The Free Agent Cycle

So much angst! Free agent salaries are so out of control that the blogosphere can barely contain itself. Baseball Think Factory has been full of aghast posters. USS Mariner has been popping blood vessels daily. Sabernomics wonders what the explanation could be.

Truly, it’s hard to like any of these outlandish deals:

• Alfonso Soriano leverages a career year to get an eight-year deal for $17 million a year from the Cubs, the fifth-largest contract ever.
• Gary Matthews Jr. does the same thing on a smaller scale.
• A below-average centerfielder gets $44 million for five years (weird Juan Pierre contract fact: After receiving $10 million in both 2009 and 2010, he’ll be paid only $8.5 million in 2011.).
• Mediocre reliever Danys Baez gets $19 million for three years from the Orioles (remember last year’s howls when the Cubs signed Bobby Howry to a three-year deal for $12 million?).
• Carlos Lee, a prime candidate for the early-decline club, signs a six-year deal for $100 million with the Astros.

In almost every blog I’ve read, many fans of these clubs love these deals while dispassionate baseball “analysts” hate them all. I’m not different, by the way. I particularly loathe the Pierre deal and I can’t even speak about the Baez contract.

But, as David Gassko reminded us earlier this week, this sort of thing has happened before. In fact, it occurs on a regular basis. Since 1969, the average major league salary has risen nearly 14% a year, and about 8% a year in the most recent eight to 10 years.

In fact, here’s a graph of the average major league salary from 1967 through 2005 (I don’t have last year’s figure yet, but I know it rose about 6%) with the gray bars signifying the percent change from year to year.

The black line slopes upward ominously, doesn’t it? But the real story is in the gray bars. Allow me to digress for a minute.

In the insurance industry, there is a phenomenon called the underwriting cycle, in which the underwriting profits of insurance companies go up and down on a fairly predictable basis. Underwriting profits, by the way, are a company’s premiums minus losses incurred on policies (gains on investments, which is how most insurance companies make money, aren’t included). I’ve seen many reasons proffered for the underwriting cycle, but I think one in particular hits the mark.

When insurance companies are making money in a market, other insurance companies try to get in on the action. Prices go down; salespeople are allowed to lower premiums in order to keep accounts. Underwriters are encouraged to take on more risk. Eventually, bottom lines erode, the market becomes less attractive, some companies leave the market, prices firm up and profitability returns. I would guess that virtually every insurance executive is aware of this, but it happens anyway. It’s free competition, it’s human nature. It’s unavoidable.

I think the same thing happens with baseball salaries. Take a look at the chart again. First off, there were the madcap years from 1976 to 1986, when free agency literally freed baseball players. There there were the Ueberroth collusion years, culminating in a year of flat salaries in 1987 (by the way, it’s an interesting comment on the natural inflation of baseball salaries that colluding owners couldn’t even decrease total salaries from one year to the next). Thanks to the courts and Andre Dawson, that little affair didn’t last long and salaries once again rose, though the next inflationary peak (43% in 1991) was slightly lower than the heady days of the 1970s.

Next came the strike years of the early ’90s, when large market teams battled it out with small-market teams and everyone battled with the players. The fallout in salary structure came in the nadir of 1995, when salaries actually declined 5%. Yet salary inflation rose again with the home run rates of Sammy Sosa and Mark McGwire, culminating in some insane contracts in 2000 (Alex Rodriguez, Derek Jeter, Mike Hampton, Manny Ramirez) that teams are still paying for. As you can see, the inflation peak of that up cycle was actually less than 20%, far below previous peaks.

Most recently, the owners found their fiscal footing and actually held salaries down in 2004 (the offseason of Miguel Tejada, Vladimir Guerrero, and three-year contracts to nearly everyone else). As J.C. Bradbury of the Sabernomics blog pointed out, owners were so “successful” that there has been a collusion settlement related to free agent salaries in 2002.

Now if you were to look at this graph and guess what would happen to salaries in 2006 and 2007, you’d say up, right? You’d be right, of course; that is exactly what we’re seeing. I think the baseball salary cycle, just like the underwriting cycle, is unavoidable. Salaries will go up and down, hitting extremes below 0% and above 20% depending on where teams are in the cycle. I can think of several reasons for the current upswing in the cycle:

• The business of baseball is awesome. Major League Baseball hit an all-time high attendance record and MLB Advanced Media is a cash cow Lots of cash to spend on players.
• The extraordinary crop of rookies and sophomores has freed up a lot of short-term baseball salary budget. As I’ve mentioned before, the 2006 minimum-salary players contributed over 1,000 more Win Shares Above Bench than the 2004 crop. In the short run, this is equivalent to an $800 million salary windfall. In fact, I don’t think the average major league salary in 2007 will rise nearly as much as you might think because kids making the minimum (or in their first year of arbitration) will help keep it down.
• The new Collective Bargaining Agreement (CBA) has a lower tax rate on shared revenue for large-market clubs. As I understand it, it’s not a big difference, but it’s something. Large-market clubs set the salary levels of free agents.

The one thing I do know is that salaries will continue to rise for a while, but they will eventually fall, too. The rookies and sophomores that are cheap today will be expensive tomorrow as they move through the arbitration process.

In fact, arbitration is how these outrageous salaries will come back to bite the owners. By agreement, arbitration results are tied to free agent salaries, so today’s higher free agent salaries will increase arbitration results in a few years. How do you think owners will act when they see their arbitration-eligible salaries rising rapidly?

The free agent cycle will continue…

References & Resources
One reader pointed out to me that I may be underestimating the impact of the new revenue tax schedule included in the Collective Bargaining Agreement. Some large-market teams will now get to keep 30% more of their revenue increase because their marginal tax rate will decrease from 53% to 31%. Other teams will see a decrease of about 13%. When a team signs a free agent, they do so in anticipation of more wins, more ticket sales and more revenue. So the revenue-sharing tax change should have a definite impact on free agent salaries.