The Liquidation Phase: A Corporate View

0:00We changed the title slightly to liquidation phase and profit margins, and one thing before we begin, it's a hundred years next year, 2012, of the publication of Mises's first book. So for you guys who are doing reading groups, you might want to get started now so you can end in 2012. Okay, so Harry had a brilliant idea, and I said, wow, that's a brilliant idea. and he said, no, this is just something everyone knows and so maybe, I don't know, we'll find out. So the popular press has asked which economic policy is the best to alleviate the recession and actually I think that question is miscast and it really should be which economic policy best converts malinvestments in economically viable capital structures.

0:54And so the liquidation phase is necessary then to realign the capital structure. So Austrians then have long said that the solution of this is, well, you just liquidate the malinvested capital, but what does this actually mean? What do we mean by liquidate the malinvested capital? How do companies do this? What is it like from their point of view? So, at the extreme, it's through bankruptcy that some of these businesses that have capital, they get broken up, they sell it off, it gets passed from inefficient uses to more efficient uses and that's the standard story that we've been doing so far.

1:42However, not all businesses fail during the liquidation phase. How do the firms that are accumulating losses but not yet ready to fold, how do they convert their malinvested capital into profitable structures? That's the question that we're asking. It's in this context that we're going to turn to look at the point of view from the business or the firm. So what we argue is the firm is trying to get back to break even, and we call it getting to break even. So consider a business with the following situation. It manufactures a product in which the gross margin is 25%. Now what this means that labor and material constitutes 75% of the cost of production, its variable cost. Now as long as the business is able to meet its variable cost, it's going to stay in business. If the firm is not able to cover its variable cost, it crosses the shutdown point and stops. So if the remaining 25% then only covers its only covers its fixed costs, its overhead, it will break even. So when a business accumulates

2:52revenue above fixed and variable costs, it begins to make profits. And this is our crossover point. This is our break-even point. So let's take an example. Let's assume that our business has fixed costs the overhead of $10,000 a month. This means that a firm must earn revenues $40,000 a month just to break even. So $30,000 pays for labor and material. The $10,000 then pays the overhead. Now, let's assume that the economy is in a downturn and the firm is losing money. So let's just pick a number, $2,000 a month. The business is able to cover its variable costs, but it's not breaking even.

3:38So this problem can be viewed either as having insufficient sales or having excessive overhead, fixed cost, right? One of the two, or a combination of the two, right? So if the business could magically expand sales, it would have to first create more product, which means the variable costs would then increase. So, in this example, the gross margin is 25% and let's assume the marginal, that the marginal, the margin, gross margin and the costs are held constant. So therefore, in order to cover the monthly shortfall of $2,000, the firm would have to increase sales by $8,000, in which 6,000 or 75% goes to variable costs.

4:28So, this comes to our government policy. The need for politicians is to do something, right? And as the recession grows, their need to do something grows. So there are two broad approaches for active fiscal policy to alleviating a recession, increasing spending or cutting taxes. Now, the Keynesians have argued that the best policy to cure a recession is to Stimulate Aggregate Demand. So suppose that the government chooses to stimulate aggregate demand by directly increasing the purchase of consumer goods. So they're just going to go out and just start buying stuff. So if the firm has experienced a $2,000 shortfall, then the amount needed in additional sales is $8,000, assuming that the costs are constant and the growth margin's at 25%.

5:26To turn the malinvestment into sustainable capital structure, it will take $8,000 of direct and sustained government purchases. Or, to get the same effect, it will only take a reduction of taxes of $2,000. Thus, in general, the tax cut approach places a lower burden on the Government or the Taxpayer. So in our paper then, what we discuss are the four categories of government spending. And the first one is grants, where the government will grant money to institutions, say universities perhaps, they like those sorts of things.

6:18And we talk about the malinvestment and the Kantian effects and the relative price adjustments that then occur and how then this will cause extra distortions and when that spending stops then all of those malinvestments have to get rolled back. And if we have heterogeneity of capital with capital specificity, how that becomes very difficult then to roll that back sometimes. Then we talk about the cash directly to consumers where Bush will give you a tax rebate back in 2001 and 2008, and people were like, hey, I can go spend a new TV, what are the impacts of that? And we have these same distortional problems. Then we have government contracts to businesses, where they just hire firms to do different things, and how that's distortionary.

7:07and then tax cuts and the reduction of regulation and so in this we then started thinking about how to talk about this advantage and this is what we've just labeled the Austrian multiplier and this is where I'm going to hand it off to my partner in crime, Harry, it's relatively simple though I lived through this because I was in the metal manufacturing business Through the recession of 78, 82, 90, and 2000, I learned really quickly that you can get a lot more money cutting costs than you can increasing sales. And so we thought, well, okay, if we're going to assume an Austrian multiplier of 25%, you can get three to four times more money into your business by cutting costs rather than increasing sales.

8:05and the concept is, is what can government do? So he said, first of all, enable the firm to operate profitably without expanding sales by 8,000. Okay, two, Keynesian economics recommends stimulating sales, but they must stimulate sales by four times the amount of the losses. Okay, so the stimulation is much greater than the cost, cutting cost. If costs could be lowered by $2,000 by kind taxes and regulation, the government could operate profitably. That means no laying people off. I've had to do that. That's not a real pleasant experience, I'll tell you. If you take a look in 1990, Wall Street Journal reported that the Bush administration, a good Republican conservative administration following libertarian economics, increased regulation, the cost of regulation of business by $200 billion.

9:03Had they repealed that under this model, it would have been a trillion dollar stimulus to the economy without any unemployment. You see, lowering those cost of regulation and taxes brings down the break-even point, allows you to operate much more efficiently. OK, this would mean that the company would not have to cut the internal structure of the firm. When you lay people off, you're actually Closing off your options, because as you lay people off, when you have the expansion, you have to go back and hire them again. So there's no problem cutting into the internal structure of the firm. The multiplier is bigger, four to one. It does not interfere with the internal structure of the firm, and thus does not imply additional malinvestments, because what's happening is you're cutting costs.

9:51You're not increasing malinvestments by increasing government demand, it does not cut the production capacity of the firm, and while the Keynesian Multiplier is specific to a small number of firms where the government money comes, the stimulus applied, where the stimulus is applied, the Austrian Multiplier is across the board. All businesses benefit. I mean, for example, if we could get rid of the affirmative action, if we could get rid of all those lawsuits, all the rest of that stuff. Everybody benefits right away. It goes right to the bottom lines. Okay? So this approach may actually eliminate many of the inefficiencies of government taxation and regulation, thereby leading to increased productivity. And we call this the Austrian multiplier. And when Paul and I were talking about it, Paul was Paul's helping me with a chapter of a book that I have coming out called, It Didn't Have to Be This Way, The Principles of Austrian Economics Applied, Create Peace and Prosperity.

10:56We're talking about it, and I saw Paul, it's very simple, when we went through this problem in my stamping company, we just did A, B, C, D, and sure enough, we pulled it out. In fact, I actually made more money in recessions than I did in booms, because what happened, My cost of steel fell faster than my sales did. I always looked at the account and I said, how come we're making money now when your cost of steel are going down? So the question is, is that, I think, at the end of this, is that the advantages are from a political standpoint. And I think we have to, remember, we have to argue out there in politics about what? You guys are cruel, you're hard-hearted, you're all the rest of it. In this way we can say, hey look, depending on the firm's gross profit margin, depends on the multiplier, we're actually much more effective in stimulating the economy by cutting government regulation, cutting taxation, and cutting the, and I guess you could probably argue if we could at least in Michigan pass a right to work law, maybe we could track some of that industry back by lowering cost and getting rid of a lot of these union contracts

12:05The Austrian multiplayer may also lead to increased tax revenue by increasing the profitability of business and lead to less unemployment. That would be among government workers. Unemployment means lower income and lower social security tax collections, which is one of the major problems that they're facing. In addition, it would lead to lower government deficits and future debt service payments by government. Remember, your children, the big problem is everybody says, oh, we can borrow the money. I said, yeah, the problem is the interest payment. Five minutes left. Finally, it presents a rationale for cutting government taxes, spending and regulation during the liquidation phase of the business cycle as a much quicker way to overcome the malinvestment crisis without causing substantial unemployment and additional malinvestment.

13:05And Paul, I guess we've got a few more minutes, but anyway, we'll leave more time for questions. But I've seen this work. I've seen it work. And so I think the Austrians have a much stronger case to present in this. in this and our multiplier is far higher because it would get a skin that depends on whatever business you're in. Paul, do you want to finish up? I'll just say that if you want a copy of the paper, we're going to send it to Joe and to Jeff Tucker and they'll put it up as a working paper or you can email us and we'll email you a copy of the paper. We appreciate feedback. Thanks.