The Failed Investments of Ivy League Schools and the Future of Hedge Funds

If the elite universities had simply invested in index funds that matched the stock market average instead of hedge funds, there would be much more money to grant to disadvantaged youth and to valuable research initiatives. Those universities have all that prestige and influence, and they even have a tax exempt status — and pound for pound they still did worse than a good average investor would have.

The New York Times highlighted the findings of a remarkable study last week. The study, by Markov Processes International, examined the 10-year returns of the endowments of the 8 Ivy League schools. The study found that all 8 endowments had lower returns than a simple mix of 60 percent stock index funds and 40 percent bonds. In some cases, the gap was substantial. Harvard set the mark with its annual returns lagging a simple 60-40 portfolio by more than 3.0 percentage points.

[…]

And, just to be clear, the Markov comparison was overly generous to the universities. Their benchmark comparison of a portfolio of 60 percent stock and 40 percent bonds is in fact far safer than the alternative investments they hold. If they actually equalized risk, the comparison portfolio might be 80 percent or even 90 stock, making the Ivy league endowment returns look even worse.

The Ivy League schools are not the only big institutional investors who are turning to alternative investments. State and local pension funds also play this game in a big way. The beneficiaries are more often private equity partners, but the basic story is the same: people who make themselves very rich by playing financial games. And, as with the hedge fund folks and the Ivies, they do not provide the promised returns.

And, there is considerably more money at stake with public pension funds. The cumulative size of the Ivy League endowments is just under $140 billion. While this is hardly chump change, state and local government pension funds have more than $8 trillion in assets. Most of this money is not in alternative investments, but if just 10 percent were placed with private equity funds and other alternatives, it would come to $800 billion.

There is much to dislike about the behavior of these financial actors. They routinely play games with the tax code and bankruptcy law to increase returns. It is standard practice for private equity funds to leverage their companies as much as possible to take advantage of the deduction for interest on corporate income taxes.[1]

They also strip valuable assets, such as the real estate on which stores and restaurants sit, so that they can book a quick profit while leaving the companies they control more vulnerable to a business downturn. Bankruptcy is a common tool, which they use to get out of not only interest payments on debt (presumably lenders knew the risks they were taking), but also pension and health care obligations to workers, and payments to suppliers.

[…]

In terms of inertia, people can point back to a period where the hedge funds did produce outsized returns, as did the private equity funds. People can think that the last decade or so is just an aberration, and that the good times will return.

While I can’t predict the future, there is a simple story that would imply the opposite. Both hedge funds and private equity funds prospered by finding seriously under-valued assets and then leveraging heavily to maximize their return. When there were few actors in the field, it was possible for some number of funds to make large returns this way. But now that there are many actors, with trillions of dollars to invest, seriously under-valued assets are few and far between.

This means that most hedge funds and private equity funds won’t be able to make outsized returns going forward. The high fees to the fund managers are a direct drain on returns that would otherwise more or less match the market average.

And just to be clear, we are talking about a 10-year period in which hedge funds have failed to match the market average. (It’s a similar story with private equity.) This is a long period, it’s not just a case of these funds having a bad year or two.

The Economy is Deliberately Rigged at the Expense of Most

The economy has been rigged to benefit the richest people at the expense of many of the poorest ones. The negative effects surrounding massive deindustrialization (most significant of which is likely tearing apart entire communities due to job losses and downward pressure on median wages) could have been significantly lessened with different governmental policies.

There have been several analyses of the 2018 election results showing that the Republican regions are disproportionately areas that lag in income and growth. In response, we are seeing a minor industry develop on what we can do to help the left behinds.

The assumption in this analysis is that being left behind is the result of the natural workings of the market — developments in technology and trade — not any conscious policy decisions implemented in Washington. This is quite obviously not true and it is remarkable how this assumption can go unchallenged in policy circles.

Just to take the most obvious example, the natural workings of the market were about to put most of the financial industry out of business in the fall of 2008. In the wake of the collapse of Lehman, leaders of both the Republican and Democratic parties could not run fast enough to craft a government bailout package to save the big banks, almost all of which were facing bankruptcy due to their own incompetence and corruption.

It is worth contrasting this race to bailout with the malign neglect associated with loss of 3.4 million jobs in manufacturing (20 percent of the total) between 2000 and 2007 (pre-crash). This job loss was primarily due to an explosion in the trade deficit. The latter was due to an overvalued dollar, which in turn was attributable to currency management by China and other countries, that kept their currencies below the market level.

While most economists now acknowledge the impact of China’s currency management, at the time there was a great effort to pretend that this was all just the natural workings of the market. The loss of jobs, and the destruction of families and communities, was not a major concern in elite circles, unlike the prospect of Goldman Sachs and Citigroup going bankrupt.

The decision to bail out the banks is routinely justified as being necessary to prevent a Second Great Depression. No one who says this has a remotely coherent story as to how the bankruptcy of these banks would have condemned us to a decade of double-digit unemployment.

We have known for 70 years how to get out of a depression (it’s called “spending money”). if the banks had collapsed, it would have undoubtedly worsened the 2008–2009 downturn, but nothing would have prevented us from boosting the economy back to full employment with a large burst of spending, just as the spending needed to fight World War II brought the economy to full employment in 1942.

Excessive CEO Pay Takes Money Away from Other Workers

The op-ed provides a good analysis of the problem with the economic structures that allow CEOs to be excessively overpaid — the substantial amount of money that the CEOs are overpaid with could instead be going to other lower-level workers. Wages in the United States have hardly increased in decades for most American workers, and the CEO pocket money would make a significant difference in their lives.

The problem is the structure of corporate governance. The people who most immediately determine the CEO’s pay are the corporation’s board of directors. These directors have incredibly cushy jobs. They typically get paid several hundred thousand dollars a year for perhaps 150 hours of work.

Members of corporate boards largely owe their jobs to the CEOs and top management. They almost never get booted out by shareholders; the reelection rate for board members running with board support is over 99 percent.

In this context, board members have no incentive to ask questions like, “Could we get someone as good as our CEO for half the pay?” There is basically no downward pressure on CEO pay and every reason to boost pay. After all, if you were sitting on some huge pot of other people’s money, wouldn’t you want to pay your friends well?

Of course, the CEO pay comes at the expense of returns to shareholders, and these have not been very good in recent years in spite of the best efforts of Trump and the Republicans to help them with tax cuts and pro-business regulation. In the last two decades, stock returns have averaged less than 4.7 percent annually above the rate of inflation. By contrast, in the long Golden Age from 1947 to 1973, real stock returns averaged 8.2 percent.

With the bulk of stock being held by the richest people in the country, there is no reason to shed tears for stockholders, but the fact is they are being ripped off by CEOs and other top management. Given the choice, we should prefer the money ends up in the hands of shareholders rather than CEOs. After all, people below the top 1 percent do own stock in their 401(k)s, as do public and private pension funds. By contrast, every dollar in additional CEO pay is going to someone in the top 0.001 percent of the income distribution.

More important than the money going to the CEOs is the impact that their outlandish pay has on pay structures in the economy more generally. When the CEO is pocketing $20 to $30 million a year, other top executives are likely earning close to $10 million and even the third-tier managers might be topping $1 million.

[…]

If a successful CEO of a large company was pocketing $2-3 million a year, instead of $20 to $30 million, the ripple effect on the pay of others near the top would leave much more money for everyone else. This gives us very good reason to worry about excessive CEO pay.

If the structure of corporate governance makes it too difficult for shareholders to collectively act to limit CEO pay, threatening them with a return to the pre-Trump 35 percent tax rate might give them enough incentive to get the job done. It has always been in the interests of shareholders to pay their CEOs as little as possible, just as they want to pay as little as possible to their other employees.

If shareholders pay a CEO $20 million more than needed to get someone to run the company, it has the same impact on the bottom line as paying $2,000 extra to 10,000 workers. No company deliberately overpays their frontline workers.

Lessons from the 2017 Tax Scam

The tax cuts were supposed to lead to an investment boom, which would increase productivity in the economy, which would then in turn provide a boost to real wages for most workers. That essentially didn’t happen of course, and it was simple enough to predict that with an economy already so rigged for the richest at the expense of everyone else.

It’s a bit less than a year since Congress passed the Trump tax cut, but we are far enough along that we can be fairly confident about its impact on the economy. There are three main lessons we can learn:

  • The tax cut is to not leading to the promised investment boom;
  • The additional demand generated by the tax cut is spurring growth and reducing the unemployment rate;
  • The Federal Reserve Board’s interest rate hikes are slowing the economy in a way that is unnecessary given current inflation risks.

The Investment Boom: Just Like Jared Kushner’s Hidden Genius, No One Can See It

Taking these in turn, it is pretty clear at this point that we will not see the investment boom promised by proponents of the tax cut. This point really has to be front and center in any discussion of the benefits of the tax cut. By far, the largest chunk of the tax cut was the reduction in the corporate tax rate from 35 percent to 21 percent, along with various other measures lowering corporate taxes.

The immediate impact of a corporate tax cut is to give more money to the richest people in the country since stock ownership is highly skewed towards the top 10 percent of the income distribution and especially the top one percent.

[…]

The data for the first three quarters of 2018 indicate that this is not likely to happen. Investment is up modestly, but we’re clearly not seeing the promised boom. In the first three-quarters of 2018 investment was 6.7 percent higher than in the same period last year. By comparison, investment rose by 6.9 percent in 2014 and increased at a 9.1 percent annual rate from 2010 to 2012.

Much of the growth we have seen this year is not from tax cuts, but higher world energy prices spurring a boom in oil and gas drilling. If we pull out energy-related sectors, the rise in investment would be even less.

[…]

There is also no evidence of the promised investment boom in any of the various surveys showing business plans for the future. For example, the Commerce Department reported last week that new orders for non-defense capital goods, the largest component of investment, were up by less than 1.0 percent from their year-ago levels.

In short, at this point, it certainly looks like the skeptics were right. Cuts in corporate tax rates are not an effective way to boost investment, they are an effective way to give more money to rich people.

Larger Budget Deficits Can Boost Growth and Employment

The second point is that the tax cuts did boost demand. This meant more growth and more jobs than we would have otherwise. This is a very good story; the 3.7 percent unemployment rate is the lowest we have seen in almost 50 years. The Congressional Budget Office is projecting the unemployment rate will bottom out at 3.2 percent next year. Its pre-tax cut forecast had the unemployment rate at 4.2 percent in 2019.

When we get to low levels of unemployment the people who are getting jobs are overwhelmingly workers who are disadvantaged in the labor market, blacks, Hispanics, people with disabilities, and people with criminal records. The chance to get a foot in the labor market can make an enormous difference in their lives. We don’t have any social programs that can make as much difference for these people as say, lowering the unemployment rate from 4.5 percent to 3.5 percent.

In addition to giving people jobs, the tighter labor market also gives workers in the middle and bottom of the wage distribution the bargaining power to achieve real wage gains. While the rate of real wage growth has been disappointing given the low levels of unemployment, workers at the middle and bottom have been seeing real wage gains the last four years in contrast to earlier in the recovery when their wages were stagnant or declining. It is likely that the rate of real wage growth will pick up if the unemployment remains this low or goes lower.

While boosting growth with a larger deficit offers clear and substantial benefits, tax breaks to the rich were hardly the best way to do it. If we had spent the money on infrastructure, education, or even tax breaks to low and moderate income households, it would have boosted demand by even more. And, we would have seen a longer-term dividend of a more productive economy if we spent the money on infrastructure and education.

Obviously, the Republicans’ priority was giving more money to rich people and, given their control of the White House and Congress, it was inevitable that a tax cut for the rich would be the outcome. The Republican Congress blocked efforts by Obama to have any stimulus in his second term, but he really did not push the case. Many of Obama’s top economic advisers were fearful of deficits and were not anxious to see additional spending that was not offset with either tax increases or spending cuts in other areas.

We see from the economy’s response to the tax cut — increased growth, lower unemployment, and no evidence of accelerating inflation — that the economy could benefit from a larger budget deficit. It is unfortunate that we were only able to get this boost by giving still more money to rich people.

Real Wages Today

Why inflation and real wage gains are low isn’t really a mystery. It’s because worker bargaining power has been largely destroyed by the policies of the last generation.

The United States labor market is closing in on full employment in an economic expansion that just began its 10th year, and yet the real hourly wage for the working class has been essentially flat for two years running. Why is that?

Economists ask this question every month when the government reports labor statistics. We repeatedly get solid job growth and lower unemployment, but not much to show for wages. Part of that has to do with inflation, productivity and remaining slack in the labor market.

But stagnant wages for factory workers and non-managers in the service sector — together they represent 82 percent of the labor force — is mainly the outcome of a long power struggle that workers are losing. Even at a time of low unemployment, their bargaining power is feeble, the weakest I’ve seen in decades. Hostile institutions — the Trump administration, the courts, the corporate sector — are limiting their avenues for demanding higher pay.

[…]

Slow productivity growth is another constraint on wages. When companies are able to produce more efficiently, they can absorb higher labor costs without sacrificing profit margins. But such gains have been elusive in this recovery, so businesses are increasing profits at labor’s expense.

More than ever, the dynamics of this old-fashioned power struggle between labor and capital strongly favor corporations, employers and those whose income derives from stock portfolios rather than paychecks.

This is evident in the large, permanent corporate tax cuts versus the small, temporary middle-class cuts that were passed at the end of last year. It’s evident in the recent Supreme Court case that threatens the survival of the one unionized segment of labor — public workers — that still has some real clout.

It’s evident in the increased concentration of companies and their unchecked ability to collude against workers, through anti-poaching and mandatory arbitration agreements that preclude worker-based class actions. And it’s evident in a federal government that refuses to consider improved labor standards like higher minimum wages and updated overtime rules.

Why the Fed Raising Interest Rates Matters

The Federal Reserve is the central bank of the United States. There are many valid criticisms of it as an institution, but it can act as a valuable force for the public interest if used properly.

As is the standard of central banks, the Fed has a powerful tool that allows it to have a major impact on short-term interest rates. Interest rates are basically bread and butter to the number of people who have jobs in the economy.

Raising interest rates has the effect of slowing the economy and keeping people — potentially millions of them, as shown in recent years — from finding jobs. Higher interest rates naturally mean less loans to businesses and organizations that could use them to hire more workers. The standard argument for raising interest rates though is to control inflation, as higher interest rates reduce pressure in the labor market, which then leads to workers having less bargaining power for pay increases.

The problem with the argument to control inflation is that inflation has already been quite low in past years, well below the Federal Reserve’s 2.0 percent annual target. The 2.0 percent target is supposed to be an average, and considering recent years, it hasn’t even been near that target. The Federal Reserve was set up with the dual mandate of both adequately controlling prices and maintaining what’s known as full employment. Full employment basically means a strong labor market with low unemployment, where workers can have good access to jobs with fair wages, and it’s quite important as a policy measure. (Due to slow wage growth among most, the U.S. economy clearly isn’t at full employment now, contrary to what you’d likely read in the newspapers.)

If unemployment is low, it means that there will be an increased demand for labor, which should both mean higher wages for workers and that the economy’s resources are being used decently well. The increased demand for labor raising wages is because employers cannot so easily hire other workers if their employees happen to leave the firm. Without enough employees, the firm risks being losing profitability to its competition and going out of business. This situation would allow an existing employee to say something like “Give me a raise or I will find a job elsewhere,” and it would potentially allow a prospective employee to refuse a job unless the wage is adequate enough.

The increase in worker bargaining power leading to higher wages and then higher inflation is due to firms needing or deciding to raise prices some after seeing that workers generally can pay more. There is nuance needed in this description, and it should be noted that wages for most workers in the U.S. have been mainly stagnant for decades due to the policy-driven upwards redistribution of income to the wealthy, but it’s a standard point. If the policy is actually directed towards the interest of the general public, the increases in prices will be more than offset by the increases in wages, however. There is evidence of this worker-friendly approach doing well in the U.S. from about 1947 to 1973.

It should also be noted that the only times that many American workers have experienced even minor real wage increases in the last four decades have been when there were tighter labor markets. This occurred in the later 1990s and over the past several years, and it points to the immense importance of the Fed keeping interest rates low.

Alan Greenspan was the economist at the head of the Fed in the 1990s, and for whatever reason, he decided against raising interest rates as the unemployment rate got lower. This was at a time when it was standard in the economics profession to claim that the unemployment rate couldn’t go below about 6 percent without leading to rapid inflation. Inflation never got that high in the 1990s though, and even if Greenspan deserves serious criticism for failing to contain the housing bubble that was the main cause of the devastating economic crash and Great Recession, he does deserve praise for doing this one thing to help low- and middle-income workers.

Janet Yellen’s chair appointment at the Fed also saw the institution keeping interest rates quite low for her tenure, which is clearly one of the main reasons that the U.S. economy is doing decently well now in 2018 relative to the last four decades. Driving around America now would allow someone to see many more help wanted signs than in at almost any other time thus far in the 21st century, and there’s an advantage to this that may not be so obvious: Disadvantaged workers (typically those from minority ethnic groups or with disabilities) will have an easier time finding jobs. The increased demand for labor means that there’s less room for discrimination against them. As proof of this, the disabilities application rate and the unemployment rate for African-Americans have fallen to historically low levels.

The unemployment rate does of course have its flaws. It measures workers looking for jobs, not the amount of people who have dropped out of the labor force and are no longer looking for employment. There is plenty of good work that needs to be done, and there are idle hands that want to do it, but the dysfunctional American economy isn’t putting the two together enough. So while the unemployment rate is an important measure, there are other relevant indicators (such as the labor force participation rate among prime-age workers) that should be considered in assessing the economy.

But if the majority of workers benefit most from lower rather than higher interest rates, why does the Fed continue to raise them then? It’s largely because financial institutions exert significant control over the Fed, and their preference is to keep inflation as low as possible. More worker bargaining power via lower interest rates can mean a shift from net corporate profits to wages for workers, and bank loans also stand to depreciate in value with higher inflation.

The after-tax corporate profit share of national income has almost doubled since 2000, and this to a significant extent is because of wages for workers being diverted into corporate profits that are largely pocketed by executives and major shareholders. According to one reputable estimate, if the after-tax corporate profit share was back at its 2000 level, it would translate to nearly $4000 more per U.S. worker in wages, a fact that is undoubtedly quite disturbing.

Since the loans of banks and other financial corporations typically are set at a fixed rate, the repayments of those loans will be worth less to them if inflation rises. For one example, if a bank offered a 5 percent home loan while expecting that inflation would be 1 percent, the bank would assume that it would receive a real interest rate of 4 percent. If the inflation rate actually becomes 2 percent, the bank will take a considerable profit loss (receiving a 3 percent real interest rate) compared to what it expected.

In sum though, the issue of the central bank raising interest rates has historically been one that’s favored powerful financial corporations at the expense of the working class, and it’s a very significant issue that should be kept in mind more.

Trade as Representing Class Interests Over Country Interests

Trade has often functioned as a way for the powerful to gain at the expense of others. Trade is something that could be incredibly good due to countries with different resources cooperating, but the record of the last several decades shows that trade is more about exploitation than improving the lives of the general population.

The economist and policy types who have been pushing the trade agenda of the last four decades often make assertions like “everyone gains from trade.” This is what is known in the economics profession as a “lie.”

No models show that everyone gains from trade. Standard models show that some groups are benefitted by trade and others are hurt. The usual story is that the winners gain more than the losers lose.

This means in principle that the winners can compensate the losers so that everyone is better off. In the real world, this compensation never takes place, so when we talk about trade we’re talking about a policy that redistributes from some groups to others.

Our trade policy over the last four decades has been quite explicitly designed to redistribute income upward. This was the point of deals like NAFTA, or admitting China to the WTO.

These deals were about putting US manufacturing workers in direct competition with much-lower-paid workers in the developing world. The expected and actual effect of these policies is to reduce employment in manufacturing. This also put downward pressure on the wages of the manufacturing workers who kept their jobs, as well as on the wages of less-educated workers more generally, since manufacturing has historically been a source of relatively high-paying employment for workers without college degrees.

This is not a story of free trade. Our trade deals did little or nothing to make it easier for highly educated professionals to work in the United States. As a result, our doctors earn on average roughly twice as much as doctors in other wealthy countries, even as our manufacturing workers earn considerably less than their counterparts in Germany and several other countries.

In the last decade, China began running huge trade surpluses with the United States in large part because it deliberately held down the value of its currency. This has the effect of making China’s exports more competitive in the world economy.

[…]

But contrary to Trumpian rhetoric, the resulting trade deficit doesn’t mean China wins and the United States as a whole loses. Companies like GE that have manufacturing facilities in China are very happy to have China keep down its production costs.

The same is true of big retailers like Walmart that are able to undercut competition with their low-cost supply chains in China. Higher-paid professionals who are largely protected from foreign competition also benefit, since they get access to cheaper imports without having to lose anything on the wage side.

Trump could have tried to at least partially reverse the upward redistribution from the US trade deficit if he had followed through on his campaign promise to put China’s currency management (he calls it “manipulation”) front and center in his trade policy. Instead, currency management appears nowhere in his vague and ever shifting complaints against China. Perhaps the beneficiaries from the overvalued dollar put enough pressure on Trump to drop one of his main campaign issues.

Instead, we have been treated with endless stories from news outlets where commentators express concern that Trump may not be sufficiently focused on the question of China “stealing” technology from US corporations. This is again where it is essential to remember it is class, not country, that matters here.

If Chinese corporations use technology developed by Boeing, Microsoft, or other US giants, this is bad news for their stockholders, but it doesn’t directly harm the rest of us. In fact, if the Chinese corporations can then produce the same products at a lower price and then export them to the United States, this would be a gain for non-stockholders. This is the classic argument for free trade.

In fact, if China has to pay less money to companies for patents and copyrights, it will have more money to buy other goods and services from the United States. Supposedly, economists are worried about inequality in the United States. If China doesn’t honor our patents and copyrights, it will be a step toward addressing this problem.

The long and short is that when Trump or anyone else tries to argue about the US interest in a particular trade policy, we’d better look more closely. They are trying to conceal who is really winning, and losing.