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Some Musings On Income Distribution - Part 3

10. What the hxxl happened in 1980?

I just watched "Inequality For All" with Robert Reich (Clinton's Labor Secretary) and found it interesting. Reich demonstrates that at some time in the late 1970's or early 80's inequality in income really started to increase. Just what happened and why? And are there any investment implications? These are the key issues we will address here.

A. Labor Unions - Unions were very powerful in the 1950's and into the 1970's but a variety of factors led to a dramatic decline in their percentage of the work force. To some degree, the industries which were most heavily unionized also were the ones to lose the most ground to foreign competition. And domestic companies were increasingly moving to right to work law states where organizing and maintaining a union was difficult. These problems were compounded by some embarrassing union scandals - the Teamster pension fund, the Yablonski murder - as well as unimaginative leadership. The unions should have been united in pushing for national legislation preempting state right to work laws and in organizing. Instead, there was considerable infighting, corruption, jurisdictional conflict, and a degree of bureaucratic torpor. By the late 80's, there had been a big decline and we were well on our way into the era in which unionization became more and more focused on public employees.

B. Regulation - For a long time after World War 2, the conventional wisdom was that concentration in various markets required government supervision to prevent abuse of monopoly power. The writings of John Kenneth Galbraith set forth the thesis articulately. Attention was trained on the auto industry, the oil industry, the big 3 networks, IBM, AT&T, and numerous other industries. IBM's monopoly was condemned and considered to be permanent. The Big 3 automakers also appeared to sit atop a license to print money by raising prices. Many industries - the airlines, trucking, railroads, banks, oil and gas, telephone - were subject to strict and detailed economic regulation. This included that new entrants obtain regulatory approval by showing that existing companies did not serve the market adequately. There seemed to be an assumption that a federal agency staffed by smart economists and industry "experts" could regulate the prices and market entry much better than the "chaotic" free market could. Of course, regulatory bureaucracies were subject to "industry capture", were frequently influenced by politics and tended to be less than competent. Embarrassing failures like gasoline lines and the nearly disastrous natural gas shortage at the very beginning of the Carter administration should have signaled that something was wrong. But the regulatory schemes had strong political support and appeared to be permanent. I was frankly surprised at how quickly some of these regulatory structures were dismantled. In fairly short order, we deregulated airlines, motor carriers, natural gas production, and the oil industry; we also opened up long distance telephone service to competition and reduced railroad regulation significantly.

C. The Corporation - In the 1950's and 1960's, a strong - perhaps even dominant - line of thinking was that corporations operated on autopilot. Most big companies - it was said - had lots of "market power" and did not seek to maximize profits in the short run. To be sure, there were stockholders, but stockholders were only one of several groups of "stakeholders", including employees, the communities were the company did business, the nation, retirees, and customers. The management's job was to serve all of these stakeholders and to produce enough cash flow to keep the doors open and expand if that made sense. "Corporate statesmen" were not concerned with such mundane matters as quarterly earnings; instead, they were in it for the long term. The movie "Executive Suite" with William Holden reflects this mindset perfectly. Holden is concerned with product quality and long term reputation and ultimately prevails over the bean counter CFO who only focuses on quarterly profits.

D. Finance - In the period around 1980, there were at least three very important and interrelated developments which changed the corporate world. Most importantly, Michael Millken at Drexel Burnham established a viable new issue junk bond market. In the past, junk bonds were primarily "fallen angels" - bonds originally issued as investment grade but then derated due to problems at the issuing company. Now, junk bonds could be issued on an original basis. This led in turn to the second development - an expansion of takeover and LBO activity. A takeover would not require much equity because a large amount of the takeover price could be financed by new issue junk bonds. "Corporate raiders" were on the prowl and could threaten management at any moment. Then, in the early 1980's we had another very important and underrated development - the SEC safe harbor rule for share repurchases. Companies could repurchase their own stock pursuant to certain guidelines and there would be a presumption that the purchase was legitimate if the guidelines were followed. And - of course - one way to discourage a hostile takeover was to repurchase stock and drive the price up. While all of this was happening, we had a very aggressive Fed chairman who pushed interest rates very high, precipitated a recession, and finally conquered inflation. He also created a very "high" dollar which made competition with imports difficult for certain industries.

E. The Brave New World - It is not exactly clear why but a variety of developments upset the old world and ushered in a very different new world. Competition was hailed as the solution, not the problem. Union power declined enormously. Corporate executives now looked over their shoulders only to see activist investors, takeover pros, and shareholder spokesmen watching their every move. For a variety of reasons, the concern about market concentration receded and government regulation of prices and entry into markets began to be disfavored. The ultra high interest rates set by Volcker set the stage for a 30 year decline in interest rates and a consequent explosion in paper asset prices. Workers (including CEOs) had less job security; shareholders began to be treated for what they were - the owners of the companies whose shares they held. Paper assets tend to be held by the well-to-do so that the increase in paper asset prices (and values) accrued to their benefit. By 1990, a share of stock in a public company implied a completely different set of rights and benefits than it had back in 1960. Of course, the business of managing, trading, issuing, and analyzing paper assets became more and more important and opened opportunities to generate enormous amounts of income. All of this led to an explosion of incomes in the financial sector, an enormous increase in the wealth of those holding paper assets, and less leverage for workers.

The next part will deal with investment implications. There are some important ones.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.