Twinkies, Unions, Debt and Bankruptcy

Hostess is shuttering its bakeries and plants that produce Twinkies, Wonder Bread and other iconic snacks because of a strike, mismanagement and shifting preferences of the American consumer.  Pro-union advocates are blaming poor management and hedge funds.  Pro-management advocates are blaming unreasonable union demands.  Clearly neither side wanted the company to liquidate its assets.  Yet what happened to Hostess, and its workforce, is what we should expect from union-management battles in the U.S.  More than twenty years ago fellow Welch Consulting economist Donald Deere and I explained why management, faced with the threat of unionization and strikes, would use debt as a tool to protect its investors.

First, recognize that the valuable asset of union membership, unlike ownership of a company, is non-transferrable.  Upon retirement older union members can’t sell the property rights to their job in a unionized plant.  This means union members discount the future more than firm owners and shareholders.  The thousands of Hostess workers who retired in the past two decades were harmed less by the decline in the profitability of the company after their retirement than they would have if they could have sold their unionized jobs to the next generation of workers.  The right to work as a union member at a healthy company would sell for far more than the right to work for an unhealthy company.  (The absence of a market for the purchase and sale of union membership rights even though these rights yield a share of firm profits is an example of incomplete markets.)

Second, recognize that unions can bargain over the return on sunk investments (plant and equipment) and not just bargain over profits.  Once a billion dollar plant has been built, a union can hold-up management for the returns on that specific investment.  If the union succeeds, investors will get a lower return than they anticipated from their investment, but as long as variable costs are covered they won’t shut down the plant.  It is impossible for a union to pre-commit to only negotiating and striking for a share of the profits.  So even if a union has good intentions and promised only to negotiate for a share of profits, investors and management would be wary and assume the worst; the returns to sunk investments are assumed to be on the negotiating table.

What can firms do to protect investors from union demands?  They can use debt to make management threats more credible.  Investors and management facing the scenario described above will prefer debt finance to equity finance because debt makes the threat of bankruptcy more credible.  (Union threats are another reason why the Modigliani-Miller theorem doesn’t hold.)  The more debt-financed a company is, the more likely an adverse demand shift, bad management decisions or excessive labor costs will push the firm into bankruptcy.  Debtors must be paid whereas union demands come before dividend payments to shareholders.  So companies like Hostess use debt-finance as leverage against unions, knowing that this allows them to get more wage and benefit concessions from unions.  Unions are constrained more if a company threatens to file for bankruptcy because it can’t pay its debts than if the company threatened to suspended dividend payments to its shareholders.

The high debt to equity policy for management is similar to the sequestration policy agreed to by the President and the Congress.  At the time the sequestration deal was made, neither branch of government wanted to go over the fiscal cliff.  The deal’s purpose was to constrain the negotiations of the parties going forward.  Likewise, the owners of Hostess did not want their negotiations to end in the liquidation of the company.  They put in place a mechanism designed to limit future union wage demands even though they knew it would increase bankruptcy risk.  They likely made such a choice in order to protect their profits and the return on their sunk investments.  The lesson is that poison pills designed to constrain bargaining positions will sometimes have to be swallowed.

Vanishing Private Sector Unions

Yesterday Indiana Governor Mitch Daniels signed the law making Indiana the only right-to-work state in the Rust Belt.  Earlier this week pollster Scott Rasmussen reported that 74% of voters favor right-to-work laws that would eliminate mandatory dues and make it much more difficult for unions to organize.  Public employee unions are also being challenged.  In November Ohio voters rejected a law that restricted the collective bargaining rights of public sector unions, and Wisconsin Governor Scott Walker is facing a possible recall after signing a similar bill in Wisconsin.

Voters’ sentiments seem to reflect their labor market experiences.   Private sector unions are vanishing, which will erode support for laws and regulations that strengthen or preserve their bargaining power.  On the other hand membership has never been higher in public sector unions.  I expect well-organized opposition to bills such as the one introduced in Arizona, which limits the collective bargaining power of public sector unions.

The latest Labor Department data indicate that union members comprise only 6.9% of the private sector workforce.  Private sector union membership rates peaked in the 1940s and 1950s at about 1/3 of the workforce.  Unions were virtually nonexistent until the 1960s.  Today the situation has reversed and there are more union members in government than in the private sector.

Union members are older than non-union workers.  In the private sector there are about the same number of non-union workers under the age of 30 and age 55 and above.  Among union members there are 2.5 workers age 55 and above for each worker under 30.  The following figure illustrates private sector union membership rates for four different age cohorts.  The only age group that ever experienced membership rates in excess of 20% includes workers who are now age 55 and above.  Younger age cohorts have seen stable membership rates of 10% or less.  If these trends continue no more than 5% of the Millennial Generation will ever be (private sector) union members.

The aging of the private sector union workforce means that the issues that matter to Richard Trumka, and the AFL-CIO, are unlikely to energize younger voters.  Voters who never belonged to a union show little interest in recess appointments to the National Labor Relations Board, NLRB rules changes that give unions an organizing advantage, the NLRB’s opposition to Boeing’s plans to shift production from Washington to South Carolina, or Indiana’s right-to-work law.  In an earlier era when the AFL-CIO had more political clout, these issues would have been pivotal in an election year.

Local government employees, such as teachers, sanitation workers, police and firemen, have the highest union membership rates that we have ever seen in any sector of the economy in U.S. history (43%).  The battleground for the labor movement has shifted to laws that limit the collective bargaining rights of unions representing government workers, as in Arizona, Ohio and Wisconsin.  These laws have gained support as local governments have been squeezed by declining property values and tax bases and increasing costs of health care benefits and pensions.  The result of the efforts to recall Governor Scott Walker will foreshadow whether public sector unions can maintain their bargaining power and political clout.

Sugar Beets and Lockouts

Yesterday’s New York Times describes how lockouts have become a more common tool in labor management negotiations. Management is more likely than ever to lockout union workers, hire replacement workers and pressure unions to accept wage and benefit concessions when contract re-negotiations become deadlocked.

The Times article focuses on American Crystal Sugar, the nation’s largest sugar beet processor, which is currently involved in a lockout with 1300 union workers employed at five plants. The article never mentions that profits and union compensation in the sugar beet industry rely on import tariffs, quotas on imported sugar, and protection from foreign competition.

It is simply cheaper and more efficient to import sugar than it is to process sugar from sugar beets in the US. As Mark Perry noted in his Carpe Diem blog two years ago, government intervention in the market for imported sugar has protected the sugar beet industry and raised the price of sugar for the American consumer. The sugar beet industry has received $242 million in subsidies over the past 15 years.  More importantly, as Perry explains, our policies have caused U.S. sugar prices to be about twice the world price for decades. In 2009 alone this cost consumers $2.5 billion dollars.

Remarkably, the topic of sugar subsidies was raised yesterday at the Republican debate. Newt Gingrich admitted that in all of his years in the House he was unable to eliminate sugar subsidies. His simple explanation for the durability of this anti-competitive policy was there are “just too many beet sugar districts in the United States.” This debate topic released a torrent of cynical (but funny) tweets . The consensus was: this is silly, aren’t there more important issues?

The story of sugar beets is a lesson in why inefficient government programs are difficult to eliminate. Every policy has winners and losers. The winners are the sugar beet processors and organized labor who are currently deadlocked over how to split the profits from operating in a market protected from foreign competition. The losers are American consumers. Unfortunately the stakes are so low per consumer, $8 per year, that we think it’s silly to question candidates about how they expect to change Washington if they can’t stop subsidizing and protecting sugar beets.