An ongoing review of politics and culture

Re: Apple’s Cash

One of the great things about Karl Smith is that he usually responds to critical comments thoughtfully and collegially. His response to my post on Apple is no exception. Let me take his responses one at a time.

Smith begins his response by writing that:

So, I am not actually making any statement about whether Apple’s stock price is “too high” or “too low.”

Smith wrote in his original post that:

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

He wasn’t saying that there is a risk that Apple will never pay out enough cash to shareholders to justify the price of the stock, but that there is “approximately zero probability” of this happening. If a share of Apple stock has the same value as a pile of ashes, then it is not only worth less $375, it’s worth less than $1. That sure sounded to me like he was arguing that Apple’s stock price of $375 is “too high.”

Smith goes on to respond to my observation, based on my experience, that it can be very beneficial to shareholders for a company to hold cash on its balance sheet so that it can act decisively when opportunities arise, by writing that:

In Jim’s scenario he has a lot of cash on his balance sheet and that allows him to make strategic purchases. But, by construction you know who doesn’t have that cash – Jim’s shareholders.

If Jim had paid out the cash to his shareholders then they would have it. And, if Jim could convince them that he really did have all of these great opportunities they could give it back to him. The fact that no one wants to give Jim cash should be taken as evidence that giving Jim cash is not a good idea.

On a blackboard, maybe. If we lived in a world where it was free, instantaneous and riskless to go through the fundraising process, I guess this might work. Actually raising cash from investors can take anywhere from days to months, and you can lose the chance to buy the asset, or lose the chance to get the best price; it is often expensive, especially in the time and attention of senior managers; and, it often results in information about the potential investment or acquisition leaking out to the market while you are raising the money, which can materially increase whatever you have to pay for the asset, and maybe cause you to lose the deal entirely.

In response to my point that maybe Apple is keeping cash on its balance sheet in part to work a tax angle, Smith writes that:

Yeah, this is just akin to saying that I am reading their signals wrong which of course could be true.

This is a very different statement than “a share of Apple stock is worth the same as a pile of ashes.” If Smith is saying that his actual argument is that it is possible that Apple is just never going to deliver cash to shareholders, because of a principal-agent problem or some other issue, then I have misunderstood what he wrote, and we are in agreement. My argument is that Smith has not come close to making the case for what a rational expectation for future cash dividends to shareholders from Apple ought to be.

In response to my point that maybe Apple is using the cash in part to deter potential competitors, Smith writes that:

Again, its clear why this is good for Apple. Its not immediately clear why its good for a diversified shareholder who also own stocks in the companies that Apple is deterring.

Except that an Apple shareholder might not have the opportunity to invest in such a competitor because it is private, or because it is a division of another company that requires making a compound bet on that division plus the rest of the company, or because the investor has finite time and attention to devote to her portfolio, or for any other of a large number of reasons. I don’t think it’s especially bizarre that a shareholder of company X tends to be made better off when company X succeeds versus competition.

Smith concludes with this:

Key in my claims is that under none of these hypotheses is it in the interest of the Management to take these actions. Whether its in the interest of shareholders to take some action different than what they are taking I am not taking a stand on.

What is true – and a puzzle – is that under some variants of my claims it would be in the interest of private equity to take over the firm. The private equity problem is difficult as well though. Because, its clear how given these principle-agent problems one can create discounted present value using private equity.

Its not perfectly clear how one extracts that value.

Smith has argued that a given shareholder will get more free cash flow by paying $380 for a bunch of ashes in a trash can than by paying $382 for a share of Apple stock. The important exception is that she can get cash in pocket by selling this share to some other buyer of the stock. Smith is arguing that any investor who counts on that is counting on a greater fool buying it, because Smith can see what they cannot, which is that Apple will not ever pay dividends. (Once again, if he is really saying that it’s possible they won’t pay dividends, then we have no disagreement.) But exactly this judgment is the contested issue. This is what markets price.

Here’s the most obvious way that you extract the value if you are convinced that a stock’s market price overestimates its true value: you short it. If Smith doesn’t believe that the market will, in any feasible investment horizon, figure out that he’s right and begin to heavily discount Apple’s stock price, then you have just defined an asset that will, with respect to this issue at least, retain its value – otherwise known as “a good investment.”

(Cross-posted to The Corner)

Blogging About Business versus Doing Business

Both Matt Yglesias and Karl Smith have blog pieces that claim businesspeople are doing pretty dumb things. The claims are in some ways mirror images. Yglesias claims that Barnes & Noble is foolishly spending money developing and selling Nook, when instead it should just return the cash to shareholders. Smith is claiming (as far as I can tell) that Apple investors haven’t figured out that Apple can’t really return much of its immense pile of cash to shareholders, because this money is required to run the business.

Yglesias says that it is an obviously bad use of shareholder funds for Barnes & Noble to invest in Nook, because their expertise is in running brick-and-mortar stores. But by this kind if logic, why would movie company Disney invest shareholder funds opening theme parks, why would brick-and-mortar retailers Walmart, Target and Macy’s invest shareholder funds developing web businesses, and why would computer company Apple invest shareholder funds developing phones?

Core competencies and intangible assets are notoriously tricky to define and quantify for a real company, but for Barnes & Noble they almost certainly include the power of their brand name as a place to look for book-related merchandise, their expertise in developing and managing relationships with publishers, and their existing back catalog of titles. I don’t know enough about the specific situation to know whether Barnes & Noble should have developed and sold an e-reader, but based on what is in the piece, Yglesias doesn’t either.

Karl Smith is a very smart guy, but keeps digging himself in deeper and deeper on his criticism of Apple’s shareholders as foolish, in direct contradiction to the fact that Apple shareholders seem to have done very, very well for some time.

Smith argued in an earlier post that because Apple has not paid real cash dividends to shareholders, that it is more valuable to put money in a trash can and burn it than to invest it in Apple shares. I did a long post pointing why I don’t think this is true. Smith has subsequently done several posts on this same topic, amplifying and clarifying his point.

His most recent post on this subject develops an analogy between the workforce of a tech company and the particles in a sub-critical fission reactor. This is meant to be literally (as far as I can tell) a sketch of a mathematical model for why Apple requires a huge amount of cash on hand to retain its employees. At best, it is pure speculation. And based on any practical experience in a tech company, it’s also extremely implausible that Apple would start to shed important engineers, or be at a disadvantage in recruiting, if it had built up, say, $40 billion on the balance sheet instead of $80 billion.

Smith is arguing that Apple shareholders are suckers who depend on greater fools coming along, because there are hidden requirements for cash in the business that mean the true free cash flow available for distribution to shareholders is less than it seems to investors based on accounting statements. This is not a crazy idea (though his argument that specific hidden requirement is that this amount cash is needed to retain employees does strike me as very implausible). It is also not a new question to ask, and in my experience is one that is debated by professional equity investors in relation to many stocks, ranging from technology companies to convenience store chains.

I have no idea whether Apple stock should be a buy, sell or hold, but if Smith is right that the current shareholder base of Apple massively misunderstands the true capital requirements of the business, then he has a huge moneymaking opportunity. If he really believes in his investment thesis, he should borrow a lot of money and short Apple’s stock.

Antitrust as Self Medication

Reihan Salam, in a characteristically excellent post here at NRO, points to a paper by Michael Mandel, who is one of the most interesting blogospheric commentators on innovation from a “New Democrat” perspective. Mandel makes the basic point that progressives should not be so gung ho about antitrust enforcement, because big organizations like AT&T Bell Labs and Apple are the anchors of business eco-systems that drive innovation.

My experiences – my first job out of grad school was at Bell Labs, and I’ve since started and built a global enterprise software company – lead me to agree with the conclusion, but to be a little more jaded about exactly how big firms contribute to innovation in the kinds of industries he discusses.

Just as Mandel indicates, there is some straight-up development of new technologies in big labs that is then deployed by the parent company (I was involved in some). And further, consciously planned eco-systems of the type he cites – for example, developers building apps for the iPhone and iPad – can help to identify and then scale successful new technologies efficiently. Both of these things matter a lot. But here’s what I have seen big companies actually do to drive innovation that I think is most important for overall job creation and long-term growth:

1. Because innovation can only be partially planned, even the best research labs that create enormous value for the parent company also inevitably discover things that cannot be practically exploited by the parent firm. In the more extreme cases, they produce innovations that would threaten the parent company’s business model. Xerox’s comparatively tiny PARC lab invented the laser printer, which Xerox turned into a multibillion-dollar business. It also developed the graphical user interface, Ethernet computer networking, and most of the other elements of the modern personal computer that Steve Jobs famously exploited to make Apple, not Xerox, a leading personal-computer company.

2. Big companies provide a cash exit for successful start-ups, either before or after IPO. In this way they act as informed allocators of capital that intermediate between general investors and the complex technology landscape. Think of most software start-ups and IBM, Oracle, SAP, Microsoft and HP.

3. Big companies also use partnerships and other vehicles to act as marketing arms and integrators for successful technologies developed by start-ups. Think of biotech and big pharma.

What’s critical about these roles for big companies is that they require that you have lots of entrepreneurial firms to compete with the incumbents. And, in fact, if my characterization is correct, you would expect most of the job creation to happen in the successful new entrants as they grow, which is just what we see. According to the National Venture Capital Association, venture capital–funded firms employ a majority of all workers across many of the most productive and growing sectors of the economy, including the software, biotech, semiconductor, electronics, telecommunications and computer industries.

I’m glad to see somebody on the Left arguing for a modernized view of antitrust, but I think that what is essential if we are to do this is to reduce simultaneously the political power of large companies to stifle competition, as manifest in manipulation of patents, financial regulation, safety rules and the endless list of regulations, subsidies and tax breaks that govern the modern economy. This is similar to what Reihan called in his post “completing the neoliberal revolution.”

The market process is imperfect and takes time, but in my view is preferable to one in which we allow large companies (who will always have an advantage in lobbying and compliance) to use the political process to protect their position, which we then counter-balance with antitrust regulation. No real system of political economy is ever pure, so we will always have some amount of political jockeying and counter-jockeying; but in general, the more we get government out of the way of innovation, the better off we will be.

I think that “de-politcizing” the economy would be an important and powerful component of a Republican presidential campaign in 2012.

(Cross-posted to The Corner)

Storytime with Joseph Stiglitz

Arnold Kling points to an article in which famous economist Joseph Stiglitz lays out a theory for a common structure for the causes of the Great Depression and what Stiglitz calls the current Long Slump.

Here is what Stiglitz has to say:

At the beginning of the Depression, more than a fifth of all Americans worked on farms. Between 1929 and 1932, these people saw their incomes cut by somewhere between one-third and two-thirds, compounding problems that farmers had faced for years. Agriculture had been a victim of its own success. In 1900, it took a large portion of the U.S. population to produce enough food for the country as a whole. Then came a revolution in agriculture that would gain pace throughout the century—better seeds, better fertilizer, better farming practices, along with widespread mechanization. Today, 2 percent of Americans produce more food than we can consume.

What this transition meant, however, is that jobs and livelihoods on the farm were being destroyed. Because of accelerating productivity, output was increasing faster than demand, and prices fell sharply. It was this, more than anything else, that led to rapidly declining incomes. Farmers then (like workers now) borrowed heavily to sustain living standards and production. Because neither the farmers nor their bankers anticipated the steepness of the price declines, a credit crunch quickly ensued. Farmers simply couldn’t pay back what they owed. The financial sector was swept into the vortex of declining farm incomes.

He then goes on to describe how this problem propagated through the rest of the economy.

It’s interesting that in the first paragraph Stiglitz specifies that “more than a fifth” of all Americans worked on farms at the beginning of the depression, and that “2 percent” do today, but makes the non-numerical statement that “a large portion” of the population did so in 1900. I assume this would tend to lead most casual readers to think that most workers were on farms at that time. In fact, about 34% of the American labor force was in agriculture in 1900, and about 21% in 1930.

The proportion of Americans working on farms has been in continuous decline since at least 1800, when about three-quarters of the labor force was in agriculture. The decade with the biggest reduction in this proportion appears to have been the 1840s, when the percentage of the workforce in farming went from 67.2% to 59.7% (a reduction of 7.5 points). The rate of reduction from 1900 to 1960 appears to have been between 4 and 5 points per decade. As far as I can tell, this was roughly the rate of reduction from about 1860 – 1960.

The Great Depression occurred around the middle of a century-long, steady decline in the percentage of the labor force on farms. How could this decline have been the special cause of a spectacular economic collapse that occurred in one of these ten decades, but in none of those before or after?

(Cross-posted to The Corner)

How Elite Business Recruiting Really Works

There has been a lot of discussion in the blogosphere about a research paper by Lauren Rivera that describes how elite professional service firms (top investment banks, law firms, and management consulting firms) go about hiring. The argument is that it is basically a self-perpetuating old boys’ network. Reading the reactions of smart, well-intentioned people with no first-hand experience of this process, and who therefore take her paper at face value, this seems to be feeding into a meme of “the capitalist game is all rigged.”

I think that there is an element of truth to Rivera’s description, but it is mostly pretty misleading. I’ll focus my comments on management consulting, where I used to work for about ten years. I participated in every stage of the process from job candidate to new junior consultant to hiring partner.

Start with some quick industry background. You can divide management consulting into “strategy consulting” and “other.” Strategy consulting is the elite end of the consulting business. Most of strategy consulting can be sub-divided into two tribes: McKinsey and “Bruce Henderson’s children.” McKinsey is the industry leader. Bruce Henderson founded the Boston Consulting Group (BCG) in the 1960s. A number of BCG spin-offs have occurred since (e.g., Bain, SPA, LEK, etc.), and some of these have created further spin-offs. By far the largest and most important is Bain. Together, McKinsey, Bain and BCG (“MBB”) are the dominant elite recruiters for consulting, though a swarm of smaller strategy firms can compete successfully for the best talent.

There is a lot wrong with Rivera’s picture of how recruiting works, but I’ll focus on three important issues.

Rivera grossly exaggerates the degree to which access is limited to graduates of 4 super-elite schools.

Rivera says that:

Employers formally restricted competition to students at the nation’s most prestigious campuses and, contrary to common sociological assumptions about the role of institutional prestige in occupational attainment, having attended a highly selective school (e.g., top twenty five) was typically not sufficient for access to elite labor markets.

Here are about 40 schools in America where BCG and/or Bain are doing on-campus recruiting this year (meaning not just that they will accept resumes, but that they are doing things like on-campus presentations to get students interested, and then doing on-campus interviews): Duke University; Amherst College; Brigham Young University; Brown University; California Institute of Technology; Claremont Colleges; Columbia University; Cornell University; Dartmouth College; Harvard University; The University of Virginia; Princeton University; Yale University; UCLA; University of Michigan; Northwestern University; University of Chicago; Massachusetts Institute of Technology; New York University; University of Notre Dame; University of Pennsylvania; Emory University; Rice University; Southern Methodist University; Stanford University; University of California at Berkeley; University of Southern California; University of Texas; Georgia Tech; Morehouse College; UNC Chapel Hill; Washington University, St. Louis; University of California at San Francisco; Vanderbilt University; Baylor University; Texas A&M University; Georgetown University; Davidson College.

They also hire a lot of people from these campuses. Consider MBA hiring into the Associate position, which is the most common starting point for the climb to partner. The top MBA programs are usually considered to be Harvard and Stanford (please save your emails, as the point will hold if you move a couple of schools up or down a notch). In the next tier, MBB hired the following numbers of MBAs by campus this year: Northwestern (88), Wharton (85), Chicago (76), Columbia (60), MIT (55), Michigan (40), Duke (36), Dartmouth (24), Berkeley (23), and UVA (20). That’s over 500 hires, or more MBAs than these firms typically hire in a year from Harvard and Stanford.

This is nothing like a random sample of American universities, but it is a much bigger pool than Rivera implies. It’s not the top 4 schools, but more like 40 or 50 highly competitive schools, and 10 or 15 highly competitive MBA programs, that get you access to these firms. Further, while the odds of getting an offer are higher from the most highly-ranked schools, a large fraction of each incoming class normally comes from schools not ranked 1 – 4.

If you get into, for example, Michigan, UCLA, Emory or the University of Texas, work hard to get good grades in a difficult major, and score very well on standardized tests, you will likely be able to get an interview with one of the leading strategy firms.

Which brings me to the next point…

Rivera grossly overestimates the importance of extracurriculars, and grossly underemphasizes the importance of standardized test scores, and especially, case interviews.

Rivera says of elite employers that:

They restricted competition to students with elite affiliations and attributed superior abilities to candidates who had been admitted to super-elite institutions, regardless of their actual performance once there. However, a super-elite university affiliation was insufficient on its own. Importing the logic of university admissions, firms performed a strong secondary screen on candidates’ extracurricular accomplishments, favoring high status, resource-intensive activities that resonated with white, upper-middle class culture.

There will be exceptions to everything I say, but the way the actual selection process usually works is like this.

Interview slots with the best strategy consulting firms are a scarce commodity. Your resume gets you selected for an interview (though in rare cases, the cover letter and any interaction you may have had with the firm at campus recruiting events can matter a little). Take the example of undergraduate resume screening. Candidates are required to submit resumes, complete transcripts, and SAT scores. As an operational matter, the pile of resumes plus supporting materials submitted for all the candidates for school X is assembled, and each of these candidates is scored independently by three members of a school recruiting team (typically consultants who went to that school). These scores are then combined to create an aggregate rank for all candidates in that school. So, school prestige, which looms large in Rivera’s artificial mock resume screens, matters in selecting target schools, but is not usually relevant in real resume screening because you are screening resumes within a school.

In my experience as a resume screener, the logic normally goes something like this.

If you don’t have at least 750 on the math SAT, you’re out. The most common score is 800. Math plus verbal scores should be well over 1500, and typically over 1550. GRE, GMAT and other scores should be scaled similarly.

Then, your degree should be in something hard: math, physics, electrical engineering, analytical philosophy, computer science and so on. It’s OK to major in history or literature, but you better have some really tough quantitative or analytical classes on your transcript, and have done very well in them. If your GPA is below about 3.5, you’re out unless there is some really compelling rationale for why. The average successful candidate has a GPA above 3.7. Everyone understands how bad grade inflation is, and that it’s worst in the most elite schools. Any reasonably smart person with good instincts about course selection can figure out how to get a decent GPA at one of these schools. A GPA-plus-major screen is not about IQ, as much as it is a quick screen to see who is capable of figuring out how to succeed in a new environment, and of doing at least some sustained work. Screeners and interviewers will typically look at the transcript to make judgments about raw candlepower; for example, checking which calculus sequence the candidate completed, and if it was the most difficult track, what grades were achieved.

Prior summer internships at an MBB firm, Goldman, etc. are a strong positive. The reason is not that this means somebody is “clubbable.” The recruiting process for internships has similar resume screen / interviewing steps, and there are even fewer internship slots available each than there are slots for full-time jobs. Therefore, it means that this candidate has succeeded already in a similar, very difficult, selection process.

Finally, extracurriculars matter; but they are marginal compared to these other factors. They are mostly relevant if they show incredible drive. For example, working your way through school in some crap job where you have to deal with people is a big plus.

If you get an interview slot, there are then typically three rounds of interviews. Rivera’s paper claims directly that these are pretty loosey-goosey affairs which people are trying to get a sense of how polished the candidates are:

Interviews – which followed screens – were reported to be highly subjective assessments, where abstract notions of “fit” and “chemistry” routinely drove hiring decisions

Here’s how interviews really work, in my experience.

Interviews begin with first-rounds on campus. Each candidate is given a 45 minute interview, about 44 minutes of which is devoted to presenting the candidate with analytical challenges, and seeing how he or she works through them. The goal is to understand how the candidate can reason analytically – translating an unrehearsed real world problem to a mathematical representation, doing the math, and then translating this back to a real world solution, with awareness of all the simplifications that were necessary – under pressure. This is an attempt to recreate the most challenging part of the job, and is termed a “case” interview. Based on these, a majority of first-round candidates are cut. Second-rounds normally happen the next day on campus. It is a repeat, except that each candidate is normally interviewed twice that day, and each interview is longer. Based on these, a majority of second-round candidates are cut. The remaining candidates are invited back for third-rounds. This takes place at the company’s offices over a full day. Each candidate is subjected to 10 or more additional interviews, most of which are case format, but some of which are more typical “let’s talk about you and us” discussions.

Each candidate is then considered holistically, but because so few people in this final selection group have anything but extremely strong grades and test scores, the interviews are usually the crucial way to try identify the highest potential performers. A small fraction of those who started the interview process are offered jobs.

Which brings me to my third point…

Firms sell into a competitive marketplace.

Almost everybody would love to live in the cozy club atmosphere that Rivera described, and it is always creeping into hiring, promotion and compensation decisions at these firms, as in any human institution. Discipline is maintained only because you have to sell into a competitive commercial market. Unlike how it works in the movies, it is very rare that the COO of a Fortune 500 company hires your case team to do a six month project at $375K per month so that you can sit around and reminisce about rowing crew together at Old Eli. The more vibrant, competitive and open the overall corporate environment is, the more you will see continued emphasis on finding people who can produce, because the corporations will only pay for what creates commercial value for them. The more the corporate environment becomes dominated by crony capitalism, the more you will see the reverse. And to be more precise, you will see the characteristics that define a competitive consultant become more the kind that Rivera describes: fit, smoothness and familiarity with the ruling class.

In an earlier post, Steve Hsu made a useful distinction between what he calls the “soft” elite firms that Rivera profiles (investment banks, law firms and management consultancies) versus “hard” elite firms such as hedge/venture funds, startups and technology companies. He argues that the hard elite firms produce something more measurable, and therefore rely less on prestige in selecting people. This distinction is a useful starting point, but what has been happening over the past 20 years or so is the increasing migration of value from soft to hard; basically, to math, technology and analytics-intensive work. This is happening within firms and industries – the emphasis on math ability was growing within consulting in the period I worked in it, as it was within banking – and across sectors as technology start-ups and math-intensive finance became the most obvious ways to make real money in America. This isn’t random, but is happening because these are huge opportunities to create value. This is in part why I left consulting to start an analytics software company. It became obvious that this was the way to create value for clients. This won’t last forever, but has been true for some time.

This should emphasize that the people selected for these jobs are in no sense a “meritocracy.” Most obviously, it has nothing to do with moral worth, as people don’t earn their genes or parents. But more broadly, what I have described is not a hunt for the “best and brightest” in some general sense, but rather for people who have an incredibly arcane bent of mind and set of ambitions that fit into an environmental niche that they didn’t create. This is as true of “hard” elite firms as “soft” elite firms. Despite all the chest-pounding, 50 years ago most of these people would have clerks; a couple hundred years ago, not especially successful farmers. 50 years from now, for all we know, these will no longer be especially valuable talents.

Ironically, moving away from the idea that firms are looking for “the best” or “most worthy” in some general sense, and simply recognizing that they should look for predictors of success within a given business model relevant to a specific point in economic history, allows not only more effective hiring decisions, but also a little much-needed humility.

(Cross-posted to The Corner)

Nobody Ever Went Broke with Money in the Bank

That’s something that one of the smartest venture capitalists I ever knew once told me.

Matt Yglesias and Karl Smith find the fact that Apple is holding a huge cash hoard instead of paying dividends to shareholders to be pretty ridiculous. Felix Salmon finds Yglesias’s argument “trivially wrong.” All three are smart observers with interesting things to say, but I don’t think any of them presents this situation very well.

Yglesias says that this cash hoarding has caused Apple’s declining Price / Earnings (P/E) ratio:

The crux of the matter, as I see it, is Apple’s ever-growing cash horde which went from $70 billion in liquid assets at the end of Q2 to $82 billion in liquid assets at the end of Q3. The company is earning huge profits, which is great, but since it seems determined to neither return those profits to shareholders nor to re-invest them in expanded operations it’s hard to see how investors aren’t going to discount the value of the enterprise.

I’ve started and run a pretty successful enterprise software company, and I generally held a lot of cash on the balance sheet. From the perspective of shareholders, there can be many good reasons for this. First, do you know when cash-on-hand is most important? When nobody else has any. You can buy up the best talent, patents and assets when they are cheap; you can make big technology investments when they are cheaper; you can make big marketing pushes for the resulting new products when competition for customer mindshare is lower, and so on. When times are good (or at least not catastrophic) it seems like you could always get your hands on cash when you needed it, but that’s least true when you most want it. Cash is the option to act decisively at the moment when this can create large advantages for the company. Another example is that Apple is apparently holding the cash outside the U.S., and might be playing for time before repatriating it because they think corporate tax rates might come down. They might be playing any one of a million tax angles. Another example is that a massive cash pile can discourage potential competitors from entering important markets, because they know you can retaliate by either crushing their foray into your territory or by going after their cash cows. The U.S. will hopefully never launch its nuclear weapons, but we use them every day.

There are also not-so-good-for-shareholders reasons for it. There is an armchair psychology theory that because Jobs went through so many close calls in business, he had an irrational desire for cash on hand. That is at least plausible. But even if so, it’s not as simple as the shareholders just ordering Jobs to disburse the cash. If you believe that Jobs had this irrational desire, but part of the package required to get Jobs to continue run the company was to allow this kind of cash build-up, and that he increased shareholder value enough versus the next best alternative CEO to more than offset the impact of holding this much cash, then it still might be rational for shareholders to let him do it. In my experience, exactly this kind of dynamic happens in the real world all the time. More generally, sometimes a very large cash balance is an indicator that there is a principal-agent problem between shareholders (who want to maximize risk-adjusted returns on a portfolio of assets that includes this stock) and management (who want an operational cushion). Though sometimes, a large cash balance is an indicator of a disciplined management team that refuses to make poor investments in acquisitions or fanciful projects.

In short, there are tons of reasons – some good and some bad – why Apple might be holding this much cash. Apple’s P/E is being affected by some combination of their growing cash pile, changing overall market conditions, the death of Steve Jobs, projections of market saturation, beliefs about future Apple investment plans, competitive behavior, and many other factors. I don’t know whether or not Apple’s cash balance is too high or not; but based on this post, neither does Yglesias.

Salmon says of Yglesias’s argument:

This is trivially wrong. If Apple’s cash pile is growing, that will increase its p/e ratio, rather than decrease it.

In simplified terms, Salmon’s argument is the following. Consider stylized company X that has: $2 of earnings today; a market projection of present value of cash returned to shareholders of $10; 10 shares of stock outstanding; and no net cash on hand. In theory, the company should be worth its present value of cash flows, or $10. This would produce a share price of $10 / 10 shares = $1 per share. This implies a P/E of $1 / $2 = 0.5. If nothing else changes except the company has $2 of cash on its balance sheet, then in theory the company should be worth $10 + $2 = $12. This would produce a share price of $12 / 10 = $1.2. This implies a P/E of $1.2 / $2 = 0.6. So, Salmon argues, Apple piling up cash should increase P/E.

But, what this ignores is that the fact that Apple management has decided to retain the cash can rationally influence investor beliefs about the present value of future cash returned to shareholders in relation to current earnings. Yglesias illustrates the size and rate of growth of Apple’s cash balance by citing a quarter-to-quarter change, but his argument refers to a chart of Apple’s P/E over nine quarters. On this kind of timescale, the fact that management has decided to retain this much cash – rather than either invest it in the business, or pay dividends, or buy back shares – could be a signal to outside investors that management believes growth prospects are lower than previously believed, or that management has become irresponsible in its use of cash, or any other of many possible positive or negative signals. Different investors almost certainly read it different ways. Yglesias is not “trivially wrong.” He might even be right. I just don’t think either he or Salmon knows.

Smith is even more scathing than Yglesias about the point that Apple isn’t using the cash to pay dividends to shareholders:

I have a theory.

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

Now that’s not quite true. Apple’s stock price is sustained by the fact that if it goes low enough someone will buy the whole company and liquidate it. However, current investors shouldn’t be under any delusions that Apple has any plans whatsoever to provide them with a return on their investment.

I think that Smith’s point is that because Apple has not paid dividends, therefore I never get paid back real cash in return for the cash I pay for a share of Apple stock, and the only thing I can do with it is to sell it on to some greater fool. The only exception is if Apple gets to a sufficiently low value that owners band together and sell off the land, buildings, inventories, desks, patents and so on in an auction, and then divide up the proceeds.

Assuming that’s what he means, I don’t think it makes a lot of sense.

First, big tech companies often don’t pay dividends for a long time, until they do. Sometimes, these dividends are massive and continuing. Second, if there are continuing growth prospects for Apple that require cash (sometimes in ways that aren’t obvious, as per the first part of this post), then it makes sense for me as a shareholder to not want dividends for some time. The present value of the anticipated dividend stream is higher by getting more money later. If, at a future date, I have a desire for liquidity, I can sell my share of stock to another investor at that time. That investor may go through the same cycle, and the person he sells to may go through the same cycle, and so on. As long as the profit growth prospects are real, nobody has been a fool. Ultimately, the purpose of equity is to be converted into cash (or more precisely, consumption); but for a company like Apple, this can take a long time, and not every investor wants to go along for the whole ride. Third, the “exception” of shareholders banding together is not an exception, but something that often happens to companies well before their stock price reaches liquidation value. This is called the market for corporate control.

I don’t believe in anything approaching purely efficient markets. But when a journalist or academic makes claims that some company could just obviously create enormous value by taking some simple action, the obvious question to them is “Why aren’t you a billionaire?”

(Cross-posted to The Corner)

Re: Wealth, Innovation and "Job Creation"

Noah,

Thanks for the, as always, great post. You start by asking:

First, if it’s very uncertain how tax policy is going to affect innovation, why does that imply that taxes on the wealthy should be low?

I did not argue that that premise implies that conclusion. Krugman made an affirmative claim (or, as I went into in the post, he used language that Ozimek showed, I think correctly, could only be interpreted reasonably as implying) that innovators capture materially all of the economic value that they create. Ozimek provided a thought experiment that shows that this seems to violate common sense. Common sense is sometimes wrong, but I think the burden of proof is on those who make an affirmative claim. Krugman doesn’t provide any evidence for his claim beyond waving his hand at “textbook economics,” and Ozimek called him on it. I applauded this.

My only addition was to make an observation. Krugman claimed a contradiction between the belief in free-market principles and the belief that innovators can create material economic value that they do not capture, because the textbook economics that he believes is the foundation for belief in free market principles also claims that workers will capture the economic product of their labor. In fact, at least some people who hold free-market principles (e.g., me) do not ground their beliefs in Krugman’s textbook economics. So I am free to simultaneously hold the beliefs that innovators often cannot capture the full value of their work, and free markets are a good general organizing principle for the economy, without (at least this specific) contradiction.

Do Job Creators Matter?

Adam Ozimek at Modeled Behavior has a really great post on this question. It is a reply to Paul Krugman’s argument that, basically, high-income people get back in compensation their total value creation for the entire economy. For example, if Steve Jobs made a gazillion dollars, that means he created a gazillion dollars of value, but took it all back as his compensation; therefore had Steve Jobs never existed, nobody else in the world would have been any worse off. This is a simplification, but one of the great things about the post is that Ozimek carefully pins down the reasonable interpretation of Krugman’s actual assertion by going back to Krugman’s textbook writing.

Krugman argues that if we accept the premise that people get their marginal product of labor back as compensation, then why not set marginal tax rates to the level that maximizes government revenue: 70%?

Ozimek’s simple, great thought-experiment in the post:

Consider, for instance, that if we suddenly kicked out the top 10% of high IQ people (or 10% most productive people, or 10% most creative people, or whatever) in the U.S.. It strikes me as fairly likely that the total output of the remaining 90% would go down. Krugman seems to argue that this would not be the case. But even if you disagree with me in the short run, in the long-run the productivity increasing innovations these people would have made won’t show up, and the rest of us would have lower productivity as a result.

Now, instead of kicking out the top 10% of workers, just make them work less as a result of high income taxes. See my concern?

Lowered incentives of job creators and other innovators should be considered as one of the likely downsides to higher taxes.

Note that if you don’t think this is true, then what business do we have subsidizing higher education? If workers capture the entirety of their higher productivity, then I don’t see who gains by giving young people money to go to college rather than just cash.

I’d only add one observation.

Krugman ends his piece with this:

My point, then, is that this claim — and the lionization of high earners as people who make a vast contribution to society — is not, in fact, something that comes out of the free-market economic principles these people claim to believe in. Even if you believe that the top 1% or better yet the top 0.1% are actually earning the money they make, what they contribute is what they get, and they deserve no special solicitude. [Bold added]

What’s so funny about this is that Krugman is arguing that “these people” (i.e., people like me who think that a 70% marginal tax rate is not necessarily a good idea for America as whole) base our beliefs about political economy on his textbooks. He is pointing out a contradiction that exists only in his mind. I don’t accept his pseudo-scientific claims to knowledge about the impacts of doubling our maximum tax rate; my “free-market economic principles” are in fact based in part on my beliefs about the inherent uncertainty of such predictions.

(Cross-posted to The Corner)

Back Off Man, We’re Scientists

In an editorial in Monday’s New York Times, Adam S. Posen, an American economist, and a member of the Monetary Policy Committee of the Bank of England, provides an excellent illustration of an economist asserting that his policy preferences are literally scientific truth:

Scientific research tells us that high blood pressure and cholesterol are associated with a higher risk of heart disease and stroke, and that certain prescription medications reduce cholesterol and blood pressure. Yes, it is difficult to prove directly that taking these medicines prevents heart disease and stroke, and taking them is no guarantee of health. But still we should take them, and our doctors should prescribe them if they are indicated. This is the same situation we are in now, with our economy’s financial circulation at risk, and quantitative easing the indicated medicine. [Bold added]

Only, it’s not quite “the same situation” at all.

The problem is that medical science has conducted randomized clinical trials that show precisely this link between cholesterol-reducing drugs and reductions in strokes and morbidity. For example, a 1999 meta-analysis of more than a dozen randomized experiments testing the effect of statins (cholesterol-lowering drugs), showed that that “on average one stroke is prevented for every 143 patients treated with statins over a 4-year period.”

Note that the first sentence of the Lancet paper describing one of the early experiments to establish the effect of a cholesterol-reducing drug on mortality is: “Drug therapy for hypercholesterolaemia has remained controversial mainly because of insufficient clinical trial evidence for improved survival.” Precisely the lack of such experimental evidence engendered a debate; resolution required experiments that established definitively the effects of the interventions.

We have nothing like this for quantitative easing. Lacking experimental evidence doesn’t mean that therefore we should not undertake quantitative easing, but the editorial is an attempt to browbeat opposition by appeal to a purported, but unsubstantiated, scientific authority.

(Cross-posted to The Corner)

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Me, Inc.

Megan McArdle and Arnold Kling (two bloggers who are very helpful in understanding the actual economy where we now live, by the way) make the point that life can be good when you have a comfortable job, but it’s dangerous, because it is likely to go away. Here’s Kling:

A job seeker is looking for something for a well-defined job. But the trend seems to be that if a job can be defined, it can be automated or outsourced.

The marginal product of people who need well-defined jobs is declining. The marginal product of people who can thrive in less structured environments is increasing.

The way I have put this is that workers in our economy are in a race between development of as-yet-non-commoditized cognitive capabilities on one hand, and wage reductions as capabilities are commoditized through technological advances (broadly defined) on the other. This has been going on for a long, long time, but it does seem to be speeding up – why?

I think there are several non-mutually-exclusive causes:

1. Information technology. Moore’s Law is creating the kind of advances in information storage, processing and transmission that automate knowledge work in the way that technologies 50 – 150 years ago were automating physical labor. Market research managers, journalists, software engineers, and most of the people they know, are now being subjected to this unpleasant process. As a practical example, the Internet has automated out of existence much of the labor that journalists, librarians, many middle managers in corporations and others used to do. The term we normally use to describe this (when it is not happening to us) is “productivity growth.”

2. Globalization. The decreasing relevance of large-scale war under Pax Americana combined with the economic re-emergence of Western Europe and Japan by the 1970s, and the Asian heartland more recently, have created trans-national labor pools through a mix of outsourcing, immigration, and importing labor content via shipped manufactured goods. We move the stuff, the jobs or the people; but, in all cases, labor in Indiana increasingly competes with labor in India. Ceteris paribus, this creates upward pressure on wages for the most skilled, and downward pressure on wages for the less skilled.

3. The market for corporate control. Starting with the leverage buyout movement of the 1980s, U.S., and later European, companies became more aggressive about seeking shareholder value through automation, outsourcing, and just stopping doing things that did not generate returns above cost of capital. The underlying causes were technology change and globalization, combined with a flexible American political economy which made the best of a worsening situation.

4. The death of the “Detroit model”. The comatose state of the whole Big Auto, Big Steel and related industrial supply chain is a very important example of these effects, but was also accelerated by other contingent factors. Because of its size, this matters. American domestic production of oil peaked in 1971; oil imports doubled between 1970 and 1975; and OPEC was able to drive large price increases. This tended to disproportionately harm those industries that were the source of high-wage union jobs. Private sector unionization has withered across the economy as the bargaining power of industrial workers declined. In what is probably inextricably both cause and effect, “non-­distributive services” (finance, professional services, health care, and so on) became in 1970 a larger part of the private economy than goods-­producing industries. This shift to services tended to enhance the prospects of the cognitive elite at the expense of traditional industrial workers.

I think that what both McArdle and Kling are pointing to is less an aberration, than a return to what is a more natural situation. The comfortable post-WWII combination of high incomes plus stability is the anomaly.

Of course, what sticks out like a sore thumb in all of this is the position of public sector workers.

(Cross-posted to The Corner)

“I just stay in bed if no one calls me”

Yesterday’s Wall Street Journal had an uplift piece on using gee-whiz data analytics to improve Chicago’s public schools. I found it incredibly depressing. Here is how the article opens:

At 7:15 on a chilly May morning, Marshall Metro High School attendance clerk Karin Henry punched numbers into a telephone, her red nails clacking as she dialed.

“Good morning, Miss MeMe,” she said to Barbara “MeMe” Diamond, a 17-year-old junior with a habit of oversleeping. “This is Ms. Henry, your stalker.

The timing of the call was key. Earlier in the year, Ms. Henry and a co-worker were spending nearly two hours a day calling every student who hadn’t checked into school by 9:30 a.m. But weekly data tracked by their office found that only about 9% of those students ever arrived. So they changed tactics, zeroing in on habitual latecomers like MeMe, and delivering wake-up calls starting at 6:30. On that May morning, 19 of the 26 students called showed up.

“I just stay in bed if no one calls me,” MeMe said. “That 6:30 call be bugging me, but it gets me here.”

Here is how the article ends:

Sharief Raines, an 18-year-old senior with a toddler at home, took the challenge after missing every school day in December. In January, she showed up 12 of 19 days. Ms. Calhoun even watched the baby one afternoon while Sharief did homework. “I saw Dean Calhoun was trying to help me,” she said. “I didn’t want to let her down.”

Sharief graduated June 11.

The attendance clerk sounds like somebody getting into the office early to get her job done, and I assume that both MeMe Diamond and Sharief Raines have faced enormous obstacles in their lives. I say this without malice, but no school is going to solve the problems of many students like this. This school exists within a sea of dysfunction that it cannot fix.

The implicit frame of reference that is normally used for these kinds of stories is the history of the communities and families in question, or the “good” suburban schools around them. Mine is different.

Globalization has created trans-national labor pools through a mix of literal outsourcing, immigration and importing labor content via shipped manufactured goods. We move the people, the jobs or the merchandise; but either way, workers in Illinois must increasingly compete with workers who live in Eurasia or have immigrated here from Latin America and elsewhere. These are no longer poor people “out there somewhere” for whom we should feel pity and give foreign aid, but people with whom, one way or another, our hourly pay is being compared by those who will decide where new jobs go. Today there are probably hundreds of millions of people on one side of the relevant labor pool who have such a different orientation toward school that the worry is that they’re working too hard, and hundreds of millions of low-skill competitors on the other who are prepared to work for wages much lower than those of even very poor Americans.

Within less than one year, MeMe and Sharief will have to compete in that environment. There is no fixed lump of labor. By specializing in what we do best, and then trading with ever-larger numbers of others who can afford to buy our output, we can become wealthier. What will MeMe and Sharief specialize in? Who in an open market will pay enough for their time to create sufficient income to support them (and Sharief’s child) in a humane manner? (It’s easy to read this as scornful, but I really just feel sympathetic, in that if dealt the same hand of cards, I think I would be in pretty much the same place.)

By extension, where are large chunks of the American labor force are headed? How much dysfunction can the productive economy carry on its back as the level of global competition rises ever higher?

The answers to all of these questions are, in my opinion, very troubling.

I don’t have any great solutions, but then again, I don’t think anybody else does either. “The Answer” is probably not there to be found. I doubt there are any silver bullets, just lots and lots of scut work in many areas, each of which can make a small contribution.

“Data-driven schooling,” if done with this perspective in mind, can certainly make an incremental positive contribution. But it’s easy to do it in a way that actually makes things worse.. If focused on short-term carrots-and-sticks that ignore character effects; if divorced from the right incentives for the participants; and if not focused on careful evaluation of the actual success or failure of interventions against validated outputs, it’s likely to be a huge waste of scare time and money.

(Cross-posted to The Corner)

A U.S. Manufacturing Strategy, Part 2

This continues from the prior post, which argued that the U.S. government ought to care a whole lot about absolute and relative American productivity growth.

Proposition 2: Not all kinds of productivity growth are created equal

I’ll illustrate two different kinds of productivity growth with practical examples from my experience in the manufacturing industry. I once invented a new production planning algorithm (essentially, the decision rules for which products to make when, and in what sequence) that improved the output of a specific factory by about 5 percent. This is pure gravy: the same people show up at the same factory and work the same number of hours, the same raw materials are purchased and so on, but the world just gets 5 per cent more widgets out of the other end. This is normally the kind of thing most people picture when they use the term “productivity growth” in normal speech. On another occasion, I figured out the financing that made it profitable to shut down an entire factory, and sell the land to a property developer. This is normally the kind of thing that most people mean in normal speech by “the locusts of private equity.” I’ll call the first example an improvement in “operational efficiency” and the second example an improvement in “allocative efficiency.” In fact, both are necessary for ongoing improvements in productivity and wealth for an advanced economy.

Let me describe the decisions around these kinds of changes from the point of view of a business owner or executive. In somewhat simplified terms, if I’m doing stuff that earns returns below my cost of capital, or if I can get someone else to do it for me at lower cost than I’m doing it, it makes sense to cut out the activity. These cut activities will tend to be those with lower productivity. Cutting activities for shareholder value reasons will therefore strongly tend to cut low-productivity activities, and increase my firm’s average productivity through pure “high-grading.” But this ignores at least a couple of important questions. First, did I fail to uncover economically achievable improvements in operational efficiency that would have allowed me to conduct these activities at higher returns and cheaper than alternatives? Second, are the cut activities linked in some non-obvious way, and potentially only over time, to the other more profitable activities, such that I have fooled myself into putting the profitable parts of the business at risk?

A business culture that ignores these questions can tend to get into a death spiral of endless high-grading against an ever-rising tide of competition that eats the business one bite at a time. The fear of many critics of American business (or “Anglo-Saxon financial capitalism”) has for a long time been that this is what is happening to the American economy on a grand scale.

And further, at the level of the entire society, while a firm can get more productive by high-grading, if the alternative employment for the people who used to work at the closed factory is collecting unemployment checks, can’t this become a society with an ever-shrinking base of people with high-paying jobs? This is the nightmare scenario of an ever shrinking number wealthy financiers, who are increasingly detached from a broader society all around them living off a combination of table scraps and handouts.

There is something to this fear. But on the other hand, the failure to allocate capital and labor from kinds of activities where there are inherent limitations to how productive they can be to those where they have greater inherent productivity will also hurt productivity growth in the long run. The key word in that sentence is “inherent.” The more we can take what is currently viewed as inherent productivity by analysts, economists and others, and improve it by unanticipated innovations, the more we can have allocative efficiency without giving up as many manufacturing jobs.

Think of operational efficiency as getting better at playing a given game, and allocative efficiency as deciding what games to play. We need both. We want to have an economic regime such that the people working a specific line in a given plant work as hard and as smart as possible to get that line to be as productive as possible; such that the management of that plant is allocating resources among the production lines, and thinking hard about the overall production process such that they make that plant as productive as possible; such that the company is doing the same thing at a yet-higher level for its collection of factories, warehouses and sales offices; and such that the economy as a whole is allocating resources across firms intelligently.

In fact, when we move from the level of the individual firm to the economy as a whole, the nature of the process of resource allocation should change. If, following Coase, we very crudely define the boundaries of the firm as the maximum extent of activity for which central planning can work effectively, then we need to use markets to allocate resources across firms. The unique virtue of markets is not so much in their allocative efficiency, as in what Douglas North termed their “adaptive efficiency”: basically, discovering entirely new ways of organizing resources. If allocative efficiency is deciding what game to play, adaptive efficiency is inventing entirely new games. Adaptive efficiency is not nearly as important for an economy in catch-up mode, but for an advanced economy, it is essential for productivity growth.

We can think of a hierarchy of kinds of productivity growth, with operational efficiency at the foundation, then allocative efficiency next, and finally adaptive efficiency as the master-allocator of resources. We then need to think about manufacturing strategy in the context of the need for the combination of operational efficiency, allocative efficiency and adaptive efficiency that will create rapid, continuing productivity growth in the economy as a whole. In effect, adaptive efficiency – which, all else equal, is likely to continue to squeeze out manufacturing jobs – needs to be the evolutionary principle by which the economy creates productivity growth, but efforts to improve operational efficiency within manufacturing will change the set of “givens” (for example., the relative profitability of in-sourcing versus outsourcing) that this evolutionary process will confront.

The next post in this series will try to sketch out some ideas for what I think is most likely to help do this.

(Cross-posted to The Corner)

A U.S. Manufacturing Strategy, Part 1

There has been an interesting ongoing blogosphere dialogue on the role of manufacturing in creating high-wage jobs in America, involving Paul Krugman, Reihan Salam, David Leonhardt, Karl Smith and Michael Mandel, among others.

This topic has been a fixation of mine for a very long time. Here is how I opened an article a couple of years ago in National Review:

I still remember the first time I walked into a working factory. In the foreground, innumerable machines whirred and clacked away in precise, interlocking dances. A massive vat shaped like a 50-foot-tall Campbell’s soup can loomed in the background. It was encased in a protective sheath of refractory bricks that glowed dusky pink with trapped heat. A crane arm dumped heavy sand continuously into the top at (literally) industrial volumes. Steaming, liquid glass gushed out of the business end at the bottom in a matching stream. I couldn’t see the heating element, but it was in there somewhere, and it was working. …

I was looking at concretized human ingenuity. In the auto industry, “car guy” is a slang term for an executive who doesn’t just view the business of a car company as making money, but loves the cars themselves. I’m a factory guy.

I spent the first few years of my career in the 1980s as one small part of a self-conscious movement to rescue American manufacturing from its projected obsolescence. I’ve worked in glass plants, assembly plants, oil refineries, and textile plants from Florida to Canada, and many points in between. I’ve carried a union card and walked a picket line.

I’ll put forward several propositions as being as being relevant to this discussion. (This would be a very long blog post, so I’ll break them up into several posts.)

Proposition 1: Competitiveness is productivity

Professional economists often pooh-pooh the importance of national competitiveness. To quote Krugman:

The growing obsession in most advanced nations with international competitiveness should be seen, not as a well-founded concern, but as a view held in the face of overwhelming contrary evidence.

They will point out that we all gain from trade, and as people in other places get richer, so can we. Countries, they say, are not like corporations.

Maybe so, but it’s still the case that some societies are populated by lots of people with high wage jobs, nice houses and good schools, and other societies are populated by lots of people hustling for tips from vacationers from the first kind of society. Over time, people who spend their working hours generating goods or services that they can sell for a big margin versus the costs of the required inputs will tend to live in the first kind of society. Nothing is forever in this world, but I want America to remain in that camp for a very long time.

This doesn’t occur by immiserating other societies – international economic competition is not zero-sum in that sense. But there are many paths open to us for how we react to the rise of non-Western economies, some of which lead to us being much better off than others, both in an absolute sense, and also in a relative sense.

Relative productivity is likely to matter a lot, because it will materially influence future absolute wealth by affecting the flow of global technology and innovation. But relative productivity and wealth also matter in and of themselves. First, they will impact the global prestige and success of the Western idea of the open society which we value independently of its economic benefits. Second, maintenance of a very large GDP per capita gap between the West and the rest of the world will be essential to maintaining relative Western aggregate GDP, and therefore, long-run military power.

In sum, we want the rest of the world to get richer, but we want to stay much richer than they get.

This demands that we sustain rapid productivity growth over many decades. Unfortunately for us, this is much harder to do for an advanced economy than for those in catch-up mode, and is likely to continue to create very tough social strains in America. Perhaps we’re just not up to it. This, and not some lets-all-succeed-equally-together happy talk, is the real meaning of globalization for America in 2011.

(Cross-posted to The Corner)