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The economic collapse of Japan and the Phoenix Suns
Most of you have heard about the Japanese gdp report; it implies an annualized rate of decline of almost 13 percent. OK, they depend on exports but why is it so dire there?
You also may have heard that the Phoenix Suns have been trying to unload All-Star players Amare Stoudemire and Shaquille O'Neal. They are not hoping to get equal talent in return but rather they need to lower their payroll. (Why pay $75 million a year for a fringe playoff club?) And the New Orleans Hornets, former contenders, traded center Tyson Chandler simply to unload his salary.
I think of the Suns or Hornets as similar to a highly leveraged institution. I don't know the debt level of their corporate structure but that is not the point. The Suns have been spending lots in recent years toward the goal of ever-rising prices for season tickets and corporate boxes. Does that strategy sound familiar? If the future price hikes don't come on the main asset, they can't afford their obligations and so they will try to shed illiquid and hard-to-value assets into an unwilling market. Sound familiar? (As an aside, I wonder if barter is one way to jump start trading in illiquid financial assets.)
Does this sound familiar?:
"You've got a market loaded with motivated sellers and only a very small group of buyers," one NBA executive told ESPN.com. "It's really ugly. Owners are scared to death right now."
Institutions can have receipts and obligations which require growing revenues even if they don't have much explicit debt on their books. I think also of the artistic non-profits which invested in expensive facilities, in the hope of ever-rising donations from their investment banker patrons. Many other parts of the economy may be "leveraged" in this fashion, with or without high levels of debt.
Japan, of course, has high levels of government debt and also a demographic problem. I wonder whether their future-oriented export strategies make them even more leveraged, de facto, in a manner resembling the (former) business strategy of the Phoenix Suns.
One lesson of this crisis will be how deep the concept of leverage extends. That's another reason why this is fundamentally a crisis of sectoral shifts.
Posted by Tyler Cowen on February 18, 2009 at 07:30 AM in Economics | Permalink
Comments
Leverage yes, but maybe just debt- saddling yourself with future payments based on extrapolating assumptions of past performance out forever.
Should contracts start including CPI provisions? As in, when deflation hits we owe you less?
Picking up Shaq seems like a boneheaded experiment at this point. Holding onto him would be more boneheaded. When something doesn't work, cut your losses. His best performance has been at the All-Star game.
Posted by: Andrew at Feb 18, 2009 7:51:07 AM
There's a lot of vitriol out there for highly leveraged banks. Nice illustration of how the concept of leverage extends into the normal economy and everyday life; to it Id add the massively overvalued English Premier League football clubs.
I wonder whether these other institutions will handle the pain better than banks have.
http://nicescenery.blogspot.com
Posted by: Scenery at Feb 18, 2009 8:09:41 AM
Using the Suns as an example is a bit of a mistake. The ownership group is notorious for brazenly acting to benefit the bottom line over the value of the on-court product (not that there's anything actually wrong with that). See http://www.nba.com/suns/news/thomas_trade_070720.html
"The Phoenix Suns today traded center Kurt Thomas and two future first-round draft picks to the Seattle SuperSonics for a future conditional second-round pick. In addition to salary cap relief, the trade leaves Phoenix with an $8 million trade exception for their use in future dealings."
The Suns were $10m over the cap at the time, so this lessened their luxury tax hit significantly (I think it's dollar for dollar over the cap, so $16m). They did not use the trade exception.
So to be clear, the Suns traded a good player AND two guaranteed #1 picks for a lot of money. At the time, the trade was universally ridiculed with a few calls to revise the NBA collective bargaining agreement, the latter group arguing that the Suns basically sold their draft picks and pocketed the difference.
Posted by: Dan Lewis at Feb 18, 2009 8:31:54 AM
> One lesson of this crisis will be how deep the concept of leverage extends. That's another reason why this is fundamentally a crisis of sectoral shifts.
i don't understand your logic; could your clarify?
Posted by: babar at Feb 18, 2009 8:47:16 AM
Tyler, this is a wonderful, provocative post, but then you leave us with that unsatisfying finish -- "a crisis of sectoral shifts." I have a sense of what you mean, and probably most of your readers have a better grasp, but how about stating it more plainly & more powerfully. "A crisis of sectoral shifts" is a fancy way of saying what? That corporations aren't going to put money into season tickets and luxury boxes? That Japan went too hog wild on its export trade & neglected the development of domestic markets?
Posted by: Hugo Lindgren at Feb 18, 2009 8:57:44 AM
I'm interested in this concept of non-debt leverage because Kevin Drum's idea of putting limits on leverage seemed like a really good idea to me. (Otherwise anyone who doesn't lever up looks like a loser, profitswise, compared to the gamblers.) So I was wondering how companies would circumvent a limit if one were in place.
Posted by: Noumenon at Feb 18, 2009 9:12:57 AM
"Otherwise anyone who doesn't lever up looks like a loser, profitswise, compared to the gamblers."
Except of course for fractional reserve banking. 10x leverage is reasonable for low margin business like banking and surely doesn't crowd out non-fractional lending ideas like microlending.
Posted by: Andrew at Feb 18, 2009 9:18:29 AM
"A crisis of sectoral shifts."
That's easy. High energy prices last year forced consumers to take a long hard look at their #1 and #2 expenditures -- houses and cars. So, less demand for those products, both of which depend on highly leveraged financing.
The painful experience of high energy prices will stick in the collective conscience for a while. Thus smaller houses and cars, and fewer of each. There's your sectoral shift.
Posted by: Bob Knaus at Feb 18, 2009 9:18:59 AM
The LA Galaxy soccer team has refused to deal their high priced soccer star David Beckham to AC Milan. LA has two pro soccer teams (Galaxy and Chivas). Their demographic is hispanic and they seem to be doing o.k. More immigrants please!
Posted by: oops at Feb 18, 2009 9:33:54 AM
Indeed this is leverage - operational leverage - fixed/variable cost ratio. Higher fixed costs make companies and economies more vulnerable to sectoral shifts. And more profitable during boom times.
Posted by: lzl at Feb 18, 2009 9:35:49 AM
link to Beckham story
http://www.telegraph.co.uk/sport/football/davidbeckham/4682305/AC-Milan-refuse-to-give-up-on-David-Beckham-as-LA-Galaxy-dig-heels-in.html
Posted by: oops at Feb 18, 2009 9:41:59 AM
"i don't understand your logic; could your clarify?"
What Tyler means is that any business model that requires future cash flow to support irreversible business decisions of today is the same as taking out debt and leveraging. Why? A firm or household that takes on debt is committing to a stream of future payments that are unavoidable without bankruptcy. If a nonprofit builds a huge infrastructure of buildings, then it is committing to a future of heating, roofing, staffing, etc. on that building. I get the point, although I am not fully buying it either. If I overbuild my house with a lot of expensive to maintain and heat elements, like cathedral ceilings, then I may not be able to keep the cash flow necessary to support that house. But, costs like maintenance and fuel will tend to decline in a deflationary/recessionary economy, so that is partly self correcting. Also, if it has to be sold at a steep loss, other assets are not at risk as they would be in a debt-fueled bankruptcy. So, the things that make the leverage model of finance tough also make a capital commitment model of doing business tough. But the impact on the former is worse than the latter. If you have no debt, sell the fancy museum space and move to modest digs. If you are loaded with debt, the painting may have to be sold along with the building to satisfy the debt.
Posted by: liberalarts at Feb 18, 2009 9:57:18 AM
I find this post to be very interesting because of how it involves both microeconomics and macroeconomics. The Japanese government tried to cut interest rates and higher government spending to save the economy from total economic collapse, but the main problem of exporting is yet to be addressed. I think the Phoenix Suns can manage to get out of debt because when compared to the economic crisis that Japan is facing, it has a high chance of getting solved.
Posted by: Rhys K.M. at Feb 18, 2009 10:05:47 AM
One must also understand how the NBA "luxury tax" works.
The Suns are at $75M in (player) payroll, and the luxury tax is at $71.15M. So it's not just the fact that the Suns have to pay $4M more in salary. They also have to pay $4M to the league headquarters.
But wait, that's not all. In addition to paying the luxury tax, being over the luxury tax threshold means that a team forfeits its share of the league-wide revenue sharing distribution and the luxury tax distribution of payments other teams make. In the past, this has been something like $5-8M dollars.
Hence, the Suns stand to gain substantially more than just the difference in Amare's salary if they trade him away for players making $4M less. They'll gain:
1. The lesser salary they have to pay the players they receive over the rest of the season ($1-2M)
2. Not having to pay the luxury tax ($4M)
3. Receiving league wide distributions since they're under the tax ($5-8M).
So they'd get a grand total of $10-14M in additional money they either don't have to pay or actually receive themselves.
The trick is this sort of trade is hard to pull off since the NBA's rules regarding trades stipulate that teams have can only take back 125% of the salary they send out in a trade, meaning that it's difficult for another team to take Amare without giving back so much salary that the Suns will still be over the tax line.
Additionally, the team taking Amare has to be sure not to push themselves over the tax line. This is very true of the Chicago Bulls, who have been one of the main suitors for Amare.
So basically, the deal isn't getting done because the Suns and Bulls haven't been able to figure out a way to get the Suns under the tax without putting the Bulls over it. The only solution I can see is to get a third team that's under the salary cap involved and compensate them financially, but that either hasn't been thought of or is a nonstarter for some reason that no one has bothered to explain.
Posted by: Michael Cardwell at Feb 18, 2009 10:06:50 AM
If Tyler or Alex recommends nationalizing the NBA, I am boycotting this site for a week. I mean business.
Posted by: Bob Murphy at Feb 18, 2009 11:02:33 AM
In the long run, players salaries will simply have to adjust lower... possibly much lower.
This already happened in the NHL four years ago, where the loss of significant TV broadcast revenue prompted owners to lock-out the players until a new collective bargaining agreement could be negotiated, which included salary caps. The rapid escalation in players' salaries has since halted, and in many cases reversed direction.
The NBA is highly likely to go through the same sort of ordeal, despite whatever resistance the players' association can muster.
Posted by: Russ R. at Feb 18, 2009 11:07:00 AM
Except of course for fractional reserve banking. 10x leverage is reasonable for low margin business like banking
If you're saying "Don't set the leverage cap at 2x, that's too low," I agree with you. I have seen several news stories where the leverage was 40x.
If you're saying something else, I didn't understand.
Posted by: Noumenon at Feb 18, 2009 11:30:05 AM
But expiring contracts aren't really illiquid assets, are they? In fact, what makes them "bad value" is precisely what makes them liquid--or as liquid as they can be within the contours of NBA trade rules.
At least in the case of Stoudemire and Chandler, these are as much a talent assessment decisions as pure money decisions.
http://willwilson.typepad.com/will_wilson/2009/02/expiring-nba-contracts.html
Posted by: Will Wilson at Feb 18, 2009 12:05:23 PM
Nowadays it's good to be Billy Beane.
Posted by: mobile at Feb 18, 2009 1:14:33 PM
OK, they depend on exports but why is it so dire there?
Isn't it because not only do they depend on exports, but unlike other export-driven economies (e.g. South Korea), which have seen their currencies weaken considerably, benefitting exporters, the yen has appreciated dramatically in the last quarter? USD went from around 105 JPY, in early September 2008, down to below 90, by late December. In contrast, USD went from around 1000 KRW in September up to almost 1500 in December. Thus, the Japanese get hit both by a collapse in demand (in the USA), and the fact their products or cost inputs or whatever have also, quite suddenly, become dramatically more expensive.
I mean, I think there's probably a complex theory to be spun out, here, but I don't think there's anything mysterious in Japan's terrible GDP numbers this past quarter. I don't know why the yen suddenly jumped in value, but it did. I suspect it has something to do with the yen carry trade, as I suspect that other export-economy currencies aren't used for that kind of thing the way the yen is. Anyhow, maybe I'm just approaching the problem at a much more superficial level than everyone else, but I was disappointed, but unsurprised, by the recent numbers.
Posted by: Taeyoung at Feb 18, 2009 4:10:46 PM
Taeyoung is exactly right in the previous comment. But I would add that the rise in the yen is not as mysterious as it seems. The problem is that most people don't know how to recognize tight money in a deflationary environment. Because tight money policies cause deflation, and deflation drives nominal interest rates down to zero, tight money is often confused with easy money. Japan since 1994 is a perfect case--so was the U.S. in the 1930s. Instead of letting the yen rise to 90/$, they could have pegged it at 110/$, by offering to sell unlimited yen at that price. BOJ policy has become effectively very tight, in the sense that the demand for yen is rising much faster than the supply in this deflationary environment. They never figured out what they did wrong in the late 1990s, and they are repeating the same mistakes now.
Posted by: Scott Sumner at Feb 18, 2009 5:11:27 PM
Phoenix is Ground Zero for the Housing Bubble. The local economy was inflated by gigantic amounts of construction of exurban homes for people trying to get their kids out of school districts overrun by the kids of illegal immigrants, so lots more illegal immigrants were imported to build the exurban homes, and around and around we go. The economic logic was wholly circular, and now it's in ruins.
Posted by: Steve Sailer at Feb 18, 2009 5:22:37 PM
One of these days, Tyler is going to get around to admitting the "demographic problem" in the exact places that wrecked the world economy: Phoenix, Las Vegas, California, and Florida. Namely, that the human capital of the residents was too low to pay off the gigantic mortgages.
Posted by: Steve Sailer at Feb 18, 2009 5:25:41 PM
Another area where highly paid players will be getting dumped is what, in old fashioned times, used to be called investment banking
Posted by: Morph366 at Feb 19, 2009 9:01:28 AM
I think the trade was universally ridiculed with a few calls to revise the NBA collective bargaining agreement, the latter group arguing that the Suns basically sold their draft picks and pocketed the difference.
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