Posted by: bmeverett | January 13, 2012

Republicans against free markets


This is a tough time to be a conservative. The US is desperately trying to work its way out of a deep and prolonged recession, and our elected officials refuse to acknowledge the one approach that will work: freeing up markets. It seems that both democrats and republicans want to enhance government power to implement their “visions” for America’s future. Most Americans don’t want a vision. They just want to live their lives.

The latest – and most troubling – manifestation of this problem is the attacks on Governor Romney’s tenure at Bain Capital, not by the usual anti-market democrats, but by other republicans claiming to have a found a new conservative critique of the free market. Governor Perry is attempting to distinguish between “venture capital” and “vulture capital.” Speaker Gingrich and Governor Huntsman accuse Romney of destroying jobs for personal gain. These attacks all smack of political consultants developing campaign themes in focus groups. Let’s take a step back and look at the reality of private equity firms. (I will bring this back to energy, so be patient.)

Private equity firms – like Bain Capital – make money for investors by buying companies and then increasing their value. The operative word is “buy”. Companies like Bain don’t just grab, steal or kidnap companies. They purchase the stock from the current shareholders at market value. As a general rule, the share price of any company will approximate the expected net present value of its future earnings. If the shareholders think they can do better by keeping the company themselves, they are not obligated to sell. Private equity firms buy companies when they believe the stock is undervalued. When they acquire a company, one of several things can happen.

First, the perfect outcome. The private equity firm injects capital into the acquired firm, which then grows rapidly, increasing employment and providing excellent returns for shareholders. Nobody complains when this happens.

Second, the private equity firm restructures the acquired firm, eliminating unprofitable parts of the business and/or reducing costs and increasing efficiency. In this case, some people lose jobs, but others gain secure long-term employment in a successful firm. The workers who are laid off are very unhappy and appear on talk shows and at the campaign events of liberal politicians attempting to show how hard-hearted capitalism is. The workers who benefit are too busy to working to retort.

Third, the private equity firm can try as hard as it can to improve the acquired company yet fail to make it successful. In some cases, the private equity firm will give up and sell the shares for whatever it can get. In other cases, the acquired company has to be liquidated, and the private equity firm loses its investment. Acquisitions are, after all, quite risky.

Every once in a while, an acquired firm is so badly structured and its business model so flawed that the company is worth more in liquidation than it was in operation. A factory making chocolate covered onions may have no chance at all of making a profit. The machinery, buildings, office equipment and chocolate and onion inventories may be worth more on the open market than the company was. In such a case, the laid off workers may be unhappy, but the capital is much better used for some other purpose.

What virtually never happens (Mr. Gingrich’s and Governor Perry’s claims notwithstanding) is that the acquired company is mismanaged by the private equity firm, broken up and put into bankruptcy with all its workers laid off while the private equity firm makes a ton of money. There are, of course, cases where a company’s management will borrow a lot of money, distribute it to themselves as dividends and then default on the loans. That’s part of what happened at Enron, and it constitutes criminal fraud. I have not seen anyone accuse Governor Romney or Bain Capital of such behavior. The accusation of pillaging a company for profit is rather like claiming that real estate developers can buy homes, smash all the windows, rip out the plumbing, throw away all the appliances and then sell the home for a profit. The world just doesn’t work that way.

The economy grows by utilizing all the available resources – both capital and labor – as efficiently as possible. Capital in our society must be free to move to its most productive uses, and the people who move capital around take considerable risk in so doing. Jobs are not property rights, and investors are not obligated to maintain workers who are not adding value – even if it’s not the fault of the individual worker. It’s better for everyone if workers at unprofitable firms do something else for a living. Otherwise, an opportunity for economic growth is lost, to the detriment of the society and workers.

Now we can come back around to energy. The creation of “green jobs” through government support for companies like Solyndra is a misallocation of both capital and labor. As I mentioned in my last post (“More Solar Power Myths”), solar energy is wildly uneconomic. Profitable investments add wealth to the society, while unprofitable investments do not. The advantage of keeping capital in the private sector is that investors are extremely careful putting their own money at risk. Mr. Gingrich acts as though it’s really easy to make hundreds of millions of dollars in the private equity market. It isn’t. Government, on the other hand, invests other people’s money and doesn’t have to care about the results past the next election cycle.

Both republicans and democrats are falling into the trap of believing that any investment that creates jobs is good, and any action that eliminates jobs is bad. If that were true, we would still have elevator operators, buggy whip makers, blacksmiths and coal delivery trucks. One can only wish that at least one of our elected officials would take the time to understand the economy and how it really works, rather than worrying only about voter reaction to sound bites.

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