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Thursday, January 29, 2009

Stimulus Economics and Reality

The Obama honeymoon didn't last long, did it? Exactly one week. From January 20 to January 27, 2009. The only question is who had a larger role in ending it -- Congressional Republicans like Senator John McCain and Representative John Boehner who publicly encouraged Republicans to vote against the current draft of the stimulus plan or House Democrats who tacked on small ("small" being a relative term in an $819 billion bill) but inflammatory spending items not directly focused on "jobs" or "economic relief."

President Obama and supporters of the stimulus plan believe it's the best (or maybe least worst) approach for immediately increasing cash flowing through the economy to slow down job losses while trying to focus a significant portion of the spending on things we should be spending money on and WILL be spending money on eventually anyway. Opponents believe the bill already resembles routine "Christmas tree" spending bills of the past twenty years and has too high a portion of spending not directly tied to the core goal of the legislation. Many opponents believe the bill should spend less and reduce taxes more to encourage private industry to reinvest in businesses and retain jobs.

Who's right?

No one. Yet.

Economics

Most of the debate around the methods and structure adopted by any stimulus plan centers around the timing of the stimulus, who is likely to benefit from the stimulus spending and what the spending is intended to produce. It's more productive to cut through the political posturing and just do some simple math to confirm how pointless the arguments over spending versus tax-based stimulus are.

Let's start with a few numbers:

* size of the September 2008 Troubled Asset Relief Program = $700 billion
* current size of the proposed 2009 stimulus plan = $819 billion
* 2008 gross domestic product = $14,330,000,000,000
* total number of American citizens = 303,824,640
* total number of American households = 105,480,101
* total number of American tax filers = 146,442,000 (#1)
* total number of full-time workers = 154,648,000 (#2)
* current unemployment rate / unemployed = 7.2 percent / 11,134,656
* median household income = $50,233 (#3)
* total value of home mortgages = $10,570,000,000 (#4)
* total number of mortgage foreclosures for 2008 = 2,300,000 (#5)
* combined mortgage delinquency / foreclosure rate = 9.16% (#6)
* total 2008 existing home sales = 4.9 million (13 percent lower than 2007) (#7)
* number of unsold homes on the market = 3.9 million (#7)
* median home sale price in 2008 = $175,400 (down 15.3 percent from 2007) (#7)
* December 2008 new home sales dropped 15 percent from 12/2007
* December 2008 existing home sales rose 6.5 percent from 12/2007 to an annual rate of 4.74 million (395,000 units monthly) (#7)

To understand the limits of the mechanics of any stimulus plan, one first has to understand the current state of American households targeted by the plan. From a housing standpoint, the very nature of the sub-prime mortgage problem indicates borrowers caught in that trap

a) could not afford normal mortgage terms,
b) had little or no equity in the home at the time of loan origination
c) likely owe 20 to 30 percent more than the home is now worth, and
d) likely have ZERO savings after burning through them making payments up until defaulting

In short, households in this predicament have ZERO margin for error. Any job loss in the household virtually assures a mortgage default and another existing home added to a nine-month backlog of inventory, further depressing home prices and curtailing demand for new home construction. Since the current household savings rate is negative, other households not currently facing the loss of a home might if they suffer a job loss. In short, most households have NO cushion with which they can hang on while stimulus dollars are being primed in the pump if they are put on the bubble.

One question commonly asked by virtually everyone (either rhetorically or seriously) is "why doesn't the government just give the bailout money to individual Americans instead of giving it to banks (via TARP) or corporations (via tax cuts) or state / local governments (via stimulus spending)?" Anyone posing this question seriously doesn't grasp the mismatch between the size of the solutions being proposed and the size of the credit overextension now crippling the economy.

How much "relief" would the TARP program have provided if paid directly to individual Americans instead of banks? $700 billion divided among the entire population amounts to $2304. If paid to every full time worker, it amounts to $4526. That's barely more than one month of median household income or maybe three mortgage payments. If that $700 billion in TARP money was aimed only at the currently unemployed, it would amount to $62,866 or roughly 15 months of median household income. If unemployment hits 10 percent, the $700 billion would amount to $45,264 for each of the 15.46 million unemployed workers or 10.8 months of median level income.

The math behind the proposed stimulus plan is actually far less impressive. Though discussed as an $819 billion dollar plan, the "plan" for the stimulus actually involves roughly $400 billion in expenditures over two years -- an immediate halving of the impact. In addition, the current plan (as of January 29, 2009) calls for roughly $275 billion of the plan to provide tax relief which immediately turns any rational discussion of the plan into a religious debate.

The absolute quickest way to provide tax relief at the consumer level is in the form of a rebate check. Unfortunately, numerous studies indicate in desperate times, the larger the check, the larger the likelihood that tax payers save it rather than spend it, which does no good from a stimulus standpoint. The most effective approach for getting taxpayers to spend more is for credits to be spread out over a longer period of time so recipients subconsciously view it as part of their stable pay rather than a one-time windfall. Providing the credit by slightly reducing payroll withholding would be ideal but, unfortunately, that is very costly and time consuming for businesses and would take months to implement, delaying the impact of the stimulus.

Perhaps the most important point about tax stimulus aimed at individuals as job stimulus is that it diffuses the impact across all taxpayers instead of focusing it at the margin on those who lost their jobs or those on the cusp of losing a job. Assuming the $275 billion in tax relief is split 50/50 between individuals and businesses, the individual tax break might amount to $939 per tax filer but remember, this is a two year plan so that's really $469 per year per filer. Woooooooooowwww. That'll really stoke the fires of economic recovery.

What about tax relief at the business level? Since the number of full time workers is greater than the number of tax filers, the per-worker average benefit of the business portion of the tax stimulus is even less than $469 per year per worker. If the stimulus comes in the form of special capital investment tax breaks, the tax benefit can only be captured

1) if the business can find an eligible capital asset related to the business
2) if the eligible asset is needed at the current time in a market with depressed sales
3) if the business can find a bank to loan it money to buy the asset (if it's expensive enough)
4) if the business is still in business at the end of each tax year to file for the credit
5) if the business actually has taxable income (assuming the benefit is a deduction, not a credit)

That's a lot of ifs. It's possible to cut through the ifs by examining recent tax cut history. The tax cuts of 2001 provide a useful recent case study of the net impact of corporate tax cuts on job creation and overall tax payments. According to studies issues by the Economic Policy Institute, roughly 4.3 million jobs were expected to be created in the first year after the 2003 tax cuts but only 1.6 million were created. (#8) Another group, Citizens for Tax Justice, analyzed tax write-offs taken by 275 corporations between 2001 and 2003 and their associated capital investment over the same period. Curiously, the 25 firms with the largest write-offs reduced their investments by 27 percent when capital investment in the overall economy only dropped 7 percent over the same period. (#9)

Is the spending side of the $819 billion dollar plan any better? The spending is aimed in part at plugging a gaping hole in GDP produced by collapsing car sales, collapsing construction work, collapsing demand for durable goods to go in the homes that aren't being built, etc. How big is that hole? If you assume the economy might actually shrink between 0.5 and 1.0 percent, that's a gap of $71 to $143 billion in a $14.33 trillion dollar economy. (#10) Of course, we need the economy to GROW a more respectable 2 percent or so to produce jobs which means we actually need roughly 3 percent of current GDP to put us back on a +2.0% growth plane. That's $430 billion in stimulus per year. The spending portion of the $819 billion dollar plan only amounts to $544 billion -- over TWO years. That's $272 billion per year or only 63 percent of what's likely to be required.


Reality

The reality is that the spending of the stimulus plan does nothing to address the short term or long term issues posing the greatest risk to the economy and its eventual turnaround. In the short term, the timing of the spending does not allow enough dollars to magically materialize from nowhere and circulate through the economy to boost economic activity in key sectors most at risk for job loss. When the normal lag between ACTUAL economic activity and improvement and PERCEIVED economic confidence on the part of consumers is factored into the analysis, the sweet spot of benefit from the spending is obviously far beyond the desired window, which is NOW.

The reality is that the tax cut side of the stimulus plan will likely provide even LESS help in saving jobs or increasing economic activity over any period of consideration. For taxpayers who manage to hold onto their job, a lump sum tax credit is likely to go into the savings account and stay there while they worry about keeping their job. For taxpayers who lose their job, the lack of household savings is highly likely to produce mortgage defaults or a personal bankruptcy, at which point a $939 credit will probably not even cover legal fees.

In the long term, nothing in the $819 billion dollar stimulus plan or the payout of the second $350 billion dollars of the September 2008 TARP disaster does a single thing to correct the root causes of the financial meltdown. Perhaps the most disturbing trend in the debate over solutions to the crisis is that virtually none of the debate even mentions the root causes. When the causes are discussed, they are always "complex" and "multi-faceted" and obviously far too sophisticated in nature for us rubes to understand. The crisis is "unprecedented", just trust us, we're professionals.

This is rubbish.

Any college degree program in economics includes classes on Money and Banking which explain the mechanics of fiat money, fractional reserve banking and their relationship to spending, inflation and macroeconomic output. They also cover the evolution of America's banking systems (there have been several) and the crises that triggered adoption of major changes or complete re-inventions of the system. The curriculum of these courses hasn't changed much in 20 years. Here are two textbooks used in actual college courses, one from 1986 and one from 2006:

Financial Crises: Understanding the Postwar US Experience
by Martin Wolfson (#11)

The Economics of Money, Banking and Financial Markets
by Frederic Mishkin, (#12)

The current meltdown began with a curious case of "vapor lock" on August 9, 2007 when inter-bank lending ground to a halt over seemingly nothing, requiring an intervention by the Federal Reserve that exceeded the emergency efforts taken after the terrorist attacks of September 11, 2001. (#13) Since then, many experts and policy makers claimed the current meltdown is the equivalent of a 10,000-year flood and is primarily due to "unprecedented" leverage built upon mortgage backed securities via credit default swaps. Unprecedented, unless you page through virtually any economics textbook and spend ten minutes reading about the Panic of 1907. In that episode, a consortium of investment trusts which had conspired to corner the market on one stock on margin failed to achieve their goal, caused a massive drop in the stock market which triggered a cascade of margin calls on other investors which then triggered runs on banks and another set of losses for speculators who had taken out bets on stocks -- not actual positions IN the stocks, just bets on their performance -- and lost their shirts.

Those bets weren't LIKE credit default swaps. They WERE credit default swaps. The bank panics produced by the crash and the realization that relying on a single private banker -- J. P. Morgan -- as the lender of last resort for two consecutive national panics (1893 and 1907) led to the formation of the Federal Reserve Bank. Regulators and legislators at the time also had the wisdom to realize the rampant gambling on stock prices and other financial numbers not only magnified the speed and depth of the downturn but served no legitimate business purpose in the first place. As a result, virtually all states across the country passed laws outlawing any contracts or speculation on individual stocks or financial instruments.

Credit default swaps remained illegal in most states until the Federal government passed the Commodity Futures Modernization Act of 2000. That legislation not only eliminated a dispute between two regulatory agencies over authority regarding futures contracts (apparently both agencies agreed NEITHER agency would pay any attention…) but it explicitly nullified any state laws restricting futures contracts and credit default swaps. This will probably surprise no one in America at this point but the Commodity Futures Modernization Act was subjected to exactly ZERO debate in the House or Senate and only took seven days from introduction in the House and Senate to a Presidential signature. (#14) Think about that for a moment before we continue.

* Zero debate
* Seven days from first draft to law
* Economic free-fall within eight years of passage
* Over $50 trillion in unregulated credit default swaps outstanding

Coincidence?

The Commodity Futures Modernization Act of 2000 is easily the worst parting gift ever bestowed upon the American public by a Lame Duck Congress and Lame Duck President.

What's Missing?

Despite the dire signs of increased economic trouble, there are some rather fatalistic Americans who believe absolutely nothing has a prayer of stopping the freefall so the government shouldn't try anything. Just get the collapse over with and pick up the rubble afterwards. The above critiques about limitations of the current plan are in no way intended as an argument for doing absolutely nothing on the spending or tax front. If the fatalistic argument turns out to be true, it won't really matter which failed approach we try before the big "Ctl-Alt-Del" of the economy and our society occurs.

On the other hand, no real turnaround in the economy is likely to begin until investors regain confidence in the stability and transparency of financial institutions to provide capital that can provide liquidity to boost lending for legitimate investment. What would instill confidence?

1) a de-emphasis on mega-banks and new limits to prevent any additional consolidation of mega-banks
2) tighter regulation on credit default swaps and similar speculative instruments and eventual elimination of them
3) increased funding for regulatory agency staffing and training
4) criminal investigations into and prosecutions of fraud in ratings agencies, banks and hedge funds

I'm not holding my breath.


==========================

#1) http://www.irs.gov/pub/irs-soi/07ifss24.xls

#2) http://www.bls.gov/news.release/empsit.nr0.htm

#3) http://www.census.gov/Press-Release/www/releases/archives/income_wealth/012528.html

#4) http://www.federalreserve.gov/releases/z1/Current/z1r-4.pdf (see table L.218 Home Mortgages)

#5) http://www.bloomberg.com/apps/news?pid=20601068

#6) http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm

#7) http://www.nytimes.com/2009/01/27/business/economy/27econ.html

#8) http://www.cbpp.org/8-25-04tax.htm

#9) http://www.ctj.org/pdf/obamastimulus.pdf

#10) https://www.cia.gov/library/publications/the-world-factbook/geos/us.html

#11) http://www.amazon.com/Financial-Crisis-Understanding-Postwar-Experience/dp/0873327497

#12) http://www.amazon.com/Economics-Banking-Financial-Markets-MyEconLab/dp/0321200497

#13) http://watchingtheherd.blogspot.com/2007/08/financial-markets-running-on-empty.html

#14) http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000

Tuesday, January 20, 2009

Anticipation, Relief and Atonement

Normally, inaugurations serve as a mechanism of literally and symbolically passing the baton to a new President. Though the process has (sadly) occasionally taken place under dire, emergency circumstances, it normally comes with a sense of positive anticipation of the future -- anticipation of a chance to continue moving forward with policies that appear to be working or anticipation of a chance to try something else, even if the status quo is good.

The Inauguration of a new President and the peaceful transition of power is perhaps the most majestic "sacrament" of our civic religion and is an awe-inspiring event under any circumstance. However, it is no literary exaggeration to say the Inauguration of Barack Obama as the 44th President of the United States of America reflected a singular event in the history of the country. The event and the coverage reflected all of the normal forward-looking anticipation of inaugurations that preceded it but that sense of normalcy vanished any time the wide-angle camera views looked down the Mall at miles and millions of citizens packed in to see or hear the event.

The crowd assembled for the Inauguration was stated to be the largest gathering ever held within Washington D.C. -- a city with many opportunities to set records for crowds. Obama's place in history has already been secured by becoming the first African-American President. From the comments of people throughout the country of every race and creed, Obama's second claim on a place in history may arrive twenty two years from now. Tens of millions of children witnessed today's Inauguration and saw every excuse for "won't" or "can't" or "why bother" eliminated in front of their eyes. One young boy interviewed by a reporter in Chicago said words to the effect of this: "He's not Superman, if he can do it, there's no excuse for me not to be able to do it." Note the young boy didn't arrogantly say "if he can get there, I can get there", as though he deserves success. The young boy said "there's no excuse" for him not to achieve his goals. If millions of children truly internalized the example of Obama's achievement, our country has much to hope for in the coming years.

It seems that millions might not have shown up to stand for eight hours in 19 degree weather or watched on TV merely to watch someone eliminate a racial barrier or confirm the possibilities of a new approach to political organization and communication. In very real terms -- with zero exaggeration -- the racial barriers eliminated by Obama's Presidency may not be the largest problem facing the country. Final poll numbers reflected 22 percent approval ratings for the outgoing President at a time of tremendous financial peril. Markets in the US traded down over 4 percent due to continued concern about the stability of banks both in Britain and the United States. Quite frankly, record crowds may have showed up with or without Obama as the star of the show -- simply out of a sense of relief at seeing the arrival of the end of such a disastrous period of leadership that dug the hole in which we now find ourselves.

The Inauguration speech itself was effective at balancing the odd combination of anticipation and relief by bringing in a third dynamic -- one of atonement. Most of the problems we face right now have nothing to do with outside forces, be they Islamic terrorists or low-wage manufacturing in China. Many are stamped "Made in USA" -- crumbling schools, collapsing bridges, inadequate regulation of financial institutions and uncontrolled "entitlement" spending. Normally none of these would constitute existential problems that could threaten the very existence of the country. Unfortunately, our country has not been operating "normally". Primarily because of the ignorance and inattention of We The People, the checks and balances of our government have been tampered with or disabled entirely and allowed what should have been transient problems to mushroom into existential problems. Obama's comments below eloquently identify the flaw in our past thinking and the balance required to correct it:

---------------------------
What the cynics fail to understand is that the ground has shifted beneath them - that the stale political arguments that have consumed us for so long no longer apply. The question we ask today is not whether our government is too big or too small, but whether it works - whether it helps families find jobs at a decent wage, care they can afford, a retirement that is dignified. Where the answer is yes, we intend to move forward. Where the answer is no, programs will end. And those of us who manage the public's dollars will be held to account - to spend wisely, reform bad habits, and do our business in the light of day - because only then can we restore the vital trust between a people and their government.

Nor is the question before us whether the market is a force for good or ill. Its power to generate wealth and expand freedom is unmatched, but this crisis has reminded us that without a watchful eye, the market can spin out of control - and that a nation cannot prosper long when it favors only the prosperous. The success of our economy has always depended not just on the size of our Gross Domestic Product, but on the reach of our prosperity; on our ability to extend opportunity to every willing heart - not out of charity, but because it is the surest route to our common good.

---------------------------

A sense of atonement is very appropriate for a day of transition like January 20, 2009. Our government is US and we have created many of the problems we face. It is now up to us to take responsibility and begin a new effort to correct them.

Perhaps the most fitting part of the entire day was the musical performance of Yo-Yo Ma and Itzhak Perlman, who played an original composition immediately before the new President took the oath of office. The piece was both beautiful and haunting -- a musical metaphor for the civic miracle of a peaceful democratic transition and the challenges facing both the new President and We the People.

============================

#1) http://cbs4.com/campaign08/inauguration.presidential.address.2.913014.html

Sunday, January 18, 2009

Mis-Adventures in Big Box Retailing

Any time a firm goes down in flames destroying billions of dollars as it goes, there are lessons to be learned. One of the highest profile business failures for the week ending January 17, 2009 was Circuit City which announced a complete liquidation of all of its stores and the eventual elimination of nearly 34,000 jobs. (#1). Circuit City's failure could provide enough material for a semester course in an MBA curriculum, assuming of course MBA students were any more capable of learning from colossal failures than the public at large. The outline of the syllabus for Mis-Adventures in Big-Box Retailing 101 might look like this:

I. The Triumph of Branding Over Reality (NOT)
II. Pay For Performance (NOT)
III. Everybody Wins with TIFs (NOT)
IV. The Real Lesson


The Triumph of Branding Over Reality

Circuit City's annual report issued in April 2008 (#2) mentioned major efforts undertaken to:

* equip associates with notepad computers to better assist customers
* rapidly expand "the city" concept for new stores with glitzy oak floors and bold red and black color schemes
* continue emphasizing the "firedog" brand for in-home support of complex home theatre / PC installations

Anyone remotely familiar with the customer experience in virtually any Circuit City store over the past five years is probably laughing as they read this. In March 2007, virtually all of the firm's commissioned senior sales staff -- over 3400 -- were laid off in an effort to lower its pay structure and cut costs. In an environment with dropping sales and inexperienced staff, the least of the company's problems was the lack of notepad computers for staffers to use in looking up prices or answering questions.

The reality was nearly every store provided a poor customer experience because of poor integration in its inventory systems which produced different prices between the web and store and even hampered pick-up of products ordered on line after verifying in-store availability. The company apparently had a plan for that as well. It outsourced much of its back-office systems in an IT services arrangement with IBM and attempted to redesign its web portal so the web site was laid out like its newly designed stores. That way, if you couldn't find something in the store, you could go online and struggle to find it there and STILL not have it waiting at the store after buying it online. Again, management focused on 'expense" rather than the underlying problems with service and functionality. But man those new empty stores really made a bold branding statement.


Pay for Performance

While Circuit City was taking "a number of aggressive actions to improve (its) cost and expense structure" in 2007 by canning all of its competent sales staff, the executive team not only managed to escape pay cuts, they actually came out ahead. Way ahead. After the new CEO Schoonover replaced CEO McCullough in 2006, dollars tossed at the CEO of Circuit City nearly doubled. The insanity of that pay plan becomes more stark after comparing annual reports and proxy statements of Circuit City side by side with those of its arch-rival, Best Buy. (See #3, #4 and #5)


FY2006 FY2007 FY2008
BB Net Sales $30,848,000,000 $35,934,000,000 $40,023,000,000
BB earnings $ 1,140,000,000 $ 1,377,000,000 $ 1,407,000,000
BB CEO pay $ 2,330,674 $ 5,596,904 $ 3,596,873

CC Net sales $11,744,000,000 $12,430,000,000 $11,514,000,000
CC earnings $ 147,000,000 ($ 10,000,000) ($ 321,000,000)
CC CEO pay $ 3,654,701 $ 6,954,948 $ 6,516,568

* CC changed CEOs during 2006 and total compensation of the two
was $3.65M


Note that in each year, Best Buy recorded increased profits. Note that in each year, Circuit City recorded larger LOSSES. Finally note that in each year, Circuit City paid more in compensation to its CEOs than Best Buy paid its CEO. Schoonover finally resigned in September 2008 (halfway through fiscal year 2009) but took home $1.8 million in severance. Oh yea. He also gets two years of health care benefits and $50,000 in placement services. Of course, the insanity of the Circuit City board may pale in comparison to that of traders on Wall Street. From January 2004 to June of 2006, Circuit City's stock actually grew 183 percent (from $10.70 to $30.39) while Best Buy peaked at $56.66, a gain of only 62 percent which vanished in October of 2008.


Everybody Wins with TIFs

Most of its customers would like to forget Circuit City as a shopping experience as soon as possible. However, the firm will leave behind roughly 668 cavernous, hulking stores that will serve as an unwanted, lasting reminder of the firm. At a time when the retail sector is likely to shrink 8-10 percent, the abandoned Circuit City locations will have virtually zero value to any other retailer or the REITs that own the space. The more crucial part of this story is that REIT investors won't be the only parties financially hurt because the big box model for retailing used by Circuit City, Best Buy, Wal-Mart, Costco and Towels-R-Us is hugely dependent upon public subsidies for profitability.

Think for a moment about virtually every big box development you've seen:

* big-box stores don't fit just anywhere
* big-box stores need 20,000 to 40,000 square feet for the store
* big-box stores need high volume which means lots of customers which means lots of additional parking
* big-box stores like company and often co-locate with similar big-box stores
* massive stores and massive parking lots require major road improvements and major development or re-development
* major development or redevelopment means the public must help

And help the public does, in the form of tax increment financing (TIF) programs which shower developers with discounted or free road and storm water improvements required by acres of paved parking and reduced property taxes for many years (10 to 20 is the norm). Often local communities are abusing eminent domain statutes to clear land of existing businesses or homeowners to make room for the big guys to come in.

Developers tell local governments that start-up costs of big stores require a little help getting started but property tax abatements and road/sewer improvements will be more than offset by increased sales tax revenue and increased employment. Local governments swallow the lie and pass it along to voters by elaborating that the beauty of the scheme is that the draw of the stores will be so great that most of the extra tax revenue will be paid by citizens in surrounding communities so that "The Galleria" or "The Commons of Consumerism" or "The Mall of Mediocrity" will virtually pay for itself and local citizens will enjoy the added benefit of not having to drive so far to buy towels from a store that stacks them 30 feet high.

Again, the theory sounds good but the reality is vastly different. The reality is that, even when the stores succeed, the larger community often sees zero net increase in tax revenues because the stores are merely bleeding off sales from other stores, many of them big-box developments from 10-15 years ago. (In my neighborhood, a Circuit City store vacated a strip mall location built in 1994 for a new store built in 2007 six miles away. A Best Buy location moved from a store refurbished in 1997 to a new location four miles away built in late 2008 with TIF incentives and eminent domain. Irony of ironies, the eminent domain partly involved pushing out an established car dealer who moved elsewhere and probably now wishes he just went out of business.) When the stores fail, they may lie vacant for years producing no rents for their REIT owners, no sales tax revenues for their local patron governments and no jobs for local citizens.

Equally likely, many may be torn down because other businesses are growing acutely aware of the fatal flaws of the big box model. Big-box construction styles create enormous fixed expenses for a business in the form of heating and cooling bills for the buildings -- most of which are little more than piles of concrete blocks with tin roofs and florescent lights (and of course the white oak floors and bold red and black "branding"). Since most big boxes don't just look like warehouses but actually serve as warehouses, the big box model proves quite risky in markets selling "perishable" items, whether they are clothes that go in and out of style or electronics that become outmoded or cheaper every few months.


The Real Lesson

It's tempting to look at the collapse of Circuit City as a case study in bad marketing, bad execution and bad capital planning by a single business. However, Circuit City's story will be common in the weeks and months ahead which indicates its situation merits a more careful review from a macroeconomic perspective. Circuit City didn't just cling to life for the past few years, it continued expanding its footprint despite YEARS of concrete evidence many customers despised shopping at its stores. In an "efficient market" for management talent and capital, rapid growth all the way to a cliff followed by a complete collapse might be possible for more illusory "products" like banking, investing and insurance where "the product" often is a promise of future, deferred value. In retailing, where stores interact millions of times daily with customers providing tangible goods, such a pattern of steady growth to collapse should be next to impossible. If lenders and investors know customers are turning away, routine statistics should point out the folly of chasing declining profits with more dollars.

So how did Circuit City happen? Circuit City's collapse points out a much bigger problem with the strategies governments and business have pursued for the past decade. In a nutshell, the meltdown in retailing is in large part due to flawed tax schemes and misguided monetary policy that have artificially reduced tax rates and interest rates that have distorted the normal "creative destruction" that weeds out flawed businesses from the herd. Those policies produce particularly distorting incentives in the niche of business models occupied by big-box retailers, in particular those focusing on expensive but "perishable" goods like electronics.

If you were investing in a business on the ground floor and were acting as an angel investor in the firm, there are five key questions you would want to ask the prospective entrepreneurs about their business plan:

Financial Capital -- How much money does it take to enter and stay in the business? For businesses like utilities, vast amounts of money are required to enter the business, producing an enormous barrier to entry which improves profitability. However, if the product or service involved is not itself a proven commodity, those financial outlays are huge risks.

Intellectual Capital -- How much brain power does it take to enter and stay in the business? Even if financial capital barriers to entry are small or non-existent, if competition in an industry requires special expertise only available to a limited number of people and you don't have access to those people, entry is virtually impossible, creating opportunities for higher profits for the incumbents or an impossible hurdle for a competitor.

Product or Service Complexity -- Is the product or service at the heart of the business complex or simple? Is it new (and unfamiliar) or existing (and well-understood)? Too much complexity may make every sale a "one-off" preventing any economies of scale from contributing to profitability. Just the right amount of complexity can allow some economies of scale to help profitability while supporting an intellectual barrier to entry that stifles competition. Very simple products or services can be cloned easily by other competitors, lowering margins and profitability.

Delivery of the Product or Service -- Does the product or service require a hands-on experience to close a sale or support the product after the sale? Products which are safely, conveniently transportable and well understood in the market lend themselves to centralization and economies of scale. Products and services not well understood (complex electronics, computers, appliances, some clothing) that require a hands on factor to seal a deal or after-the-sale support resist centralization, producing challenges to economies of scale and staffing.

Labor Costs -- Are the people required to run the business highly trained and rare to find (and thus expensive) or does the product or service simple enough to allow lesser trained, more readily available labor to make, deliver and support the product or service? Using highly trained labor to sell low price, low-margin products doesn't make sense. Attempting to use low-wage labor to sell expensive, "perishable" products doesn't make sense either.

Highly profitable large businesses tend to the following combinations of these factors:

* high financial capital, moderate intellectual capital, low service complexity, local delivery, low labor costs (utilties)
* low financial capital, high intellectual capital, high service complexity, central delivery, moderate labor costs (software)

Less profitable but viable smaller businesses tend to the following combinations of these factors:

* high financial capital, low intellectual capital, low service complexity, local delivery, low labor costs (grocers)
* low financial capital, moderate intellectual capital, high service complexity, local delivery, moderate labor costs (lawyers, accountants)
* low financial capital, low intellectual capital, low service complexity, local delivery, low labor costs (barbers, lawn care)

Now think of the combination of factors Circuit City was attempting to deploy in its business:

* high financial capital -- in the form of expensive, oversized stores and expensive inventory
* low intellectual capital -- clearly no one in the management of Circuit City was in MENSA
* high complexity products -- electronics and over-accessorized appliances with short product life cycles
* local delivery -- complex products required good in-store support for sales and service
* low labor costs -- 3400 high-performing salesmen were fired because anyone can sell a $1200 television or $2000 washer/dryer set

For a firm with vast capital expenditures and expensive, complicated, rapidly outmoding product lines, the attempt to operate the business with sub-par management and under-qualified labor was virtually guaranteed to fail. Yet, as stated earlier, the firm continued to build more monster stores almost until the day it collapsed.

Why?

At the most macroeconomic layer, Circuit City survived as long as it did because

1) artificially low interest rates made big ticket items artificially more affordable on credit
2) artificially low property taxes subsidized construction costs of many big-box stores and distorted the long term profitability of the big-box model

The real lesson from Circuit City's collapse is that artificially low interest rates and artificially low taxes do NOT produce sustainable economic growth. The combination of low interest rates and low taxes actually creates a perverse set of economic incentives for business to attempt to operate in the "no man's land" of business strategies which can only succeed in the best of times with all economic cylinders firing smoothly. Such firms barely have enough profitability inertia to survive in normal downturns. In the type of financial rip tide hitting us now, such businesses have zero chance of survival and their sudden, complete collapses magnify the impact of the downturn that capsizes them.

Taxes and interest rates act as a brake on economic activity, as millions of "pro-business" advocates will tell you. However, when you consider that not all economic activity is truly viable over a full business cycle and some models are uniquely prone to bubbles followed by drastic collapses, the philosophical and strategic question becomes more challenging. This isn't to say federal, state and local government policies should try to pick winners by manipulating taxes and interest rates to provide a BARRIER for businesses not deemed worthy to enter the field. However, federal, state and local governments need to be VERY aware of the fact they are already intervening on the other side by manipulating taxes and interest rates which SUBSIDIZE huge businesses with well established strategic and operational flaws.

Circuit City is merely the latest poster child of the fruits of that manipulation. More examples are on the way.

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#1) http://www.circuitcity.com/closed.html

#2) http://newsroom.circuitcity.com/secfiling.cfm?filingID=1193125-08-93063

#3) http://library.corporate-ir.net/library/83/831/83192/items/294174/051508Proxy.pdf ( Best Buy 2008 proxy)

#4) http://library.corporate-ir.net/library/83/831/83192/items/246554/bby_2007proxy.pdf (Best Buy 2007 proxy)

#5) http://investor.circuitcity.com/downloads.cfm (Circuit City reports)

Thursday, January 15, 2009

Applause at a Wake?

I just finished watching President Bush speak at the requiem for his own Presidency. (#1)

The meat of Bush's address boiled down to this paragraph:

Over the past seven years, a new Department of Homeland Security has been created. The military, the intelligence community, and the FBI have been transformed. Our nation is equipped with new tools to monitor the terrorists’ movements, freeze their finances, and break up their plots. And with strong allies at our side, we have taken the fight to the terrorists and those who support them. Afghanistan has gone from a nation where the Taliban harbored al Qaeda and stoned women in the streets to a young democracy that is fighting terror and encouraging girls to go to school. Iraq has gone from a brutal dictatorship and a sworn enemy of America to an Arab democracy at the heart of the Middle East and a friend of the United States.

These points sound so good you WANT them to be true but reality says otherwise. Despite billions spent shuffling deck chairs between federal agencies to form the Department of Homeland Security, America still lacks a unified radio communication system for first responders, a problem flagged as one of the key barriers to a more effective response on September 11, 2001. The military, intelligence community and FBI have been "transformed" yet Rumsfeld's fantasy of an outsourced, right-sized, high-tech, remote control strike force in Iraq failed to achieve Goal #1 of any war -- secure the territory -- and produced a descent into anarchy that trapped us in a five-year conflict. An intelligence community that ignored information we had about Arab nationals taking flying lessons with cash payments and no interest in landing still wasn't transformed enough to properly analyze and reject trumped up intelligence about WMD capabilities Iraq did not possess. The FBI and Justice department were transformed by one Attorney General who approved wholesale illegal wiretaps and a second Attorney General who politicized daily operations of the Justice Department.

Like his partner in war crime -- Dick Cheney -- George Bush stuck to the talking points of his internal dialogue that helped justify all of the bad advice he accepted and the good advice ignored that didn't fit his image of a "leader" willing to make the "tough choices". Here's the exact quote:

Like all who have held this office before me, I have experienced setbacks. There are things I would do differently if given the chance. Yet I have always acted with the best interests of our country in mind. I have followed my conscience and done what I thought was right. You may not agree with some tough decisions I have made. But I hope you can agree that I was willing to make the tough decisions.

News flash to Mr. Bush and all future Presidents. The American people don't give a **** about making "tough decisions" -- we care about making the RIGHT decisions, whether they're easy or tough. If you had made a few more RIGHT decisions, you would have had fewer TOUGH decisions to make.

Maybe the oddest part of the short address was the round of applause from the hand-picked audience at the beginning. I thought applause at the beginning of such a somber occasion was awkward -- a bit out of place. Then again maybe the attendees were as excited to watch the end of George Walker Bush's reign of error as roughly two thirds of the rest of us are.

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#1) http://www.cbsnews.com/stories/2009/01/15/politics/bush_legacy/main4726092.shtml

Wednesday, January 14, 2009

Exit Interview with a Vampire

A final "exit interview" of Dick Cheney was aired on The NewsHour on January 14, 2009. (#1) Topics ranged from the wars in Afghanistan and Iraq, the war on terror (TM), adventures in economic crises and that special relationship between the Presidency and We the People. Of course, none of Cheney's comments on any of these topics are surprising in the least. When printed out in black and white and held up against the headlines of January 14, 2009, however, the contrast between reality and the fantasy world Cheney inhabits borders on the pathological.

Early in the interview, Jim Lehr asked Cheney about mistakes made in his role as Vice President. Cheney responded by citing assumptions about the ability and willingness of the Iraqis to hop onto their feet and take control of their country after our heroic toppling of their dictator as a mistake. Lehr asked a followup:

Is it fair to say the miscalculation resulted in the chaotic situation that existed immediately after for a while , immediately after the invasion?

I can't say that, I can't link those two particular points. What I can say is I think if we had been able to move more rapidly to stand up a government that was capable I think we might have avoided some of that but I don't want to blame all that on the Iraqi government - it was a difficult situation but It was successful. We now find ourselves in a situation where 5 years later we've achieved most of the objectives that you would have set out when we set out in the spring of 2003 when we launched into Iraq.. We've got the violence level down to its lowest level since 03, we've had three national elections, a constitution written, a new government stood up, a new army recruited and trained, the Iraqis increasingly able to take on responsibility for themselves, and we've now entered into a strategic framework agreement with the new Iraqi government that will provide for the ultimate withdrawal of US forces. You could not have asked for much more than that in terms of the policies that we started on in 03.

Mr. Vice President, getting from there to here, 4500 Americans have died, at least one hundred thousand Iraqis have died. Has it been worth that?

I think so. I believed at the time that what Saddam Hussein represented was -- especially in the aftermath of 9/11 - was a terror sponsoring state -- so designated by the state department -- he was making payments to the families of suicide bombers., he provided a safe haven and sanctuary for Abu Nidal and other terrorist operations, he had produced and used weapons of mass destruction -- chemical and biological agents -- he had a nuclear program in the past, he had killed hundreds of thousands of his own people and he did have a relationship with Al.Queda. We've had this debate and people keep trying to conflate these arguments. That's not to say Saddam was responsible for 9/11. It is to say -- as George Tenet, CIA Director, testified in open session of the Senate -- that there was a relationship there that went back ten years. This was a terrorist sponsoring state with access to weapons of mass destruction and that's the greatest threat we faced in the aftermath of 9/11 with the next time we found terrorists in the middle of one of our cities, it wouldn't be nineteen guys armed with airline tickets and box cutters, it would be terrorists armed with a biological agent or maybe a nuclear device. So I think given the track record of Saddam Hussein, I think we did exactly the right thing, I thing the country is better off for it today. I think it's been part of the effort, alongside Afghanistan, to liberate 50 million people and establish a vibrant democracy in the heart of the Middle East. I think those are major, major accomplishments.

On the same day Cheney is citing "accomplishments" in a pre-emptive war of choice based on demonstrably and utterly false intelligence,

* the Pentagon confirmed a 9/11 suspect was tortured and his case will never be prosecuted (#2)
* factions within a party that won power in an election America promoted are firing rockets into Israel and giving Israel an excuse to return fire through innocent Gaza civilians
* Osama bin Laden released a new tape, confirming $588 billion haven't silenced the man who launched the "war on terror" (TM)
* despite promises of a drawdown in Iraq, net deployments of US troops will RISE as America attempts to catch up in the war we almost won then abandoned in Afghanistan, after seven years of fighting (#3)

If that's success, I'd hate to see what Dick Cheney and his boss would deem a failure.

Another question Lehr posed about the standing of the Bush / Cheney Administration with the American public might have captured the true inner sneer and contempt of the upper echelon of the Bush team more effectively than anything else published so far.

It doesn't trouble you at all to be leaving office next week with the overwhelming disapproval of the majority of the people as measured by the polls?

I don't buy that. No, first of all - I don't buy that. And I find, when I get out and talk with people, that that's not the unanimous view, as you would have it. Things that count for me, in terms of the people I want to make certain are with us are, for example, the American military - young men and women who serve, the folks who go out and put their lives on the line to carry out the policies we've decided upon. President and I had the opportunity, for example, last Saturday. We went down to Norfolk; we commissioned a brand-new aircraft carrier named after his father. Then we went over and spent the afternoon with about 650 Navy SEALS. These are guys that have been in the battle in Iraq, in Afghanistan, deployed many, many times, have done all the heavy lifting in connection with our policies that we pursued in that part of the world and they are a magnificent group of people. They are also very, very supportive of what we did and they're the ones that put their lives on the line for the rest of us, It's not just cocktail party talk for them, this is the real world they live in and having THEIR respect and THEIR approval counts for an enormous amount.

Cheney is so confident in his unique insight into all things political, military, social and economic that he absolutely DOES NOT CARE one iota what the America voters -- We The People -- think about their policies and strategies. Once we vote them in, they have free reign to do whatever they want -- Constitution and decades of established military and legal precedents be damned -- until we remove power from their cold dead hands or they leave office. There is no other middle ground. Cheney is so isolated from the real world he thinks attending a gathering of active-duty Seals held in conjunction with the christening of a new Navy ship named after the sitting President's father, himself an ex-President, constitutes a reflective cross section of validating American public opinion.

Cheney's contempt for any balance of power and rejection of accountability is nothing new. It was readily apparent less than three months into the first term when secret Energy Task Force meetings were held and quickly became the subject of the first power struggle between the Administration and the American public via Freedom of Information Act suits. It's hard to fathom even in hindsight how telling that omen was for the country.

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1) http://www.pbs.org/newshour/bb/politics/jan-june09/cheney_01-14.html

#2) http://news.yahoo.com/s/afp/20090115/wl_afp/usattacksguantanamotorture

#3) http://uk.reuters.com/article/burningIssues/idUKTRE50D65O20090114