Value Investing using Economic Value Added (EVA)

Five commandments for paying the boss

Back in 2006 before the world of finance fell apart, FORTUNE's Shawn Tully wrote an article (here) in which he laid out 5 rules that boards and shareowners should follow when crafting executive compensation.  If only someone listened.  We would not have as many examples of CEO and top executive pay coming so unglued from economic performance.

Of course, there are many exceptions like Harsco (HSC), Herman Miller (MLHR) and Briggs & Stratton (BGG), but they are few and far between.  Tully writes:

Misguided pay is expensive; worse, it is a recipe for decline, because it rewards self- defeating behavior, such as inflating earnings per share to wow Wall Street.

It is up to corporate boards to stand up to the bullying of the compensation consultants and to design plans that work for the best interests of the company. One place to start is to limit severance pay and eliminate bonuses when executives don't perform.

"You don't get paid for failure if things don't work out in a leveraged buyout," notes a prominent hedge fund manager. "Why should you in a public company?" And if performance is not sustained, CEOs should pay back the big bonus.

Such clawback mechanisms make it less likely that CEOs will "pump and dump" - that is, buy earnings through bad management (e.g., cutting R&D), then sell when the stock price begins to drop a few months later.

CEOs that pump and dump?  CEOs that leverage their companies to the hilt? Earning hundreds of million dollars before you get fired and the new guys get hauled in front of Congress while you figure out how to hide your dough off-shore somewhere?

Maybe some of that behavior could have been avoided if boards would follow these five FORTUNE commandments:

I. Thou shalt pay shareholders first.

 

II. Thou shalt base bonuses on economic profit.

 

III. Thou shalt not rely on restricted stock.

 

IV. Thou shalt favor options, cautiously.

 

V. Thou shalt force CEOs to hold, not sell.

 

I'll have something to say about each of these in later posts.  Value-Aligned companies already explicitly follow these rules - that's only 10% or so of the Russell 3000.  Pity the fools that hold forever the rest.

 

BERK

When General Motors was an EVA Company

Bennett Stewart, the author of the Quest for Value and co-founder of Stern Stewart & Co. - the EVA Company, writes a short essay (here) at HBR Now about the meaning of the bankruptcy of General Motors.  He explains how any company can become a ward of the state or go into liquidation if the financial management system bows at the alter of the accounting based EPS metric.  Accounting does not charge for equity capital, only debt capital, so the mandate for the operating managers and the board too, is SPEND, SPEND & SPEND.  Spend until the company fails. 

He begins by recounting the last time GM almost went under before the Great Depression, and how DuPont, not the government, stepped in with cash and one Alfred Sloan:

 

GM was at death's door, and only a healthy infusion of cash and financial restructuring saved it. Actually, not just saved GM — made it great.

But unlike this time around, when the heavy hand of the government is at the wheel, it was an investment from DuPont, whose chairman was instrumental in bringing in the legendary Alfred Sloan to run GM, and a financial restructuring orchestrated by J.P Morgan, that saved the day.

By 1923, Sloan had arranged for the GM management team to acquire a large block of the company's stock from DuPont, financed with a non-recourse loan that would be repaid by diverting bonuses. GM's management effectively participated in the incentives of a leveraged buyout of the firm, but without imposing a like financial risk on the company itself. As for the bonuses, they were based on simply allocating a sizable portion of GM's operating profit above a 6% cost of capital hurdle rate, which gave the managers unlimited upside for achieving income efficiency and balance sheet asset management. There was no calibration of the bonuses to a market pay scale, which only tends to institutionalize a guaranteed level of pay irrespective of performance. There was the risk and the return of the owner on the shoulders of management.

And that, coupled with excellent management, set the stage for greatness.

Basically, Sloan's magic formula was to incentivize operating managers of semi-autonomous divisions by paying them some pre-determined fixed share of operating profits above a 6% hurdle rate - low, but much higher than the after-tax cost of debt - the hurdle rate in an accounting-based system even today.

A fixed-share of "excess operating profits" is the same thing as a fixed share of the Economic Value Added or "EVA" of the divisions.  The best part was that it was a pre-determined formula which meant the operating managers could shoot for the moon as long as they figured they could get an excess return on their investments/spending.  It was as though Sloan had created a way to give a fixed share of the intrinsic value growth of their specific operating units.

What happened?, you may be asking.  Well Stewart says:

Over the years, GM moved away from the incentives and value focus of an owner to the incentives of a bureaucrat. Bonuses were hitched to growth in earnings-per-share, and a raft of situational metrics that obscured responsibility for delivering real value.

Spend, spend, spend is the mantra of the EPS-addled manager. And so they did, and now, it's time to pay the piper.

Indeed.

 

BERK

Risk v Executive Reward

All this screaming about excessive incentives for risk taking.  I think it has more to do with asymmetric incentives.  If you give someone the motivation to make a huge amount of money without losing much, then you have done a poor job of incentive design.

The crazy thing about all this talk about pay design for top executives like in this WSJ article today, is that it mostly talks about the pay for the titular heads of these massive companies.  What about the people at the operating levels? And those traders that bet everday with the firms' money?  Those guys that headed the units for mortgage lending? It's the operating guys that we need to restructure pay for.  They take the risks.

Here's my suggestion:  Pay them in variable cash bonuses linked solely to the intrinsic value growth of the unit measured by economic profits in dollars (not ratios). Accrue bonuses earned in a reserve and pay 1/3 (or some fraction above a target for "normal" or "expected performance") of earned bonuses in the reserve each year.  There is then something at risk when future performance is subpar.  If they take another job, they lose their bonus reserves.  If they retire they get it.  Of course, for those of you who know me, I could not have invented something so simple but so beautiful.  No that was the invention of the smart guys like Steve O'byrne, Bennett Stewart and Joel Stern, among many others I am sure. 

Here's what Professor Murphy, the guy that wrote the paper with Michael Jensen that got much of the "structure of pay design" discussion started. 

Kevin Murphy, a finance professor at the University of Southern California's Marshall School of Business, says it is possible to control how much risk is built into pay packages. He said compensation fell sharply for CEOs of banks receiving federal bailout money last year, compared with those of other banks and non-financial companies.

Mr. Murphy says paying executives with cash bonuses, restricted stock and stock options creates strong penalties for failure. He says companies also can control risk by paying executives for longer-term, rather than shorter-term results, and "clawing back" pay when big losses wipe out prior profits.

I argue with Professor Murphy that equity in the whole company which is not bought and paid for by the individual does much good - there really is nothing at risk especially if they get paid a lot of money.  But if they earn or pay for their equity I am all for it.  How do they earn their equity?  By giving them the option to purchase it with a multiple of that cash bonus reserve we just talked about.  Or for top executives make them take loans out and buy stock.

But it is a minor argument and probably differs only with the level of executive or employee we are talking about - I am talking about the guys that take the risks - the traders, division heads, etc.  Not the CEO only.  Murphy'sbig contribution in this article though is that clawback thing - we called it a "bonus bank" at Stern Stewart.  And it is designed to mimic ownership like incentives for operating people with a much better line of sight.  They will be less likely to tank the whole company like at AIG if the risks they are taking are borne mostly by them.

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BERK

The Death Spiral in the "Accounting Based" Financial Management System

Insanity is doing the same thing in the same way and expecting a different outcome. 

Maybe businessmen in regulated or unionized industries, like steel and utilities, are insane.  Probably a better explanation is that they work in an insane system.  After-all, as Nietzsche said “Insanity in individuals is something rare, but in groups, parties, nations and epochs it is the rule”  He left out bureaucratic companies with antiquated decision making systems.

My good friend Marc Hodak at Hodak value Advisors sent me a note this morning - really early - about this Wall Street Journal story "Fixed Costs Chafe at Steel Mills".

It turns out that a few steel mills are raising prices even though demand is stalled at best at a very very low level.  Sounds like madness doesn't it?  Raise prices and demand should fall more, right?  But you see the guys that run those plants get paid on productivity usually measured by margins - and as the quote below shows their unit costs are rising fast so unit profitability is crashing.

We are raising prices because of the increased costs of operating our mills at the current lower levels. We are not seeing an increase in demand," said Dennis Oates, chief executive officer of Universal Stainless & Alloy Products Inc. He has boosted prices 5% to 6% twice since the beginning of May.

Think about this.  If they sell 10 steel bars for $20 each they collect $200.  If it takes $80 of direct materials to make the product and fixed costs like union labor and overhead is $100, then the total costs per unit sold is $80 + $100 = $180 divided by 10 units of steel bar, for a cost of $18 per unit.  $20 price minus $18 cost = $2 profit.

OK that's fine and dandy but what happens when volume falls in half by 50% to 5 units sold.  They only produce 5 units.  What happens to costs?  The CEO above says they go up - I say they did not change.

Let's look at the answer Mr. Oates' accounting financial management system gives him.  We know that it costs $8 of materials per unit for $40 ($8 x 5 units of steel bar) and we know the fixed costs are $100 or $20 per unit.  The unit cost in his system is now $40 + $100 units or $140/5 units = $28 cost per unit of steel bar-a 55% increase.  So according to his accounting system his costs are going up 55% as his demand declines so let's say he raises prices to $30 per unit to maintain his $2 profit margin.

What happens?  Well marginal buyers for steel go somewhere else and now he only sells 3 units.  Uh oh, now costs are really high. $8 per unit plus $100 in fixed costs divided by only 3 units now = $100/3 per unit or $33.33 per unit, for a total unit price of $8+$33.33 = $41.33 cost per unit.  That strategy really worked, he gets $30 per unit for $33.33 cost = -3.33 is what his accounting system tells him he loses.  What now?

Unlike mill increases announced in recent years, this is obviously not driven by increasing global demand, but rather by fixed costs being proportioned across significantly lower demand," the company said in a letter to customers.

This problem is known technically as the "unitization of fixed costs" or as Marc likes to call it - the "death spiral".  It happens when performance evaluation for a plant manager or employee is based on "unit costs" or "average costs", which includes fixed costs.  The problem is that fixed costs do not change as volume varies.

In this type of system two things will happen: 1. the manager will raise prices to compensate for his increased average cost per unit and then volume will fall thereby raising cost per unit further, or 2. The plant manager produces and produces regardless of demand so his volume and capacity utilization stay high, but his unit costs stay low because fixed costs divided more volume = lower costs.  Never mind that all those units just fill up a warehouse or a supplier where there is little or no end demand. Basically the managers bury the costs on the balance sheet in inventory which is costly but not to them because they are evaluated by margin per product or by minimizing unit costs.

If we charge them capital maybe they'll do the right economic thing and REDUCE FIXED COSTS IN DOLLARS.  Layoff workers, sell extra factory space, etc.

Marc sums it up like this in his note to me:

This strategy is based on (1) illusion and (2) delusion.  The illusion is that one’s “costs” are increasing when volumes drop.  But the only cost going up is the accounting fiction called “average cost.”  Variable costs, i.e., the economic floor for pricing, hardly budge.  Total costs, i.e., those that affect EP (economic profit), actually come down.  The delusion is that prices can be based on costs.(my emphasis) 

Read all that carefully and you will see why single payer health care, that relies on some Politburo of unelected experts to set reimbursement rates for doctors, nurses, hospitals, drug companies and medical device companies based on 'average cost", will massively misallocate resources.  Pricing off of costs is not market pricing and gives false signals and misaligned incentives to the good faith actors in any economic system.

Short the companies that don't get it; buy their competitors that get it, like Nucor (NUE). 

BERK

Disclosure: Long Nucor (NUE), no position in Universal Stainless (USAP)

Cost of Capital Rising Due to the "painful tug-of-war between our monetary policy and our fiscal policy"

Niall Ferguson, author of the Ascent of Money:A Financial History of the World, a book I just finished and  highly recommend to put today's economic recession and money panic in a sweeping historical context, wrote our title.  He said in  "History Lesson for Economists in Thrall to Keynes", Financial Times, May 29, 2009:

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that "the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds" was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a "painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year.

At the end of last year, in the depths of the financial crisis, the yield on the 10 year US Treasuries was 2.1% - it is now over 3.6% - a huge move in a few months.  The problem for investors like us is that the yield on the 10 year is the base return we use to discount future cash flows to arrive at the present values of shares of companies.  The higher the interest rates go, the lower the fair value estimates of the shares of our Value-Aligned companies go. (In an efficient world that means stock prices in the stock market go sown too.) 

The 10 year treasury yield is one proxy for the cost of capital in the United States.  We are not saying that we used the low 2.1% rates that represented a flight to safety during the panic as our proxy for a cost capital, but we are saying that a steady move higher in the cost of capital of the United States is bad for investment in US assets - stocks, bonds, real estate and industrial investment (read US jobs).

...the stimulus package only accounts for a part of the massive deficit the US federal government is projected to run this year. Borrowing is forecast to be $1,840bn -- equivalent to around half of all federal outlays and 13 per cent of GDP. A deficit this size has not been seen in the US since the second world war. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House's over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 per cent of GDP by 2017. And this ignores the vast off-balance-sheet liabilities of the Medicare and Social Security systems. (my emphasis)

It seems silly even to mention this but all that debt that the government has to issue to pay for the stimulus, the entitlements, the bailouts, etc.  must drive up interest rates - or else why would people buy it? 

Anyway, the Obama administration and Congress seem to care little about all this, or maybe they care but can't get their freight train to stop hurling down the mountain - that would mean their long held beliefs are inconveniently untrue.  Social justice may just be best arrived at when every segment of income is growing, when the pie is growing (see 1946 cartoon below).

Even with today's announcement that Congress will adhere to "Pay as they Go", which means in practice that taxes will be raised somewhere to pay for all the goodies that they will pay-off various feverish factions that are owed something for getting them all elected.  Probably more taxes on the ever shrinking "rich".

Ferguson acknowledges that the policy mistake has already been made by adopting the fiscal policy to fight a world war to fight a bad but not end of the world recession.

We need credible commitments to reduce our structural deficits AND credible that will raise growth - and revenues.  Raising tax rates on income and capital during a recession will further depress IRS collections thereby further increasing the deficit.

Growth is the answer and that means rolling back fiscal stimulus and attacking Medicare and Social Security in that order.  Unfortunately, this President thinks it means spending MORE on medical care to SAVE the system money - burn the village to save it.  The bond market and our customers in China don't lie - for the first time in my lifetime the solvency of the United States government is being questioned as though we are Argentina.

Buenos Dias.

BERK

 

You Can't Measure a "Saved" Job - Bush Press People Envious

Saved or created" has become the signature phrase for Barack Obama as he describes what his stimulus is doing for American jobs. His latest invocation came yesterday, when the president declared that the stimulus had already saved or created at least 150,000 American jobs -- and announced he was ramping up some of the stimulus spending so he could "save or create" an additional 600,000 jobs this summer. These numbers come in the context of an earlier Obama promise that his recovery plan will "save or create three to four million jobs over the next two years.  Bill McGurn WSJ Opinion

I mentioned this a couple of days ago in a post. The real tragedy here is that I heard the President's ridiculous claim that he created and saved 150,000 jobs and will now step on the gas to create or save 600,000 jobs: but I did not hear anyone, anywhere in the regular old media question it or explain it.

No office of government measures a "saved" job. 

They are made up out of thin air and until the press corp begins to ask tough questions (the networks and newspapers that are just about extinct anyway should be absolutely embarrassed - perhaps they are waiting for their own bailout, I'm not kidding) Americans will continue to support the President even though Americans seem to increasingly disagree with his policies.  We need to wake up and smell the NAPAM one of these mornings.  That's prosperity you smell burning away.

"You would think that any self-respecting White House press corps would show some of the same skepticism toward President Obama's jobs claims that they did toward President Bush's tax cuts," says Mr. Fratto. "But I'm still waiting."

Mr. Fratto was a colleague of McGurn's in the Bush administration, and as a senior member of the White House communications shop, he knows just how difficult it can be to deal with a press corps skeptical about presidential economic claims.  

The press did their job in that case - they were skeptical and as it turned out, Bush did try to spin a bad situation into a better than reality situation.  This is what we expect the press to do.  Not so far during the Obama Presidency though. 

It's like they are investors that fall in love with a stock.  Any information contrary to the investment thesis is rationalized; the press have so much invested in this President, any information that may lead to a contrary conclusion is dismissed.  Unbelievable.  And the worst thing is that the White House knows it.  That is why they are in such a hurry.  They must rush things through before someone in the press catches on and grows a pair.

BERK 

Millions are Missing this Opportunity to Bolster Retirement Lifestyle

March 9th marked the bottom of the hideous bear market.  Unfortunately, for many, that day also marked the day of their final capitulation and the day that probably marked a period where the maximum damage was done to the vast majority of savers.  We know because right about this time the amount of money in cash yielding below 1% was at its maximum.  And then the stock market soared +45%.

We had made the case that stocks are typically under represented in a person's portfolio because stocks are rising income investments that will hedge against inflation.  It is not merely enough to know how much money you will need at retirement and how much income you will need at that point.  You must understand that inflation is the cruelest tax and without rising income investments to combat the erosion of purchasing power in retirement, you could wind up with far less than you need to live a life of dignity in retirement.

Turner investments has this take on inflation in this morning's Morningstar front page:

So historically even above-average inflation hasn’t constrained stocks. As we see it, stocks are the best way to keep up with inflation and the rising cost of living (even with 3% annual inflation, prices double in 24 years). If inflation does accelerate going forward (and we think it probably will in 2010, although not to extremes), stocks such as energy-services, heavy-equipment, fertilizer, mining, and restaurant shares may do particularly well, based on past patterns.                    Chris McHugh, Portfolio Manager Turner Investments

Our Value Aligned Investing process was designed with all this in mind.  We create portfolios of great companies that have systems in place that are likely to guide the company well into the future. We diversify just the right amount so we can reap the benefits of undervalued shares rising over -time to a more fair valuation - with as little short-term risk as possible to mitigate our human tendency to deviate from well thought out plans when panic sets in.

If you are not sure that you will have enough in retirement drop us an email at David@BerkAdvisory.com for a FREE second opinion.

Berk

What Should Investors & Their Families Do About Inflation?

Inflation is on the way.  The bond market is telling us so.  The rapid decline in the dollar over the last  month is telling us so.  And common sense is telling us so.  This does not have to be hyper-inflation where we will be taking sacks of cash to the grocery store.  Anything over 3% per year can silently rob your dignity in retirement by eating away at the purchasing power of your fixed income streams that so many advisors make sure you own.

Stocks of Great Companies are a Hedge Against Inflation.

Always remember that stocks are our only diversifiable defense against the erosion of our purchasing power in the future.  The real retirement time bomb lurking now, just as retirement periods get longer due to increasing life expectancies, is the mounting irrational fear that the stock market is too risky.
 
Where did that idea come from? I wonder. It's the memory of the short-term volatility (see below).
 
This misapprehension originates in a person's early life, and specifically in the worldview absorbed from their parents.  For instance, in describing her father, my mother in law has often explained to us that we will never know what it's like to have it all, and then have it all taken away.  Her father was driven to school by a driver in a limo in his youth.  Then, suddenly, his family lost everything in the crash of 1929, not because stock prices went down, but because the family was forced to sell assets near the bottom to meet margin debt calls from its brokers, who in turn were getting calls from their banks, who in turn were getting calls from their depositors for cash.  It wasn't stocks that doomed my wife's grandfather's family; debt took everything away.
 
People usually define their concepts of financial risk and safety only in terms of principal, loss of value, whereas it's a matter of financial life (and death) that they learn, before it's too late, to see that the real risk is the erosion of purchasing power.  They fear that they will lose their money.  That's a risk which, over a 30 year period, is historically nonexistent.  What they should fear is the risk that they will outlive their money.
 
The cost-of-living has never, in the 62 years of a typical retiree's life, stopped going up.  The only reasonable assumption that we can make is that the cost-of-living will never stop going up.  Take a look at the stamps below.  The two 3 cents stamps on the left were issued 62 years ago; the two on the right were issued last year at 42 cents.  That means that the cost of a stamp has increased by more than +4% per year for the 62 years of the 2008 retiree's life. 

That's why bonds or annuities are not the main answer for the long-term. By producing fixed payments from a fixed asset (not adjusted for inflation), bonds are considered conservative investments.  But the only thing that they are conserving is a fixed amount of paper dollars whose purchasing power is constantly eroding.  Bonds may be conservative of principal, but they are relentlessly destructive of purchasing power. 
 
And again we come down to time and perspective.  Financial journalists in their obsessive quest for viewers and readers, at the expense of good advice and truth, only report what's going on right this minute or what just happened by hyping every historical, rear-view mirror economic and market statistic.  This is why we recommend that you simply turn off CNBC.  It robs you of the ability to think through time.  This leads people to confuse risk with volatility, a critical mistake. Our job is to help you match the long-term historical perspective of the returns of shares of great companies with the realties of your long-term plans.

Conventional broker and/or advisor advice is to have the same percentage of fixed income in your assets as your age.  Therefore, a 62 year old should have about 60% of her assets in bonds.  But the average 62 year old will live some 20 - 30 years more after retirement.  We don't think that this portfolio will keep up with the 4% inflation as indicated by the stamp price.

The answer: own stocks of Great Companies whose profits and dividends will rise at some rate plus inflation.

BERK

Not "Will There Be Inlfation?", But "When?"

My hockey team, the Black Aces of the Red Bank Armory's Men's League won our first summer league game of the season last night.  A 3-0 shut-out by our great goalie, pictured to the right in one of his saves against Wayne Gretzky. (not really of course, but if any of the Devils are reading this give us a call so we can help your families grow your wealth too)

We have a bunch of middle aged men - married or divorced with school aged children - in the league and on my team.  There are lawyers, IT professionals, marketing gurus, medical technicians, doctors and contractors.  I am the only stock market guy.  Most of the guys think of me as a "hedge fund" guy - so I am lower than an ant to them right about now - but of course I try to correct them and remind them that I am a Family Financial Advisor who believes in the power of compounding stocks of the Great Companies over a life-time.  In other words, I advise families like theirs.  OK - some are a little wealthier but that is simply because they are second or third generation wealthy already.

My cap asked me last night - when will we see the inflation?  I told him I think we are already seeing a reflation as the Chinese in particular begin hoarding materials and other commodities in expectation of price increases.  That is all you need for inflation in the future - people need to change behavior now because they expect prices to go higher.

The Chinese are not your average consumers though.  They are motivated by their huge dollar holdings.  Therefore, much of the Chinese hoarding could be simply their hedge against the exploding US budget deficits and the Fed's monetization of that debt.  (The Fed buys the debt the US government issues, thereby creating money at of thin air - or "printing more dollars")  More supply of anything without the commensurate demand means that price will have to fall - the Chinese do not want to be caught with devalued dollars and a need to buy commodities and materials with those dollars.

That's a long way of saying that I believe big-time inflation is on the way, but not until US and European capacity utilization begins to move up, and rigidities in wage contracts make their way into more and more jobs in the US. 

For instance, if the government allows the Employee Free Choice Act to become law, which will make it difficult for say WalMart to avoid union contracts along with the rules and fixed wage rates associated therewith.  (By the way: WSJ reported this AM that WalMart will be hiring 22,000 new workers in the coming weeks).  Most think that Congress will not pass the provisions of this anti-growth law that call for the potential elimination of secret ballots for employees - that's good.  What's bad is that the concession to the unions will probably be effective government wage controls by forcing through the force of a law, Federal arbitration within a short period of time after negotiations start. 

This coupled with runaway government deficits and more dollars out there means that when aggregate demand comes back, consumers and businesses will, like the Chinese, anticipate inflation which will cause inflation like we have not seen in the U.S. since the 70's.

My hockey captain is prescient.  He called the calamity in September - he kept telling me that something ain't right.  And now he sees inflation - he's right unless we get major policy reversals by Congress and the President, which are not likely.

See my next post on what you and your family should do about it.

BERK

US Borrows Much Less From Abroad Despite Huge Internal Government Deficits

Our current account deficit is the amount that we have to borrow from abroad. The chart below, which I found on Don Marron’s new and insightful blog, shows how this amount changed from the first quarter of 2008 to the first quarter of 2009 – by some $400 billion.

Is that good or bad?  Usually soaring government deficits would translate into more borrowing from abroad.   If other factors stayed the same, our borrowing from abroad would have needed to increase from $693 billion in Q1:2008 to $1,236 billion (1.2 trillion) in Q1:2009.

 

But, as Marron reminds us, other factors didn’t stay the same. 

Individual Americans started saving again, reducing our nation’s borrowing needs by $455 billion at an annual rate.  And private investment plummeted, reducing borrowing needs by another $458 billion. Together, those two changes largely explain how U.S. borrowing from the rest of the world could fall by $400 billion over the past year, despite booming government deficits.

In the long run, the increase in personal saving will be a welcome development, as Americans rebuild their wealth and help finance government deficits (in the short run lower consumer spending may weaken the recovery).  The decline in private investment is more troubling.  In the short run, some of that decline is healthy as we work through excess inventories of products, houses, and some types of commercial real estate.  In the long run, however, we will need growing investment to boost the nation’s productive capacity.

It looks like some of the private investment is coming back a bit as yesterday’s order component of the Purchasing Manager’s Index was 51 – which indicates expanding orders.  At the same time inventories (part of private investment) are still decreasing at a record pace.  Perhaps, private investment is about to spring upward.

BERK 

 

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