Cronyism is NOT Capitalism
Thank you for joining us for this edition of the NovaBlock newsletter. Here, we explore the intersection of technology, finance, politics, and of course, the crypto asset space.
Cronyism is NOT capitalism. Full stop.
And make no mistake, the recent government bailout of the airline industry is cronyism incarnate.
But what exactly are the differences between capitalism and cronyism? Does capitalism inevitably lead to cronyism?
The terms we use to describe economic systems (capitalism, socialism, etc.) are loaded with connotations and can be defined in many ways. While there is no single definition, to most economists capitalism embodies a system in which entrepreneurs accumulate and invest in capital to produce goods and services deemed valuable by society. The bedrock of any truly capitalist system are the concepts of private property and a level playing field. In order for business owners to take risks, they must be confident that their risks will be rewarded and they will be able to reap the fruits of their labor. When market participants believe the system is rigged, entrepreneurship and risk taking are severely discouraged.
Cronyism is the political practice of awarding economic benefits to friends, trusted colleagues, or those within one’s network. Cronyism rewards participants closest to the government teat, which is often a function of an organization’s sheer size and political power. You may recall the pronouncements of “too big to fail” describing the insolvent banking behemoths during the 2008 Recession. When the taskforce responsible for passing TARP consisted of former Chairman of Goldman Sachs, CEO of Fannie Mae, and previous heads of other financial institutions, you could be sure saving the banks would be the top priority.
According to economists G.P. Manish and Daniel Sutter in their paper, “Political favors and regulations actually interfere with free competition in the market, and they do not necessarily enrich businesses. Cronyism can create a system of skewed competition. Consequently, the best entrepreneurs who value mastery may have no interest in joining or continuing to participate in a rigged game. Without strong entrepreneurship in an economy, economic growth will falter.”
While “free market” and “free competition” are commonly used buzzwords with little bearing on how real-world capitalist systems actually function, their analysis of risk-taking behavior in heavily manipulated economies is spot on.
Cronyism occurs when corporate and political institutions become so large they are able to coordinate for their own benefit at the expense of challengers, strangling competition in the market. Capitalism isn’t without its flaws and negative externalities do exist that may require government intervention, but cronyism is a far more insidious phenomenon that undermines the mechanisms by which healthy economies thrive.
Back to the airlines.
As part of the recently passed stimulus package, airline companies will receive $25 billion in grants and loans, of which American Airlines will receive $5.8 billion, Delta will receive $5.4 billion, and Southwest Airlines will receive $3.2 billion. The majority of funds (~70%) are in the form of no-strings-attached grants with the remainder in low interest loans to be paid over 10 years.
These are the same companies that used 96% of their cash flow on stock buybacks over the past 10 years. From 2014 to present, the Big 4 airlines (American, United, Delta, and Southwest) purchased stock buybacks totaling $42.4 billion, a practice that enriched executives with compensation packages mainly comprised of vested stock options. Over this period, the CEOs of these companies received $430 million in stock-based compensation, separate from their salaries, deferred benefits, etc.
Doug Parker, American Airlines CEO and major beneficiary of stock buybacks and 2020 Covid-19 bailout
Bailouts are a blunt tool to reduce short term pain, but they have long term consequences that undermine the very system they are trying to support. Similar to artificially low interest rates, bailouts exacerbate the zombification of the economy, as unproductive companies continue to scrape by and fail to discover more sustainable business models. Secondly, bailouts are a form of universal basic income solely for the politically connected at the expense of all other dollar holders. Every dollar printed and stuffed in the pocket of a corporate executive diminishes the value of dollars held by everyone else.
Bailouts are a form of socialism, and not the Scandinavian kind. The many socialize the losses of the few. In our “capitalist system”, it seems this transpires every ten years or so.
Public and private companies already have a self-correcting mechanism by which poor performance is penalized and companies are able to restructure to live another day. When companies undergo chapter 11 bankruptcy, the business and company’s assets will be protected while they negotiate new terms with creditors. Crucially, during the proceedings, the company remains operational often with minimal disruption to the workforce. Layoffs may occur, however, those who are let go and are owed wages or benefits become creditors and join the ranks of vendors, trade creditors, secured creditors, and even bondholders. Thus, their interests are placed above shareholders and unsecured debt holders in the company’s capital stack.
Even more importantly, in a liquidation scenario, the speculators, shareholders, and board members are the first to be wiped out. Thus, corporate management is appropriately incentivized to seek innovation and maximize business performance.
Companies that are unwilling to file bankruptcy always have the option to tap the debt and equity markets to access capital in times of emergency. In times of uncertainty, corporate loan interest rates may be high and equity valuations may suffer, but if management is confident the shock is only temporary and their business is sound, they would be able to find lenders and investors willing to stomach the risk.
Capitalism is a system based on creative destruction. As consumer tastes and desires morph over time, and as the realms of nature and technology both create and destroy business opportunities, companies that are unable to adapt will suffer. Alternatively, companies that innovate and foresee societal changes will prosper. The exogenous shock of the coronavirus is no different. As much as politicians would love to publicly proclaim the contrary, the post-Covid-19 world will look fundamentally different from the one before it and consumer preferences will indicate as much.
Does it really make sense to send your team of consultants across the country for an in-person meeting with your client when a simple Zoom call would suffice? Do restaurants need to have large 200 seat capacity dining rooms to serve meals when customers are happy to order take out and dine at home?
According to OpenTable, seated diners at restaurants declined 100% in early April. At the same time, food and grocery delivery services have experienced a surge of activity requiring Amazon Fresh to hire an additional 100,000 workers and Instacart to hire 300,000 full-service shoppers. Although the restaurant business will rebound as economies reopen, some portion of the decline will stick as consumers realize the benefits of food delivery services.
Year-over-year daily restaurant seated diners declined 100%
As demand for business and leisure travel decline, air travel may transform into an increasingly premium product. Instead of individuals traveling to kill time and explore new corners of the world, skyrocketing ticket prices and fear of virus transmission may confine air travel for only the most important business meetings and family reunions. This trend may be further accelerated by advances in video conferencing and communication technologies.
Just like the natural world, the economy has always been a continuously re-morphing organism, and the virus is accelerating trends already in motion. No amount of physical social distancing will erode our identity as social creatures. However, the norms and customs influencing the way we interact will change in ways that have yet to fully manifest. Companies that are able to foresee these societal changes and adapt their product offerings and business models to take advantage of these changes will be strengthened. And no amount of taxpayer bailout funds handed out to incumbent corporate interests will induce the innovation needed for real growth.
Quick Bits
Grayscale Investments, the world’s largest digital currency asset manager, reported a record-setting $503 million in inflows to its digital currency funds in Q1 2020. This is nearly double the previous quarter high of $254 million set in Q3 2019. Over the last quarter, institutional investors represented 88% of all inflows, the majority of which were from hedge funds. For the first time, inflows into Grayscale products over a 12-month period crossed the $1 billion threshold ($1.07 billion), showing strong and sustained evidence that investors are increasing their digital asset exposure at current levels. Despite recent volatility in the crypto markets, institutional demand appears to be increasing, especially for Grayscale’s flagship Bitcoin Trust product. To learn more about Grayscale, see my recent interview with Grayscale Managing Director Michael Sonnenshein.
Digital transfer agent Vertalo, custodian PrimeTrust, security token exchange tZERO, and consulting firm Advantage Blockchain are helping to tokenize $300 million in real estate. The portfolio belongs to Pennsylvania-based Real Estate Capital Management, and the companies plan to tokenize the portfolio in phases, starting with $90 million of office and hospitality real estate over the next three months. Hotels in Pennsylvania and Costa Rica will be the first to be tokenized in the deal. The market for tokenized real estate is heating up. This initiative represents a shift in strategy by issuers in which existing assets are tokenized instead of using security tokens as a mechanism for fundraising. It will generate liquidity for shareholders and create more robust secondary markets.
Hong Kong’s securities regulator has approved the jurisdiction’s first-ever Bitcoin index fund designed for institutional investors. Arrano Capital, the Hong Kong asset manager’s blockchain arm, announced the rollout of its Bitcoin fund, after clearing licensing conditions to let it deal in virtual assets with the Securities and Futures Commission this month. It’s the first such fund approval since local regulators started to look into ways to exert oversight over the crypto industry about a year ago. Along with 3iQ’s recent launch of The Bitcoin Fund traded in Canada on the Toronto Stock Exchange, regulators are starting to approve exchange traded products for Bitcoin. It is only a matter of time until the SEC changes its tune and approves the launch of a US retail-focused Bitcoin ETF.