 points (-9.1 percent) from opening, and then rapidly rebounded. By the ring of the closing bell, the Chicago Board of Option Exchange’s Volatility Index for the S&P 500—a prime gauge of market fear—had surged 31.7 percent from the previous day’s close, the sixth-largest volatility spike this tumultuous decade. The Securities and Exchange Commission and the Commodities Futures Trading Commission later concluded the plunge was triggered when a “large fundamental trader” sold a batch of E-Mini S&P 500 futures contracts and S&P 500 SPDR exchange traded funds (two highly active financial instruments tracking stock indices) via an “automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9 percent of the trading volume calculated over the previous minute, but without regard to price or time.”

So a shoddy computer program exerted massive downward price pressure without paying attention to price signals, triggering other automated algorithmic sell orders. Ten minutes wiped out $862 billion from securities’ market capitalization and some assets were buffeted to implausibly low valuations. The Focus Morningstar Healthcare ETF, for instance, briefly plunged to 60 cents from $25.33 per share and some trades were later canceled by regulators because market pricing was so distorted. This squares with which version of the efficient market hypothesis (EMH)? (Developed by economist Euguene Fama and associated with the freshwater Chicago School of economics, the EMH essentially states that market pricing efficiently reflects all public and in some cases non-public information.) Oops.

If you’re unmoved by the near-bankruptcy of a large equities market maker or whipsaw plunges on the Dow, watch this cool visualization of HFT volumes on U.S. stock exchanges surging since 2007, via Felix Salmon. Where’s the value added in this surge of high speed, algorithmic trading—trading that can trigger a flash liquidity crisis in the stock index futures market that spills into the real stock market? In the words of Paul Krugman: “The economic value of all this trading is dubious at best. In fact, there’s considerable evidence suggesting that too much trading is going on.” Throwing a little sand in the wheels would slow trading velocity, but wouldn’t adversely affect the societally valuable side of financial intermediation: directing funds from savers to borrowers looking to finance business expansion or the purchase of a home or education. (For a more thorough analysis of the efficiency improvements and the impact on productive investment, see this report by Dean Baker, who has been championing an FTT for years.)

A broad-based FTT would effectively shut down high speed automated trading, which is pure, unadulterated rent seeking by large financial firms—activity that adds systemic risk without adding value—but even as such, it would be a cash cow. A version proposed in the Congressional Progressive Caucus fiscal year 2013 Budget for All, based on an FTT scored by the Tax Policy Center, would raise a hefty $849 billion over the next decade—a comparable sum to allowing the upper-income Bush-era tax cuts to expire. Baker and Robert Pollin reckon an FTT could raise considerably more, in excess of $175 billion annually. And as my colleague Josh Bivens noted, it’s not just a way to raise revenue, it’s an exceptionally progressive, efficient way to raise revenue. For these reasons, support for an FTT has been growing not just abroad but also in the United States, with other variations having been proposed by Sen. Tom Harkin (D-Iowa) and Rep. Peter DeFazio (D-Oregon), as well as in comprehensive budget plans produced by the Center for American Progress, Roosevelt Institute Campus Network, and Our Fiscal Security—a partnership of Demos, EPI, and The Century Foundation.

The United States could take a lesson from the French—it’s time to raise some revenue and restore some sanity to financial markets run amok by lightly taxing financial transactions.