The Story Of Recent American Policy And Economic History

What follows are extracts from the Chairman’s statement in the annual report of M&T Bank (2016). It was published online some three weeks ago here. Last year, I had read the 2015 Chairman’s statement upon the ‘recommendation’ of Jason Zweig – author of Your Money, Your Brain – on his Twitter profile. So, I remembered to go back and check this year as to when the annual report for 2016 was published online. I was three weeks late. But, better late than never.

On the vanishing manufacturing and American middle class

(1) The markets that M&T serves are, in the main, those of historically middle class communities with historically vibrant local economies, often manufacturing-based. Economic and survey data, as it pertains to them, are concerning. On so many measures of economic well-being and security, the so-called middle class has been losing ground for many years.

(2) Since 1973, total median household income from all sources, including wages, which comprise more than 80% of income for middle class families, has increased only 13%. In fact, earnings for the typical family actually peaked in 1999. Even as the overall economy, as measured by GDP growth, has approached recovery to a pre-recession level, the typical family has yet to make up the earnings lost in both the 2001 and 2008 recessions. It is no wonder that a declining share of households even consider themselves to be part of the middle class; 63% did so in 2001. By 2015, that number had fallen to just 51%.

(3) Numbers alone cannot fully convey the effects of such stagnation, effects our colleagues observe among their neighbors and in the communities surrounding our branches—whether in college enrollment foregone, retirement postponed, even modest vacations put off. It is worth considering what effects the macroeconomic policies that impact banking referenced above might also have on the hopes and plans of families, workers, and small business owners.

Regulatory response to the crisis of 2008

(4) The responses in the years following the worst of the crisis were also unconventional. Rather than spending to promote growth, the government instead enacted legislation and regulation that in practice restricted it—effectively, a form of negative fiscal policy. Put forth in the name of preventing a recurrence of the circumstances that led to the financial crisis, the plethora of new regulations intended to limit taxpayer risk have ultimately proved a drag on growth.

Fed monetary policy and those earning less than US$100,000

(5) Interest income for households has declined sharply in the aggregate. In 2014, it had, compared to 2005, fallen by some $64 billion. This disproportionately affected households with an income less than $100,000; their interest income declined by $44 billion, or 68% of the total decrease for all households. There are, to be sure, some who can take such a drop in stride—those, for instance, fortunate enough to hold dividend-paying stocks. Dividend income in 2014 was, in fact, $162 billion higher than it had been in 2005. But 95% of that increase in dividend income has accrued to households whose income was greater than $100,000. Indeed, only $9 billion of the $162 billion increase in total dividend income has found its way to households with annual earnings under $100,000—not enough to offset the lost interest income.

Impact on retirement income and plans

(6) Pension plans sponsored by employers, long a pillar of retirement savings for many workers, face similar pressures. Low rates that pension funds earn on investments mean either that businesses and governments must set aside more to ensure future benefits, or put those benefits at risk by under-funding them. The trend is disconcerting. Although, at the end of 2007, corporate pension plans showed a modest surplus, they had, by the end of 2016, developed a $408 billion deficit. Not even public sector employees can remain confident in the health of their pension plans, as some major state pension funds reduce their estimated rates of return and contemplate reductions in benefits.

(7) To offset the impact of low returns and still deliver on their promises to consumers, investment professionals are increasingly turning to alternative investments such as hedge funds and private equity that offer the potential for higher returns, but come with more risk. Given these costs and challenges, many businesses have responded by transitioning away from offering pensions altogether, instead sponsoring programs such as 401(k) accounts through which employees largely bear responsibility for determining the amount they save and the manner in which they invest. Workers then confront the same difficult choices as investment managers, weighing the tradeoff between accepting low returns or undertaking greater risk with their hard-earned savings.

Impact on large vs. small businesses

(8) By many measures, the performance of large businesses following the recession has been impressive. Between 2007 and 2012, the receipts of firms with 500 or more employees increased, in real terms, at an annual rate of 2.4%. Employment levels for such firms have fully rebounded from the Great Recession and then some; as a group, they employed 2.4 million more workers in 2014 than in 2007. So, too, we saw the profit margins of the corporations in the S&P 500, the nation’s largest public companies, exceed pre-recession levels and reach their highest level in the past three decades, increasing from less than 6% near the end of the Great Recession to 9.2% in 2014.

(9) In effect, the largest firms—and their shareholders—have benefited disproportionately from a recovery fueled by monetary policy based on inexpensive access to financing and historically low interest rates. Highly-rated corporations issued more than $1.2 trillion of debt in 2016 alone, the highest level ever recorded. Indeed, the level of debt as compared to earnings before interest, taxes, depreciation, and amortization has reached its highest level since 1980.

(10) Unfortunately, due to the stagnant economy, firms are left with no choice but to return their earnings to their shareholders, few of whom are middle class families. Indeed, in 2015, S&P 500 companies returned $978 billion of their earnings to shareholders through dividends and share buybacks, exceeding the $923 billion they invested in capital goods and research and development of the sort that would lay the foundation for future growth.

Mergers and acquisitions and communities

(11) These large firms have also taken advantage of low interest rates and their own appreciating share prices to acquire smaller competitors. During 2015, the S&P 500 companies alone spent more than $400 billion on such acquisitions. This is all the more concerning because, to the extent that we have seen job growth, it has come on the payrolls of the largest firms. Job growth that is bought, not hired, is not net job growth for the community.

(12) Implicit in the story of how larger businesses and their shareholders have benefited from economic policy is the less-than-happy but related tale of how small businesses have not.

The impact on small businesses

(13) While U.S. businesses have added more than 44 million jobs since 1980, small businesses accounted for less than 12 million jobs, or just 26%, of this growth. The severity of the Great Recession and its aftermath only exacerbated this trend. Where large businesses have seen employment grow by 2.4 million since 2007, small business employment is down by 1.9 million over the same period. Payrolls in real dollars have retreated by $85 billion at small businesses but are up $245 billion at their larger counterparts. As the number of large businesses has grown, the ranks of smaller firms have declined by 224,000 since 2007. We have seen small business growth wither and its independence threatened, with implications for communities and the overall economy.

The Obama effect on small businesses

(14) There is more to this story than just the stagnant economy. At M&T, we surveyed
our small and medium-sized business clients in an effort to understand the challenges they face. One might expect them to express traditional concerns—such as the cost of materials or the pressure of competition. Instead, 55% cited the cost of employee healthcare benefits as their greatest hurdle, while 36% cited the not-unrelated challenge of complying with government regulation.

(15) As we have found in our own markets, so has a national survey conducted by the National Federation of Independent Business (“NFIB”). Indeed, since 2009, that survey has cited regulation as the single greatest challenge facing small businesses across the country. This suggests that their core problem is not a lack of opportunity, but government-imposed obstacles that limit their ability to capitalize on the opportunities they identify.

(16) One especially worrisome insight from a 2012 NFIB study: 55% of small business owners would not again choose to open shop. The declining rate of small business formation reflects this growing caution on the part of would-be entrepreneurs. The number of new small businesses has declined from an annual average of 529,055 during the period 2003-2007 to 399,483 during 2010-2014—a 25% decline. Even more worrisome is the fact that the average number of new jobs created annually by new small businesses decreased from 2.8 million during 2003-2007 to 2.0 million during 2010-2014—a 26% decline.

What does private equity investment do to communities?

(17) Private equity firms in particular have been aggressively consolidating industries, buoyed by capital from pension funds and insurers and leveraged by low-cost financing. During 2015 alone, private equity firms acquired more than 4,100 businesses at a cost of $737 billion, surpassing even the number of such acquisitions in the boom years preceding the financial crisis. Nationally, the number of businesses owned by private equity funds has increased by 46% since 2009.

(18) Locales with long traditions of industry and industriousness, innovation and livability, have found themselves buffeted by a perfect storm of business regulation, business takeovers, and subsequent exits. Left in its wake, these communities face a lower tax base but greater social service needs, at the same time the business and corporate philanthropy that was once a bedrock of local charity has shriveled.

(19) This is a downward spiral that starts with what has happened to many small and middle market firms we find in our footprint—whether in central or western New York, central Pennsylvania, or Delaware. It is tempting to believe that the shuttering of once-thriving independent middle market businesses in so-called Rust Belt communities is an inevitable side effect of much larger economic factors. We do not subscribe to this view. Policy matters.

(20) The cost and complexity of regulation helps to make these communities and their smaller employers vulnerable to takeover by outsiders, both public and private, with the scale necessary to prosper in the face of ever-greater regulation. Following such takeovers, headquarters offices depart, and local employment—and, quite possibly, technological innovation—withers. Local tax revenues of all types— whether based on home values or business offices—decline. Ancillary businesses, whether lunch counters or parts manufacturers, are at risk as well. This is how communities with great histories, a willing workforce, and affordable housing are passed by and hollowed out.

(My comment: Check out what happened to Charles Murray, the author of Coming Apart: The State of White America, 1960-2010.)

Examples of specific communities impacted

(21) We found that, since 2004, at least 55 small and middle market firms in the Syracuse area alone were acquired by firms headquartered outside the region. After being acquired, these firms subsequently reduced employment by 40%, or 7,687 jobs. The jobs lost just by these firms represent 2.4% of all jobs in the Syracuse area. This is no isolated case. Across our markets from upstate New York to Maryland, we identified at least 407 local businesses that were sold to buyers headquartered elsewhere—employment at these businesses later declined by an average of 25%.

(22) Beyond the jobs and families directly affected, we looked at the impact of this loss of local companies upon some of the largest charities in our mid-sized markets. In city after city, from Buffalo to Syracuse, from Rochester to Harrisburg, the same pattern emerged. Research showed that, for local companies that were acquired by out-of-town firms, associated corporate and employee donations have declined by 59% to 89%.

(23) This is in contrast to the trends for companies that preserved local ownership, where philanthropic giving remained essentially flat or, in some instances, modestly increased. Membership of business leaders on not-for-profit boards declined—robbing the community of not just dollars but advice and expertise. Such local businesses have not only created new jobs but also groomed generation after generation of leaders for their communities, a critical role that distant acquirers cannot easily fill. So it is that we see the sinews of healthy communities atrophying, the quality of life for their citizens deteriorating.

Banking regulation

(24) Regional banks are penalized at the starting line, paying dearly to try to narrow the gap but not always succeeding. At M&T, our own estimated cost of complying with regulation has increased from $90 million in 2010 to $440 million in 2016, representing nearly 15% of our total operating expenses. During 2016 alone, M&T faced 27 different examinations from six regulatory agencies. Examinations were ongoing during 50 of the 52 weeks of the year, with as many as six exams occurring simultaneously. In advance of these reviews, M&T received more than 1,200 distinct requests for information, and provided more than 225,000 pages of documentation in response. The onsite visits themselves were accompanied by an additional, often duplicative, 2,500 requests that required more than 100,000 pages to fulfill—a level of industry that, beyond being exhausting, inhibits our ability to invest in our franchise and meet the needs of our customers.

Stress tests and lending decisions

(25) Regional banks base decisions to grant loans not just on such empirical and universally available) factors as credit scores, but on local and personal knowledge, as well: the established reputation or known character of the applicant, or on the unquantifiable value that business owners bring to the table through their proven experience or entrepreneurial expertise.

(26) Yet the regulators’ models do not acknowledge the full range of valuable skills and local market knowledge that banks have long used in prudently determining whether to extend loans to worthy borrowers. Instead, banks are forced into a regulator’s Procrustean bed, called upon to follow an altogether formulaic process for reporting the characteristics of each loan.

(27) Regulators then evaluate the potential risk of default for each transaction using only financial models that use a prescribed set of variables, including the borrower’s credit score, the age of the business, and the type of lending product in question.

(28) A recent industry analysis demonstrates the extent to which the stress test may distort the allocation of capital. The study suggests that, in the context of the stress test, banks must effectively hold as much as 140% more capital for a small business loan than for a loan to a larger firm—remarkably, small business loans are actually treated more punitively than even the potentially risky trading assets predominantly held by the largest banks.

The effect was all but inevitable: small business loan originations by regional banks subject to the stress test have not grown at all since 2009.

(29) Other regulations such as the so-called living will, a mechanism intended to assist regulators in coping with the potential failure of one of the largest global banks, have also been inappropriately applied to regional banks with simpler business models. Such a rule may be sensible for the largest institutions; just five of these large banks each have, on average, 1,977 subsidiaries. In contrast, at M&T, in a structure more typical of regional banks, the total number of such entities is only 41.

Policy decisions post-crisis 2008: Obama years

(30) But the policy decisions made in the aftermath of the Great Recession also matter—and have made crucial differences. The growing weight of regulation and the low interest rate environment that has outlived its usefulness have added impetus to this wave of takeovers. In their own way, they have held the economic recovery in check.

That was a very long post. The Chairman’s statement is a tour de force. It reminded me of someone who was once regarded as the man who spoke truth to power but no longer does. Well, he stopped long ago, as a matter of fact.

It has summarised many lessons: globalisation, capitalism’s wrong turns in the last few decades (corporations’ short-termism), the toxic effects of the rise of finance and financial capitalism on employment, on communities, the decline of manufacturing and middle classes in American communities (the decline of manufacturing itself has been documented so well by Schott and Pierce and Brad Setser, thanks to mindless international trade liberalisation without safeguards), the impact of policies pursued in response to the crisis of 2008 on middle and lower income families and the law of unintended consequences (stress tests and bank loans to small businesses).

In the process, this statement exposes how and why America voted the way it did. No surprises and no puzzles. The surprise and puzzle elements only relate to why it has been so difficult for so many to understand the real picture.

This also explains Trump’s policy agenda – replacing the current health-care system and de-regulation. Devil may be in the details, but the intent and the principles are sound and empirically founded.

It will be hard to find a full-semester course that would provide such valuable insights on a range of contemporary issues that have bedevilled America.

This piece was first published on the writer’s blog, The Gold Standard, and has been republished here with permission.