Business Cases: Priming the Pumps

Courtesy Garney Companies, Inc.

In the old days, when fewer Americans had cars but many more people lived in rural areas and drew their water from wells, advocates of fiscal expansion used different metaphors. Instead of talking, as President Obama did, about giving the economy a “jumpstart,” they’d talk about “priming the pump.” You see, it was often necessary to add water to old-fashioned hand pumps before they would work; similarly, people would argue, you need to add funds to the economy before it will get back to producing jobs and income.

In the case of the Obama stimulus, priming the pump was more than a metaphor: some of the most obvious beneficiaries were companies that made … pumps. The Recovery Act allocated $7 billion for drinking-water and wastewater projects, creating a number of new opportunities for companies in the business of moving water around.

A case in point was Garney Construction, a Kansas-City based company specializing in water and sewage projects whose slogan is “Advancing Water.” By the summer of 2009, Garney had won contracts to work on nine water- and sewer-related projects that were being financed in whole or in part by the Recovery Act.

None of these infrastructure projects were dreamed up as ways to spend more money; they were all things that state or local governments had been planning to do eventually. “I think most of these projects were sitting on a shelf, waiting for funding,” Garney’s president told a local business journal.

Although the stimulus was good for Garney, it was not exactly a financial gusher. In 2007, the United States spent about $100 billion on water-supply and wastewater infrastructure; the extra $7 billion coming from the stimulus, not all of it coming in one year, was basically a, well, drop in the bucket by comparison. Indeed, Garney said that only about 10% of its business was coming from stimulus money. And despite the stimulus, the company had less business than it had two years earlier.

Still, Garney and other companies in the water-infrastructure business were clearly getting some benefit from the Recovery Act.

Business Cases: The Perfect Gift: Cash or a Gift Card?

Richard B. Levine/Alamy

It’s always nice when someone shows his or her appreciation by giving you a gift. Over the past few years, more and more people have been showing their appreciation by giving gift cards, prepaid plastic cards issued by a retailer that can be redeemed for merchandise. The best-selling single item for more than 80% of the top 100 American retailers, says GiftCardUSA.com, is their gift cards. What could be more simple and useful, so the thinking goes, than allowing the recipient to choose what he or she wants? And isn’t a gift card more personal than cash or a check stuffed in an envelope? (And gift cards have pretty pictures, too.)

Yet several websites are now making a profit from the fact that gift card recipients are often willing to sell their cards at a discount—sometimes at a fairly sizable discount—to turn them into cold, impersonal dollars and cents.

PlasticJungle.com is one such site. At the time of writing, it offers to pay cash to a seller of a Whole Foods gift card equivalent to 95.55% of the card’s face value (for example, the seller of a card with a value of $100 would receive $95.55 in cash). But it offers cash equal to only 78.75% of an American Eagle Outfitters card’s face value. PlasticJungle.com profits by reselling the card at a premium over what it paid; for example, it buys an American Eagle Outfitters card for 78.75% of its face value and then resells is for 87% of its face value.

Many consumers may be willing to sell at a sizable discount to turn their gift cards into cash, but retailers are eager to promote the use of gift cards over cash. According to GiftCardUSA.com, 5% to 15% of gift cards are never redeemed. Those unredeemed dollars accrue to the retailer, making gift cards a highly profitable line of business. The Wall Street Journal placed the value of “breakage,” the amount of a gift card that accrues to the retailer rather than to the card holder, at $41 billion between 2005 and 2011.

How does breakage occur? People lose cards. Or they spend only $47 of a $50 gift card, figuring it’s not worth the effort to return to the store to spend that last $3. Also, retailers impose fees on the use of the card or make cards subject to expiration dates, which customers forget about. And if a retailer goes out of business, the value of any outstanding gift cards disappears with it.

In addition to breakage, retailers benefit when customers intent on using up the value of their gift card find that it is too difficult to spend exactly the amount of the card; instead, they spend more than the card’s face value, sometimes even spending more than they would have in the absence of the gift card.

Gift cards are so beneficial to retailers that those which used to reward customer loyalty with rebate checks have largely switched to dispensing gift cards. As one commentator noted in explaining why retailers prefer gift cards to rebate checks, “Nobody neglects to spend cash.”

Business Case: PIMCO Bets on Cheap Money

J. Emilio Flores/The New York Times/Redux Pictures

Pacific Investment Management Company, generally known as PIMCO, is one of the world’s largest investment companies. Among other things, it runs PIMCO Total Return, the world’s largest mutual fund. Bill Gross, shown at left, who heads PIMCO, is legendary for his ability to predict trends in financial markets, especially bond markets, where PIMCO does much of its investing.

In the fall of 2009, Gross decided to put more of PIMCO’s assets into long-term U.S. government bonds. This amounted to a bet that long-term interest rates would fall. This bet was especially interesting because it was the opposite of the bet many other investors were making. For example, in November 2009 the investment bank Morgan Stanley told its clients to expect a sharp rise in long-term interest rates.

What lay behind PIMCO’s bet? Gross explained the firm’s thinking in his September 2009 commentary. He suggested that unemployment was likely to stay high and inflation low. “Global policy rates,” he asserted—meaning the federal funds rate and its equivalents in Europe and elsewhere—“will remain low for extended periods of time.”

PIMCO’s view was in sharp contrast to those of other investors: Morgan Stanley expected long-term rates to rise in part because it expected the Fed to raise the federal funds rate in 2010.

Who was right? PIMCO, mostly. As the accompanying figure shows, the federal funds rate stayed near zero, and long-term interest rates fell through much of 2010, although they rose somewhat very late in the year as investors became somewhat more optimistic about economic recovery. Morgan Stanley, which had bet on rising rates, actually apologized to investors for getting it so wrong.

Bill Gross’s foresight, however, was a lot less accurate in 2011. Anticipating a significantly stronger U.S. economy by mid-2011 that would result in inflation, Gross bet heavily against U.S. government bonds early that year. But this time he was wrong, as weak growth continued. By late summer 2011, Gross realized his mistake as U.S. bonds rose in value and the value of his funds sank. He admitted to the Wall Street Journal that he had “lost sleep” over his bet, and called it a “mistake.”

The Federal Funds Rate and Long-Term Interest Rates, 2009–2011

Source: Federal Reserve Bank of St. Louis.

1. Why did PIMCO’s view that unemployment would stay high and inflation low lead to a forecast that policy interest rates would remain low for an extended period?
2. Why would low policy rates suggest low long-term interest rates?
3. What might have caused long-term interest rates to rise in late 2010, even though the federal funds rate was still zero?