Chapter 6

How Is a Can of Tuna Like a Smartphone? Yes, Context!

The corporate world can be like a pressure cooker. Shareholders want higher returns. The workers grumble about their pay increases. CEOs have to make critical decisions on where or whether to build a new factory. To understand new regulations a company may need legions of lawyers.

How does the company get all this done? Part of the answer is through assessing the context around decisions it has to make.

In this chapter, we look at factors such as corporate taxation and regulation. How much do they influence CEOs when it comes to important decisions? We examine the rationale for taxes on small business.

We also take a closer look at how a company, in the middle of the recession, made a decision to build a major new factory that will be producing the computer chips that power our tablets and smartphones and whatever else Silicon Valley types can invent in the future.

Another important fact of life for a company is that corporate life can be Darwinian. In others words, acquire a competitor or be swallowed up yourself. To better understand the context around the decision to buy and sell companies we talk to a deal maker who tries to find creative ways to merge companies.

A Company Decides to Build Chips

A recession can scare a company away from making big investments. Lenders may turn down loans to anyone but the most creditworthy. Stock market analysts may clamor for cuts, not investments. And boards of directors may simply decide to wait for the storm to blow over.

But sometimes a business sees the economy and the context surrounding its decisions in a different light and decides to plow ahead. Let us introduce you to one of those fearless firms: GLOBALFOUNDRIES, a company that wasn't in existence until March 2009, the worst period during the Great Recession.

Today, GLOBALFOUNDRIES (GF) owns a state-of-the-art semi-conductor factory—in Saratoga County, New York, about 20 minutes north of Albany. The building with a white and gray metal shell covers an area roughly the size of six football fields. Inside are miles of pipe and wire and hundreds of very sophisticated machines designed to produce tiny transistors used in electronics such as games and smartphones.

The initial cost to build the enormous factory was about $4 billion, a very large investment in the middle of the recession. Since breaking ground on the project in 2009, the company has already expanded the campus with additional production capacity and a new research-and-development (R&D) facility, bringing the current project budget to $8 billion.¹

Given the state of the economy in 2009, who would do this? And why?

Part of the answer revolves around the semiconductor industry itself, which has a history of making big investments almost every year. Historically, annual R&D investment by U.S.-headquartered semiconductor firms has averaged about 15 to 20 percent of sales per year, according to Falan Yinug, director of industry statistics and economic policy at the Semiconductor Industry Association in Washington, D.C.

“No matter whether it's a good year, economically speaking, or a down year, high levels of RT&D investment is just the cost of participating in the industry,” says Yinug.

At the same time, the industry has been on a powerful growth track. Yinug says that global semiconductor sales in 2012 were $292 billion, over double the sales of 10 years ago. Global sales a decade ago were over double the sales 10 years prior to that.

This strong growth leads to more spending just to keep up with the demand. “There comes a time when there is just not enough global semiconductor capacity to keep up with growing demand,” he explains. “When this occurs, semiconductor firms start thinking about actually investing in new plant and equipment to meet the ever increasing needs.”

And those investments can be huge. Yinug estimates the typical leading-edge semiconductor fabrication facility costs about $5 billion. “The only type of facility currently more expensive to construct is a nuclear power plant,” he says.

The investor in GF is Advanced Technology Investment Corporation (ATIC), which is based in Abu Dhabi. On its web site, right under where the company tells visitors, “Real change takes time,” ATIC enumerates why it could look at the world economy and shrug off the downturn: “We recognize that value creation is more about sustainable wealth generation than short-term profit.”

ATIC can afford to be somewhat patient because it is investing some of the sovereign wealth of Abu Dhabi, which has about 4 billion barrels of oil reserves, according to the U.S. Energy Information Administration. However, Abu Dhabi has as one of its goals shifting from an oil and gas economic base to a knowledge-based economy by 2030.²

“So they are making strategic investments in certain key industries to make that switch happen,” says Travis Bullard, a spokesman for GF. Bullard has some unique perspective on the investment since he was involved with it from the start—in 2006, before any oil money became involved. That's when the company he worked for, Advanced Micro Devices (AMD) of Sunnyvale, California, said it would spend $3.2 billion to build the chip factory in Malta, New York. In 2006, AMD had ambitions to expand beyond the single chip factory it owned in Dresden, Germany.³

But building a semiconductor plant, referred to as a Fab by the industry, requires billions of dollars. Even with a big package of financial incentives from New York State, AMD needed more financial help. Two years later, it partnered with ATIC. By the fall of 2008, AMD decided to exit from the chip manufacturing business and sold the Dresden Fab to the Abu Dhabi investors.

“The original press release of October 7, 2008, essentially said, ‘Watch this space, a new company will form in a few months,’” recalls Bullard. But that fall, the economic news deteriorated. Lehman Brothers was in bankruptcy. The U.S. Treasury had announced it would fund the Troubled Asset Relief Program (TARP) with $700 billion to bail out the banks. And Bullard recalls that as the headlines got worse, people kept asking, “Is this thing still going to happen?”

Looking back on it, he thinks the reason that AMD was able to complete the deal is that no one knew how bad things were. “Everyone knew it was a big deal, but I don't think anyone understood how big a deal it really was,” he recalls. “If it wasn't for the cash that was available from Abu Dhabi, there was no way—in my humble opinion—that this was going to happen because all the investment dollars were drying up.”

But the deal did not require financing: ATIC was paying cash. According to the press release, the Abu Dhabi fund paid AMD $700 million, assumed $1.2 billion in AMD debt, and added $1.4 billion in new capital.⁴

However, to be a player in the business, ATIC required more than just deep pockets because there were some serious competitors. In the United States, Intel had many Fabs producing chips for the computer industry. In Asia, the Taiwan Semiconductor Manufacturing Corporation had a long list of customers from its 27 years of making chips. And China was quickly getting into the business as well.

Owning one chip plant in Germany would not give ATIC the ability to be competitive. So in June of 2009, ATIC paid $3.9 billion for Singapore-based Chartered Semiconductor. Now, ATIC owned a company with six Fabs, all in Singapore. ATIC was suddenly sprouting corporate muscles to compete against some of the large players.⁵

However, most of Chartered's business was in what Bullard terms “mainstream” technology, in other words, older computer chips. ATIC had given GF the ability to compete with both the older technology and the newest “leading-edge” computer chips. Sitting at a conference table at the Fab campus, Bullard explains how part of the context of the business is the shrinking size of the chips themselves and the increasingly expensive machines to make them.

The industry measures the chips in terms of nanometers. A single nanometer is a billionth of a meter. A human hair is about 50,000 nanometers. Today, mainstream computer chips are manufactured using measurements of 65 to 90 nanometers. But a leading-edge chip includes components measured at just 20 nanometers or smaller. By way of comparison, Bullard says a single silicon atom is about 5 nanometers.

“So we are basically talking about lining up four to five atoms—that's how small we're talking about here,” he says. “We are basically moving molecules around.”

Moving molecules around to produce tiny transistors starts with a “clean room,” where there are no particles in the air. The air is 10,000 times cleaner than an operating room and recirculated every three minutes. Technicians working in the clean room look like they are wearing moon suits so that no pieces of skin or hair contaminate the room. To prevent vibrations, which might jar the sensitive machines, some parts of the concrete foundation are 12 feet thick.

At the same time, the Fab requires copious amounts of ultra-pure water. In the case of GF, the factory uses about 3 million gallons of tap water per day. But the tap water is put through an intense purification process so there are no impurities in it. The water is necessary because lithography is the main way that chip manufacturers imprint silicon wafers. Lithography is basically a photographic process where an image of the electronic circuit is imprinted on the basic silicon wafer.

“You take a silicon wafer, you clean it, and then you pattern it and then you etch it and then you wash it off,” explains Bullard. “There could be a thousand different processing steps, so those processes include the application of chemicals and you have to rinse away those chemicals . . . and so it's a constant rinsing,” he says.

At the same time, the business is getting increasingly expensive because the imprints on the chips are getting tinier and tinier. “The reason it's getting so expensive is that the width of the lines (the circuits) are way smaller than the wavelength of light,” says Bullard. “So we're using a bunch of tricks basically to be able to draw lines that small.”

The tricks, however, are expensive. Many of the hundreds of machines in the clean room cost $35 million to $40 million each. But Bullard says the next generation of tools to make semiconductors is getting closer to $100 million.

“These tools are so big and so complicated it takes several 747s to deliver each machine,” he says. They require a special attachment on a crane to minimize vibration. The attachments cost $1 million, says Bullard. “And it is designed only to move these machines,” he says.

Why spend all this money?

In part it is because of context: the changing nature of electronics. There is a very large premium to be the first company to introduce a new technology. “The industry is very competitive, and our customers place a gigantic premium on being first, so it's a very time-sensitive industry,” explains Bullard. A good example of this is that when Apple (which does not produce its own chips) introduces a new product, consumers line up outside the company's stores hours or even days in advance.

In addition, the demand for smaller and smaller chips can come from customers who barely existed only a few years earlier. Bullard pulls out a chart that shows who requires the newest technology. One new area: the huge server farms that are involved in cloud computing. “They don't just want performance, they want lower power usage because those server farms consume huge amounts of electricity,” explains Bullard.

However, for a chip manufacturing company, there is a big risk that it will miss a burgeoning market because it takes so long to develop the technology to produce the chips. In press interviews, Intel's CEO has admitted that the giant company missed out on mobile devices. It now says it will be more responsive to smartphones and the next hot trend—intelligent glasses and watches.

Another contextual element in making the investment in the middle of the recession was financial aid. Because governments all around the world as well as state governments consider Fabs to be economic drivers, they are quite competitive in offering financial incentives in any number of combinations: grants, subsidies, tax relief, road construction.

“Texas gave Samsung over $1 billion, and Dresden gave AMD about the same amount,” recalls Dennis Brobston, the president of the Saratoga Economic Development Corporation in Saratoga Springs, New York, which was competing to get the new investment.

“At the time, we were competing with Israel, China, Malaysia, Dresden, and in the U.S., Texas and Phoenix,” recalls J. Shelby Schneider, who at the time worked for Brobston.

New York's package to woo GF included $500 million for construction, $150 million that had to be spent on R&D in the state, and tax incentives of about $650 million over 10 years, says Brobston.

Bullard says the package “helped to make New York a more competitive option versus other places around the world.”

There were still other factors that also led GF to locate in upstate New York. About 15 years ago, an AMD executive had helped the University at Albany-SUNY develop a nanotechnology center. Today, GF recruits engineers and scientists there. At the same time, locating in Saratoga County puts GF close to IBM's research facility in East Fishkill, New York, where over 100 GF engineers are doing research.

In the fall of 2013, it was still too early to know if ATIC's investment would pay off. Bullard agrees that the start-up costs have been so high that the company was still in the red in the fall of 2013. However, the potential is quite large.

Brobston says GF has said it hopes to ship 60,000 silicon wafers a month to clients. The average wafer costs about $100,000. This comes to about $6 billion a month in revenue or $72 billion for the year.

“So you can see how your investment gets paid back rather quickly, which is why the ATIC folks got involved because it is a business that gives high returns,” says Brobston.

The Urge to Merge Depends on Context

While some companies grow by building new factories, others use context to decide when is the best time to expand by buying someone else. Indeed, American businesses love to merge, acquire, and fight over who gets to take control of someone else.

Hardly a day goes by when the business pages don't have some announcement of a takeover. In 2012, a record year for corporate weddings, there were 11,957 acquisitions. This worked out to almost 48 every workday. The first nine months of 2013 were even stronger.⁶

The announcements are full of phrases lauding the takeovers as a way to make a “strategic investments” or “expanded service” or lifting an acquired company “to the next level.” All these phrases are quoted from takeover announcements by just one New York firm that buys and sells companies regularly.⁷

There is hardly a day when Wall Street is not buzzing about the prospect of a takeover probably put together by an M&A (mergers and acquisitions) shop.

Meet David Braun, one of the matchmakers, and the founder and CEO of Capstone Strategic, Inc., which advises companies on potential acquisitions. Braun is somewhat unusual in that his office is not on Wall Street or even in New York. His 25-person firm is based in McLean, Virginia, close enough for Braun to drive to the American Management Association (AMA) in Crystal City, Virginia, where he teaches a class on mergers and acquisitions.

He is an affable storyteller who can easily talk about vastly different client mergers such as a company that cans tuna and a firm that tries to save money for hospitals and health care systems.

Although it's natural for a CEO to get excited about an acquisition, Braun tries to keep his clients focused on the most important part of the merger—what happens after the acquisition. “I think that too often people think an acquisition in itself is the strategy; they get excited about the deal and forget that it has to make sense,” he says in a meeting room at the no, the American Management Association (AMA) as mentioned earlier “The transaction part is not the hard part. We can get the lawyers and accountants together and make all that stuff work. The hard part is that you actually have to implement it.”

Sounds logical, doesn't it?

But then the conversation turns to one of the largest mergers in U.S. history: the combination of AOL with Time Warner in 2000, which cost an estimated $160 billion to $182 billion.⁸ Braun keeps a copy of the January 10 announcement of the merger in his office as a reminder of how not to write press releases about these types of combinations. An example of the corporate hype:

Braun figuratively scratches his head. “My question is, did the press release tell me at all why they did this? I've talked to the AOL executives and they say, ‘One of the biggest things we struggled with is have we overcomplicated this?’”

By way of contrast, he says the announcements from legendary investor Warren Buffett are quite simple. “Most of them are one sentence explaining why they made the acquisition,” he says. “They are extremely purposeful.”

As it turns out, overcomplication of the press release was the least of their problems. The merger is now considered a huge failure. AOL, for example, had a market value of only $2.7 billion in mid-2013. “I think the vision of it is very inspiring,” says Braun. “But the execution of it is the difficult part.”

However, looking back at the context of the merger, it becomes a little more understandable why the executives would call the new company “uniquely positioned” in their press release.

When the AOL–Time Warner merger was announced, the dotcom era was still in full swing, recalls Braun. He compares it to a modern-day gold rush. “These dot-coms were gold,” he says, “and no one knew where e-commerce was going.” This led to one of those periodic Wall Street buying panics. Mutual funds, hedge funds, and investors from Peoria all wanted a piece of the action.

“Companies were being bought who not only did not have any profits, they did not have any revenues because it really was a feeding frenzy where people said, ‘We don't know what's going on so consequently we better buy stuff or we are going to miss out.’”

To Braun, an element of negative context around the merger was the millennial shift. There were plenty of news reports questioning whether computers, phone systems, and other electronic devices would still work on January 1, 2000. He terms it an issue of bad timing—no pun intended—since it began to raise an element of doubt just when the mega-merger was in the works.

“Remember, people got up in the middle of the night to check to see if their phones worked, people took cash out of the bank in case there was chaos at the banks,” he says. “So there was this background of fear.”

Add in yet one other issue of context—there was also plenty of money around to invest in these types of deals. “As a result of that, it was a lot of the ‘other people's money’ phenomenon,” he says, referring to how deal makers used investor funds to enrich themselves.

But that was then. Does context still matter in the world of mergers and acquisitions? Indeed, it does, says Braun, who observes that some of the contextual issues include whether a company is in a position to take advantage of changes in the economy, whether it is a good time to borrow to do a deal or use cash, and whether it is a good time to enact a merger from a tax standpoint.

One example of how taxes matter to corporate buying and selling happened at the end of 2012. Congress was wrestling with ways to resolve a budget impasse that had gone on for months. Unless some agreement could be reached, there was a real possibility that capital gains tax rates might rise. Wall Street advisers beat the drum: sell now to avoid paying more taxes in 2013.

The pitch worked: according to Dealogic, the volume of acquisitions was up 67 percent compared to the prior quarter. The rate of mergers slowed slightly in the first half of 2013 but then roared back later in the year.¹⁰

The slowdown did not worry Braun because of the pressure for CEOs to always “move the needle.” What's the needle? The needle, says Braun, is the stock price, which is also another part of context.

But moving the needle is not that easy, he points out. For example, if a company with $90 billion in revenues buys a $100 million company, the needle doesn't move. The same with a $1 billion purchase. “But if they make a $10 billion acquisition, what happens?” asks Braun. “It moves the needle.”

However, most deals are smaller, says Braun, who estimates that 97 percent of acquisitions are under $500 million. “If I am a $200 million a year company and buy a $10 million a year company, you will never know about that,” he remarks. “I don't have to report it; you can't track it and find out if it was a success or failure.”

In fact, many of the most successful acquisitions don't necessarily make the headlines, but they can move a company into a dominant position in an important industry.

Look at GE, he says. While many people know that the giant company makes cooktops and dishwashers, Braun says the company has been steadily making acquisitions in the water business, which has been estimated to have about $2 billion to $2.5 billion in revenue by Wall Street sources. (GE does not break down its water revenues.)¹¹

“Most people don't realize it but GE has a major position in water—municipal water, potable water, ultra-pure water used for chemicals,” he says. “They did it by cobbling together very strategic assets and very patiently brought them together with one single purpose, which is to say, ‘We're going to own the water business.’”

Braun thinks one of his own deals involving the seafood company Chicken of the Sea is more typical of the types of smaller deals that make sense. In 2003, the CEO of the San Diego–based company asked Braun for some ideas to grow. Buying another canned tuna company was unlikely since the industry had consolidated to three companies. All three competed so fiercely that margins were low and consumer demand was far from robust.

“So we said, ‘Let's think about this: what do you really have to leverage?’” says Braun. “Number one is the name brand; everyone knows their brand name. Coca-Cola, Apple, Cadillac, they spend tons of money to get you to remember their brand name. But here's a company that doesn't spend any money and you remember it.”

At the same time, Braun started to look more deeply into what Chicken of the Sea actually did. Yes, they catch or buy tuna around the world. Once the white albacore are caught, they have to be packed and shipped to a cannery.

“So you know what they are really good at?” asks Braun. “Logistics.” So what do you buy that capitalizes on this? In Chicken of the Sea's case, it was Empress International, a Port Washington, New York, importer and distributor of frozen shrimp.¹²

“It created a whole new category for them to grow that business but at the same time leveraging what they were good at,” says Braun. He adds that the acquisition added new products, new customers, and new sources of supply—all critical factors in the seafood business.

Will corporate America ever tire of the continuous dog-eat-dog world? Not likely because the tax code makes mergers compelling. How so?

Braun says a common scenario is for one company to buy another for its real estate that has already been depreciated. The acquirer gets to redepreciate those assets at current value, he says.

“We had one deal where part of what the acquirer bought was 11 or 12 facilities, mostly office buildings. But the seller did not realize the value of those assets. So our client buys them, ends up selling them and getting the tax benefit for it which basically paid for 50 percent of the cost of the deal.”

For Braun, there is a bit of personal context in making deals. Two of his favorite board games are Risk and Monopoly. And, he confesses, he was always a fan of Let's Make a Deal.

The Corporate Tax Conundrum

It all sounds so simple. All you have to do is cut taxes and reduce regulations and the economy will boom and all will be right with the world. At least that is the approach to economic policy that many believe makes sense. But not all tax cuts have the same impact. Not all changes in regulations create additional economic activity or come without costs. It depends on the type of business tax cuts and regulatory changes and how far they go. That is what context is all about.

While the Supreme Court may have ruled that businesses are like people, the reality is that people run a business.¹³ How the corporation operates; what it does with its funds; how it reacts to changes in taxes, regulations, or economic factors are all determined by who, at the time, happens to be running the company. It cannot be said that two different CEOs will always behave in the exact same manner even if the issues they face are precisely the same.

It is in that context that company actions and reactions must be evaluated. It is not enough to say that all you have to do to expand the economy or create new jobs is to reduce corporate taxes. Lowering business operating expenses is not even a necessary condition for companies to hire more. There are many circumstances where increased costs and a growing economy occur simultaneously. So let's look at a few so-called givens and determine if they really do what they are supposed to do.

Corporations Are People, Too, and They React Accordingly

We talked about how consumers' reaction to tax policy is dependent on their incomes, confidence, wealth, age, and the business cycle itself. Well, since people run businesses, it should not surprise anyone that the same can be said about corporate responses to changes in taxes.

It seems that whenever the economy is in trouble, the proposed solution, at least by some, is to cut corporate taxes. That seems to make total sense. If the business of business is business, lowering the cost of doing business should cause firms to expand, right? Not necessarily. Indeed, cutting taxes could be a waste of time and money under a variety of economic circumstances.

Let's go back in time to 2009. The housing sector had collapsed, banks and vehicle makers were failing and being bailed out by the government, and the world financial sector was teetering on the edge of collapse. And that is not an exaggeration. Essentially, the economy, which had actually entered the recession in December 2007, started going downward with a vengeance.¹⁴

With fears of a major recession, if not a depression, looming, consumers assumed the turtle position: they basically stopped shopping almost completely. So how did businesses react to demand's falling apart? They did what we have said they did: they revised their business plans so that the goal was to be open on January 1, 2010. In order to do that, they cut expenses to the bone, and that meant laying off workers. In the first six months of 2009, nearly 4 million jobs were lost.¹⁵

Let's review things: The financial and housing sectors collapsed, households stopped buying, and the labor market was a blood bath. Into that breach, some people actually thought that it was a good idea to cut business taxes. Indeed, the stimulus bill passed in the spring of 2009 contained not only tax cuts for households but tax cuts for businesses as well.

How much of those tax cuts do you think went to adding jobs? Think of it this way: If you are a CEO who is trying to survive and you are cutting jobs, cutting output, and planning for a depression, how much new capital are you buying? Do you really need to add a new machine or a new plant when your sales are crumbling and could falter further? What is the potential return on that potential investment? It cannot be very high. Indeed, it is likely to be negative, especially if those fears of a depression turned out to be correct.

The lesson: When the economy is falling apart, businesses are not going to hire more people or invest, so giving firms new tax breaks is simply a transfer of income: It goes from taxpayers to owners and managers of the firms. It doesn't find its way back into the economy as more output or employment. In short, cutting taxes makes no economic sense when the economy is a mess. Some politicians thought that was the way to go during the recession and it remains the common wisdom for many.

What about when the economy is booming? When we have hit the sweet spot in growth, and profits are high, wages are rising, and households are confident, shouldn't we cut taxes then? The better question would be: why would we even think of cutting taxes when happy days are here again?

What is the purpose of a corporate tax cut? It is to incent companies to expand their hiring, production, and/or capital spending. That is usually done when companies need some help or a push. It is best done when, without that assistance, firms are likely to act cautiously. In other words, tax cuts should increase growth when it is lagging.

When profits are soaring and the economy is booming, firms already have the wherewithal to hire and expand. They don't need more money; they already have enough, or at least should have enough. They should not want to be supported by government subsidies, though they will always take a handout when offered.

Indeed, during the good times, when chief financial officers do their calculations on the economics of growing the business, it is usually quite positive. Thus, adding to cash flow by lowering taxes doesn't do a whole lot to change the calculations. Again, it is more likely to be just a transfer of income from taxpayers to owners of capital as well as management. Conclusion: Tax policy needs to account for the thinking of business leaders, and they are worried about the same things that consumers worry about.

To Regulate or Not Regulate, That Is the Question!

If you ask any businessperson, they will tell you they can deal with tax increases as long as they know what those costs will be. What they hate the most, though, are regulations, or what most executives think is the tendency to overregulate the economy. Not only does it cost businesses money to comply with all the crazy quilt of requirements, but regulations keep firms from operating in ways they would like to or prevent them from getting into markets they consider good opportunities.

Why is government so obstinate, demanding that firms conform to so many rules and regulations? Well, it comes down to the basic calculation of the cost to society of underregulation versus the cost of overregulation. It can be hard to fully calculate the cost of regulations. You have to ask what firms would do if they could enter a market or could operate differently. Essentially, you don't know how successful the firm would be if the regulations didn't get in their way.

There are also the compliance costs, which have been estimated a number of times, though the range is extremely wide. For example, in 2011, the Office of Management and Budget's 2009 report to Congress estimated annual costs at around $50 billion to $60 billion. Meanwhile, a September 2010 report prepared by Nicole V. Crain and W. Mark Crain for the Office of Advocacy within the Small Business Administration (SBA) stated that the annual cost of federal regulations was about $1.75 trillion in 2008.¹⁶

The cost of regulation is either small or extremely large. Clearly, both approaches to the problem have been criticized vehemently, usually from groups who have one axe or another to grind. Those who worry about businesses running wild have sided with the Office of Management and Budget (OMB), while those who want businesses to be unleashed believe in the Crain and Crain report. Of course, we can talk about the cost of regulations all we want, but the discussion makes no sense without balancing it with the benefits. And the benefit analysis can be as touch-feely and questionable as the cost analysis. For example, in OMB report in 2013 put the benefits of the regulations in place over a 10-year period at somewhere between $112 billion and $678 billion.''¹⁷ To say the least, that is a very wide range, and it makes it hard to have much confidence in any economic research on the subject.

Well, if the studies don't come to a conclusion, is there any way for us to judge what would happen if regulations were relaxed? Well, yes, we can try it in the real world. That is precisely what former Federal Reserve Chairman Alan Greenspan did during his term of office. He led the charge to eliminate the Glass-Steagall Act, which had put a wall between banks and investment companies. The Financial Services Modernization Act of 1999 officially allowed finance firms of all types to essentially become one.¹⁸ Banks, investment companies, and insurance companies could now merge, and they did.

Mr. Greenspan also took a laissez-faire approach to regulating these companies. He strongly believed in the “self-regulatory approach” to central banking. He called it, in his testimony in front of Congress in October 2008, the “self-interest of lending institutions to protect shareholders' equity.”¹⁹ As a consequence, financial institutions were given leeway in operating in a wide variety of ways and were allowed to use just about any and all financial products they could create.

Well, we know the cost of deregulation and the laissez-faire approach to financial regulation: the Great Recession. What is not clear is what the cost would be from overregulation. undoubtedly, it could stifle the truly aggressive competitive juices of those firms and individuals that operate at the outer edge of the regulatory envelope. They push it as far as they can, and if it breaks, so be it.

Much of business experimentation derives from doing things in ways that have not been thought of before. That is called innovation. Stifling innovation is probably the worst thing that a regulator can do, as it slows not only current economic activity but future activity as well.

When you consider the long-run potential for an economy, additional output can come from two sources: employing more workers and employing workers more efficiently—that is increased productivity. One example of a way to expand productivity is better use of machines. In other words, a lot fewer auto workers can make a lot more vehicles with the help of robots.

If regulation slows the rate of growth of investment and innovation, it will reduce the potential growth rate of the economy. Regulators must therefore consider the cost of overregulation with the cost of underregulation. Like the rest of us, regulators cannot look into the future with any certainty. It is doubtful that Alan Greenspan would have looked the other way as financial institutions created all those innovative new products if he had known that those products would wind up collapsing the economy, which means the regulators have to assume they are going to make some type of error.

But which error should regulators make? Should they overregulate and slow current and future growth, or should they underregulate and risk another calamity. It depends on the potential cost of the mistake.

Take the example of the minimum wage. This is a regulatory action in that it forces a certain, specific pay scale on businesses. Should there even be a minimum wage, and if so, what should it be? The minimum wage has been studied many times by a large number of economists. Not surprisingly, the conclusions are hardly consistent.. The logic is simple: If you put a floor under wages, then firms will limit or reduce hiring of workers who don't produce enough to make themselves profitable. In economic terms, a company hires someone only if the value of the output they create exceeds their costs. It's hard to make a profit if your workers don't earn their own way. Therefore, if you raise the minimum wage, employment will go down, right? That is not exactly what the literature shows.

In a comprehensive review of the literature, John Schmitt showed that while there are some indications that for low-wage workers raising the minimum wage could have a small impact, overall there is no definitive proof that the effects are significant.²⁰ Indeed, there are some studies that actually find a positive relationship between raising the minimum wage and employment, which seems to make no sense at all.

The point here is that something that appears obvious may not be true in the real world. How is it possible that raising the minimum wage doesn't cause firms who employ many low-wage workers to cut back? Like anything else, avoidance and adjustments are the operative factors. It's not the regulation itself as much as how the costs can be spread around that really matters.

And there are frequently many ways to do that. As Schmitt wrote:

Regulations are rarely welcomed or appreciated by the firms being regulated, but they are not necessarily all bad. Some may restrain growth, while others may limit the ability of entrepreneurs to do what they believe is needed to get things done. Some executives believe that just about any regulation would reduce profits, not just immediately but for a long time.

But not all regulations turn out, over time, to be nearly as bad as they are initially perceived. Few vehicle makers welcomed the Corporate Average Fuel Economy (CAFE) standard. Car makers believed the new regulations would kill the vehicle sector when they were introduced in 1978. Fast-forward 35 years—and with fuel prices pinching consumers—companies are now battling it out to have the highest average for their fleets and their individual vehicles.

What the examples of the minimum wage and vehicle mileage requirements show is that regulators need to understand that their actions have impacts that may not be obvious. These two examples turned out well, or at least not badly, for the economy. Not every regulation is so lucky, and not every attempt at reducing regulations turn out well. There are costs and benefits from regulations, and they depend on the context of the economy.

Essentially, what we are saying is that regulators must directly recognize what every statistician knows: There are two types of errors. You can do something you shouldn't do, or you can fail to do something you should do. When it comes to regulation, the first error is that you put in too much regulatory oversight and too many requirements. That is doing something they really should not do. In the second case, you don't put in enough regulations when you should be regulating more aggressively. That allows businesses to do things they probably shouldn't be doing also a bad move.

The regulators must decide which error to make. If they make the wrong one, we all suffer. But keep in mind that they are going to make a mistake. The one they make will cause problems, whether it be slower growth or a massive recession. And businesses must adjust accordingly. As we saw with both of the examples in this chapter, firms do adapt to tax and regulatory constraints. It is the context in which those adaptions occur that determines the success or failure of a firm.

While companies are busy trying to make money, Washington is often busy debating how to spend it. In the next chapter, we look at some of the contextural issues in the $3.7 trillion the Obama administration estimated it would spend in FY2014 and a mystery surrounding an important part of it.

Notes

1. GLOBALFOUNDRIES, press release of January 8, 2013. www.globalfoundries.com/newsroom/2013/20130108.aspx.

2. ATIC. January 13, 2014. www.atic.ae/vision/abu-dhabi-2030/.

3. Luther Forest Technology Campus history, www.lutherforest.org/about_concept.php.

4. AMD press release, December 8. 2008. The Foundry Company was later named GLOBALFOUNDRIES. www.amd.com/us/press-releases/Pages/Press_Release_129458.aspx.

5. GLOBALFOUNDRIES press release, September 7, 2009. www.globalfoundries.com/newsroom/2009/20090906.aspx.

6. Data from Dealogic, a financial and technology company, www.dealogic.com/media/81237/dealogic_global_m_a_review_-_first_nine_ months_2013.pdf.

7. Various press releases from KKR&Co, LP One example: KKR's acquisition of ReSearch Pharmaceutical Services, Inc. on July 31, 2013. http://media.kkr.com/media/media_releasedetail.cfm?ReleaseID=781663.

8. Merger estimate from various news sources. For example, the New York Times said the merger was worth $160 billion (http://learning.blogs.nytimes.com/2012/01/10/jan-10-2000-aol-and-time-warner-announce-merger/?_r=0), while CNN Money said the value of the merger was $182 billion (http://money.cnn.com/2000/01/10/deals/aol_warner/).

9. Press release, January 10, 2000. www.timewarner.com/newsroom/press-releases/2000/01/America_Online_Time_Warner_Will_Merge_to_Create_Worlds_01-10-2000.

10. Dealogic data. January 2, 2013. www.dealogic.com/media/55516/dealogic_global_ma_review_-_1h_2013.pdf; http://www.dealogic.com/media/81237/dealogic_global_m_a_review_-_first_nine_months_2013.pdf.

11. One estimate came from Global Water Intelligence. October, 2009. www.globalwaterintel.com/archive/10/10/general/ge-stresses-its-commitment-water-market.html.

12. Chicken of the Sea press release, October 21, 2003. http://chickenofthesea.com/multimedia/?p=264.

13. Citizens United v. Federal Election Commission, No. 08—205. Argued March 24, 2009. Reargued September 9, 2009. Decided January 21, 2010.

14. National Bureau of Economic Research, “Business Cycle Expansions and Contractions.” www.nber.org/cycles.html. January 13, 2014.

15. Bureau of Labor Statistics. Current Employment Statistics, Naroff Economic Advisors, Inc.

16. Nicole V. Crain and W. Mark Crain, “The Impact of Regulatory Costs on Small Firms.” Lafayette College, Easton, Pennsylvania, contract number SBAHQ-08-M-0466. Release date: September 2010.

17. Office of Management and Budget, 2013 Draft Report to Congress, “On the Benefits and Costs of Federal Regulations and Agency Compliance with the Unfunded Mandates Reform Act.” May 21, 2013.

18. The Financial Services Modernization Act of 1999, enacted November 12, 1999.

19. Testimony of Dr. Alan Greenspan, Committee of Government Oversight and Reform October 23, 2008, Federal Reserve Board of Governors.

20. John Schmitt, “Why Does the Minimum Wage Have No Discernible Effect on Employment?” Center for Economic Policy and Research, February 2013.

21. Ibid.