“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” – F.A. Hayek
As any casual NBA fan already knows, Kevin Durant was in the news last week with his decision to leave his long time team and 2016 Western Conference runner-up Oklahoma City Thunder for the 2016 Western Conference winner and NBA Finals runner-up Golden State Warriors. Other than die hard Golden State supporters or people who cheer for dynasties, most NBA fans were not happy to hear the news. Durant is arguably one of the top three talents in the league amongst the likes of LeBron James (Cleveland Cavaliers) and Stephan Curry (Golden State Warriors), so his decision to abandon his team in order to join the team which has kept the Thunder out of the NBA finals the past two years was seen as a betrayal to say the least. But Durant isn’t the first player to make such a move as LeBron James did the exact same thing back in 2010 when he left Cleveland in order to join Dwyane Wade and Chris Bosh in Miami to create an all-star team which won two and competed in four of the following NBA finals. Super-stars joining forces is a relatively new phenomenon. When asked about LeBron’s decision in 2010, Michael Jordon stated, “There’s no way, with hindsight, I would’ve ever called up Larry [Bird], called up Magic [Johnson] and said, ‘Hey, look, let’s get together and play on one team’...In all honesty, I was trying to beat those guys.” So why are star players leaving their former teams to create all-star teams with other star players and what lessons, if any, can be drawn from the microcosm economy of the NBA to teach us about the larger global economy as a whole?
The NBA was launched in 1946 with a $55,000 salary cap per team. After one year, the salary cap was abandoned and the league played under no cap until the 1984-85 season when the cap was re-introduced at $3.6 million per team. The idea behind capping salaries is pro-owner since it puts a ceiling on their salary outlay as well as pro-league since it creates a more level and competitive playing field. This is a win-win as it makes the league more interesting for fans and leads to higher revenues for the league. In addition to the salary cap, the NBA and the Players Association (NBPA) have negotiated various collective bargaining agreements (CBA) associated with player pay including the introduction of the max salary in 1999 and tying the salary cap to a percentage of basketball-related income (BRI) for the league. On the surface, these aspects of the CBA appear to be in the player’s best interests as it ensures they make their fair share of the profit center that is the NBA. But these two parts of the current CBA are why super-stars like Kevin Durant and LeBron James have left their former teams to form dynasty teams with other basketball super-stars.
Under the current CBA, players are entitled to 51% of all BRI (roughly 90% of the salary cap). This provision essentially sets the floor on how much an NBA owner has to collectively pay is team. In addition, the current CBA has a rule which establishes an individual ceiling on how much a player can be paid, tied to years in the league, ranging from $22 - $31 million for the upcoming season. Some may ask why the CBA would include an individual salary cap. The answer is the NBPA negotiates terms on behalf all NBA players and not just its super-stars. Rules that “spread the wealth” benefit a larger number of individuals in the NBA, which the NBPA supports.
The 2016-17 season will be the first under the new nine year, $24 billion media-rights deal with ESPN and Turner Sports. As such, the team salary cap is projected to go from $70 million up to $94 million next year because the cap and floor are both tied to a percentage of all BRI. As such, plenty of mid-level players are expected to sign massive contracts this off-season to soak up all the extra cap room. The embedded video from SB Nation unpacks this in more detail.
FiveThirtyEight, a statics heavy blog most famous for their political predictions, estimates that some of the top talent in the NBA would be paid north of $50-$60 million a year if there were no individual caps in place. Confirming this assertion is the following chart from EconomicData estimating that top tier talent would be paid close to $50 million with no individual caps.
And why shouldn’t they? Perhaps more than any other team sport, a single super-star player in basketball can have a huge impact on the performance of the team as a whole. As one example, the Cleveland Cavaliers winning percentage dropped from 74% to 23% the year LeBron left to play with the Heat. As previously mentioned, the Heat went to four consecutive NBA finals with LeBron before he decided to return to Cleveland and subsequently took the Cavs to two consecutive finals winning the last one against the aforementioned Golden State Warriors. It doesn’t take a statistics nerd to understand that LeBron going to six consecutive NBA finals on two different teams is proof positive of just how impactful a super-star can be on an NBA roster.
That being said, most people don’t care about a NBA super-star’s fair value in the market. You are much more likely (probably 1,000 to 1) to hear people complain about how much money NBA players make versus how they are underpaid relative to their true economic value. This sentiment has led to a system where the market clearing price for top talent is artificially suppressed while salaries for mid-level players are inflated. In other words, the CBA is effectively forcing super-star players like Durant, James, and Curry to subsidize the salaries of the mid-level players on their team. As such, parity has been lost in the NBA since teams can now afford to have several super-stars on their roster rather than having to make the tough decision between a top heavy team with a well-paid superstar versus a more balanced team with a deeper bench. Since teams can no longer compete on price, they have to lure super-stars through other means such as quality of life (location), friends (Wade & James), and chances of winning a championship. The current system fosters dynasty teams, crushes any chance of parity like we see in the NFL, and ultimately will be bad for the league as championship runs become a foregone conclusion.
Although the NBA is a relatively unique economic microcosm, there are still lessons to be learned from this whole situation. This is a perfect example of Unintended Consequences as the CBA was intended to benefit the vast majority of NBA players, but in the end, it might end up costing them and the league in general dearly. Along these same lines, we are reminded of the infamous economist Fredrich Hayek’s defense of classic liberalism during a time when central banks around the world were starting to embrace Keynesian economics at the beginning of the last century. The basis of Hayek’s Austrian Economics belief was that the economy is a complex system which can’t be managed from the top down because attempting to do so creates distortions and bubbles that eventually pop. Today, Hayek’s laissez faire views are all but gone as central banks around the world try to steer their economies through the natural boom/bust cycle with quantitative easing and negative interest rates (e.g. Keynesianism on steroids). It remains to be seen if the current global Keynesian experiment will solve all of our economic problems or if it will simply create more unintended consequences and potentially harm the system it is trying to protect…not unlike the travails the NBA currently faces.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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