NBA Lockout: NBPA Economist Kevin Murphy Speaks Up

Classroom-visitors-murphy_mediumOne of the great mysteries behind the NBA Lockout is that amidst all of the proposals and positions thrown around the one thing that is difficult to do is truly understand how these concepts play out in real-time. Enter super-economist Kevin Murphy, who teaches at the University of Chicago and has been hired by the NBPA to help represent the players' interests.

Murphy gave a lengthy interview with Steve Aschburner, which I would strongly encourage you to read through.

Renowned Economist Murphy Lends Smarts to NBPA's Cause | NBA.com

The interview takes a while to get going, but once Murphy moves into economic projection areas, he really takes off in helping us understand the nature of trying to argue economics and self-interest concurrently. I have excerpted a few of his more provocative answers, re-arranged for more comprehension, and added a little of my own commentary.

Is economic analysis open to interpretation or do the numbers generate one "truth?"

Kevin Murphy: In certain cases, it's relatively straightforward. In cases like this, there's more room for disagreement. All those moving parts, people can put them together in different ways. Everybody has their own vested numbers, so everybody shapes their numbers in their own direction.

You might be surprised to hear this, but being an economist is not as sexy and high-rolling as you might think. Having worked with a number of economists in the past, I can attest to the fact that most of them are incredibly smart, incredibly driven, and more often than not, incredibly incorrect. In fact, one of my favorite personal sayings is that economists are great at explaining why their estimates proved to be wrong.

The trouble lies in the fact that, at the end of the day, an interested party wants to hear one number from his economist. It doesn't matter what that number is, but the party is looking for certainty in a constantly changing world. Hence, even if the NBA and NBPA could agree on numbers in principle, where those numbers take you could still be oceans apart.

Are the League's reported financials trustworthy?

Murphy: I would say the primary disagreement is not over the accounting numbers. It's what you include and how you interpret the numbers. For example, the accounting picture of the NBA isn't very different from what it was five years ago or 10 years ago in terms of ratio of revenues to costs and all the rest -- it's changed very little. Which immediately tells you, wait a minute, if the underlying financial picture is similar today to what it was five years ago or 10 years ago, and people are paying $400 million or whatever for franchises, and you're telling me that these things lose money every year, something's missing, right?

Well, the answer is pretty clear. There are a couple of things that are really attractive. One is, historically, you've seen franchises appreciate in value and that appreciation has more than outstripped any cash-flow losses that you've had. And if you're in the right tax position, it's actually pretty good because you've got a tax loss annually on your operating and you've got a capital gain at the end that you accumulate untaxed until you sell it and then pay at a lower rate. So you get a deferred tax treatment on the gains and an immediate tax treatment on the losses, that's not a bad deal.

Murphy does a great job explaining here how exactly owning an NBA franchise impacts the owner economically. Many of us groundlings watching the spectacle might not be able to relate in a direct way, because for most of us our big ticket assets are our homes and our cars. Homes generally appreciate over time, but we as a population have gotten in trouble when we see homes as a liquid asset. Alternatively, our cars are a terrible investment, losing value as soon as we drive it off the lot.

However, if some of us are fortunate enough to own other assets such as rental property, charter fishing boats, or corporate jets, there are two ways in which our net worth increases. The first is through our cash flows - bringing in more than we spend. The second is through capital appreciation, which means that your asset is worth more tomorrow than it is today. As long as you hold that asset and watch it increase in value, your net worth goes up, and as Murphy states, you don't pay tax on it until you sell it. So Murphy's argument is, when we're talking about assets worth hundreds of millions of dollars, the capital appreciation far outstrips the cash flow losses that the team may incur each year.

How about an example?

Murphy: Let's say the NBA is a $4 billion revenue business -- that's not exactly right but it's close enough. Then let's say you lose $200 million. That's 5 percent. OK, my franchises are worth -- let's make it simple, 2½ times revenue, which is well below Forbes [valuations] -- that's $10 billion. Now let's say it's appreciating at 4 percent a year. I'm getting $400 million in appreciation even though I only have $200 million in losses. I'm getting better tax treatment on the $400 million that I'm making, and I deduct at a higher rate the $200 million that I'm losing. Suddenly this picture doesn't look so crazy any more.

One effect of equalizing payrolls is you incentivize good players to go where the money is available. But another might be paying good money to players who might not deserve it, just because more franchises have to spend on ... somebody.

Murphy: That's a problem. The other thing is, there is some relationship between pay and success but it's not nearly as strong as people think it is. Even if you were to completely equalize pay across teams, there still would be an enormous variation in strength of teams. In a statistical sense, the level of payroll of a team explains somewhere like 5 percent to 10 percent in the variation in outcomes.

I find the question itself kind of interesting because, well, that's happening already even without a hard cap, which is what "equalizing payrolls" is really a synonym for. How else would you explain this?

To Murphy's answer, he is really just re-stating what we already know - the relationship between payroll and success is tenuous, but also that it really only tells half the story. The best franchises are the ones that combine good decision making with an open bank account. The champions of the past four years (Lakers, Celtics, Mavericks) certainly bear that out. The true genius lies not just in having the courage to jump, but also knowing when it is the right time to jump.

The owners will say there's been a franchise bubble not unlike the housing bubble. A number of them bought high and don't think they'll see the equity growth.

Murphy: The fact is, guys have not done well over the last few years as asset prices generally have gone down. I don't doubt that. But to say that you lost money in the worst asset crash in memory -- and franchises haven't gone down nearly as much as many assets have gone down -- that's not telling you you need concessions going forward.

If you go back before the last 3-5 years, these guys did incredibly well. Their franchises weren't going up by 4 or 5 percent, they were going up by 8 or 9 percent a year. They were making money hand over fist. Should [the players] get credit for that? Should we get that money back?

You could argue from this take that the real problem that the owners have had is a problem with duration mismatch and liquidity risk. Owning a franchise is an inherently risky business, not the least of which is because owning a team is very illiquid - you can't just sell it like you can sell a share of stock without the risk of serious loss in value. If owners bought high and now find themselves underwater, well, that is sort of the nature of the beast. Owners are sophisticated investors and they should know that buying something like a franchise will always carry the risk of both net loss as well as capital loss.

Of course, when you're an owner of big ticket items, there are ways to both mitigate risk as well as transfer risk. You mitigate risk by simultaneously owning another asset that is likely to go up when the other one goes down. This is what is known as "diversification." You transfer risk by either trading it away (such as with an interest rate swap) or in the owners' case, shifting it onto the backs of the other owners (enhanced revenue sharing).

How does it make sense economically to hold out for a small percentage that's much less, in sheer dollars, than what the players are losing by missing games? A gap of 2.5 percent is worth $100 million annually, but a missed month of paychecks is $400 million.

Murphy: Part of it on our side is an investment in the future. If you give up a lot today, you're not just giving it up today, you start the next contract from that much lower. So you're talking about the long-term impact of that kind of concession.

I often wonder how people like Murphy explain this fact to the players. I would imagine that, since most players play for on average of less than five years, they feel very little incentive to forgo income now for the benefit of future players' income later. Some players no doubt understand the sacrifice and are willing to make it, but those guys are players such as Kevin Durant, Kobe Bryant, and Dwyane Wade. Not only will their careers likely last into the next CBA, but their overall economic portfolios will absorb the lost income seamlessly. By contrast, how do you convince a player like Dan Gadzuric (who must know in his heart of hearts that he's being way overpaid) that he should sacrifice now when he will likely never see another big payday again?

Murphy is talking about the long game, and indeed that is the right one, but I would still love to hear a player talk off the record about what these kinds of concessions really mean.

When do the rosy growth projections of 4 percent used by both sides take a hit from fans' backlash to this lockout?

Murphy: If we get a deal here soon, I think the long-term consequences will be minimal. The longer it goes, the more substantial the risk. I think everybody's taken a hit to some extent. It might not show up in the financial numbers right away, but I don't think this has been good for either side. Both sides have looked not so good at times, comical at other times.

To borrow an illustration from our country's current job market situation, we as a nation are at a point where according to CBO reports we must add at least 90,000 jobs every single month (estimates may vary) to keep up with the rate of population growth and participation rate. Putting aside the veracity of that number for a moment; the point is, if job growth falls below that 90,000 mark in a given month, we cannot even get back to the watermark, let alone see net job expansion. It also means that in the subsequent month, job expansion has to go above and beyond that 90,000 mark just to break even again.

In the same way, by the league canceling a portion of its season, they are lowering their expected forecast below what it should have been had there been no work stoppage. Cancel enough of the season and it too lowers the potential watermark so that the league's performance would have to go above and beyond normal returns just to get back to where it would have been had no lockout occurred. If the lockout lasts long enough, you could see an entire generation of players come and go before the NBA makes it all the way back.

Comical indeed.

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