Justin Fox on Corporations and Economists

Brad DeLong links to a very interesting article by Justin Fox in the Harvard Business Review:  What We've Learned from the Financial Crisis, which I heartily recommend.

I just want to comment on his discussion near the end, in the section entitled: "Economists Start Losing Control of the Corporation":

[O]ne narrow way of looking at the world can’t be the only valid path toward understanding its workings. There’s also a risk that emphasizing individual self-interest above all else may even discourage some of the behaviors and attitudes that make markets work in the first place—because markets need norms and limits to function smoothly. These concerns are relevant in many fields, but in recent years they have probably been placed in starkest relief in the study of corporate governance.

The current popular conception of the corporation is of an organization that exists to maximize returns to shareholders. This is very much the work of economists. Milton Friedman made the case rhetorically with his 1970 argument in the New York Times magazine that the social responsibility of business is to increase its profits. His former students Michael Jensen and William Meckling elaborated in a widely cited 1976 academic article that described the great challenge of corporate governance as getting the “agents” (managers) to act in the interest of the “principals” (shareholders).

Friedman, Jensen, and Meckling were out to counteract what they saw as a disturbing tendency among CEOs to view themselves as responsible not just to shareholders but to customers, communities, and other stakeholders—an attitude that has continued to hold sway in Japan and parts of Europe. Such diffuse accountability, the thinking went, could bring confusion, be an excuse for complacency, or enable self-dealing. As leading U.S. firms began to confront overseas competition in a big way in the 1970s, this wasn’t an idle concern.

But the doctrine that came to be known as shareholder value, although it seemed to offer straightforward marching orders for managers, often did nothing of the sort. If the stock price was in fact an accurate reflection at all times of a corporation’s current condition and future prospects—as was believed by most finance scholars and a lot of economists from the 1960s through the 1980s—the job of a manager was simply to do whatever made the price go up. The technology stock bubble of 1999 and 2000, however, disabused all but a handful of diehards of the notion that stock prices are fundamentally efficient. And as Jensen himself wrote in 2004, overpriced stock “sets in motion a set of organizational forces...that almost inevitably lead to destruction of part or all of the core value of the firm.”

Ever since, a battle has been waged over what this means for corporations. Some argue that if only the principals had more power over their agents, everything would work better. Others, while agreeing that in the end corporations should be judged according to investment returns, point out that high-turnover professional investors often push for short-term-oriented behavior that destroys value. Finally, a motley crew of sociologists, historians, management scholars, corporate reformers, and even a few dissident economists think it was simply wrong to apply the principal-agent model to corporations in the first place.

Now I'm an attorney, not an economist, so I approach this more from a legal perspective than from a economic one.  From that perspective, I have never really had a problem with the notion that a corporation exists to maximize shareholder value.  It seems to me that this is, as Fox says, a good guide for driving corporate decision-making.

The problem is how do you enforce the norms and limits that, as Fox notes in his first paragraph above, are necessary for markets to function smoothly.  Fundamentally, we are talking about the norms most ancient and easy to understand: thou shalt not lie, and thou shalt not steal.

The stock price bubble of 1999 and 2000 was not a failure of corporate governance.  Stocks and securities were being sold at prices that were based on widely unrealistic representations about the future prospects of the companies whose stock was being sold.  

The same thing happened in the run up to the financial crisis. Mortgages of poor credit quality were sold as AAA securities. 

Stated simply, the people who organized the corporations and other investment vehicles that issued the stock ans securities lied, and made a lot of money by doing so.

Making money on the basis of false representations is fraud.  It is larceny.  It is the kind of thing that people should go to jail for.  And despite Enron and WorldCom and Arthur Andersen, in fact very few people were held accountable for the massive frauds that were perpetrated during 1999 and 2000.

I think we go way too far in saying that there is something fundamentally wrong with the corporation as an entity.  

I am reminded of Alan Greenspan's famous testimony to Congress almost five years ago to the day:

"I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms....[T]hose of us who have looked to the self-interest of lending institutions to protect shareholders' equity (myself especially) are in a state of shocked disbelief...."

When I read Fox's piece, I get the impression that what he wants is some entity that can function according to the rules without the need for outside oversight - without the need for external mechanisms to keep the various constituencies in line. 

I don't know how anyone can be shocked as Greenspan was. If a person can profit by breaking the rules knowing that the rules won't be enforced, he or she will break the rules. Nobody should be shocked by this. 

We have norms.  We have rules, We have laws.  They aren't being enforced. 

And that's why the system failed - and continues to do so.

Is This What They Mean By "the Good Old Days"?

So I was perusing some old tax rulings for a paper I'm working on about partnership taxation.

When you have a progressive income tax, you can reduce your tax by "splitting" your income.  This is because the more money you make, the higher the rate of tax.  For example, under current law, a single person with taxable income of $50,000 pays income tax of $11,127 (assuming no credits), while a single person with taxable income of $100,000 pays tax of $26,522.  Thus, one person making $100,000 pays about $4,200 more in tax than two people making $50,000.

So if you could split your income - say between husband and wife or between parents and children - you could reduce your tax.

In the old days, there were no joint returns or special rates for married couples (I haven't bothered to find out when that changed, but I think it was in the 1950s). So a common way businessmen would try to split income was to have the business owned by a partnership - the other partner being the businessman's wife.

But I learned the IRS found a way to combat this.  You see, in those days (the 1910s and 1920s), the common law still ruled in many states, and a wife was not legal able to enter into contracts - only the husband could. So, the IRS said, since a partnership is a contract between people and a wife couldn't legal enter into the contract, there could be no such thing as a partnership between husband and wife!  And yes, when litigated, the IRS won.

Is this what they mean by the good old days?

  

Massively Wrong

It is amazing how a person can be so massively wrong and cause so much harm and yet still be respected by our elite media.

Case in Point:  Alan Greenspan

Here is Dday's take on how he is being feted over his new book:

It’s impossible to change the channel this week without coming upon the grinning face of Alan Greenspan. The former Federal Reserve chairman’s new book, The Map and the Territory, releases this week, and he’s spending it on a grand tour through media green rooms across the country, from CBS to NPR to the BBC. Even Jon Stewart treated him with kid gloves. By Friday he’ll have a Food Network show.

So far, he’s gone virtually unchallenged. He has said the 2008 financial crisis “was the first time ever that markets were broken and could not fix themselves” (ever hear of the Depression?), and that he “ could have caught a number of different crises” during his tenure at the Fed (which begs the question of why he didn’t). Journalists have asked such penetrating questions as, "You were knighted. Does that come with a title or anything?" Even the tough-minded Binyamin Applebaum called Greenspan "one of the nation’s most astute economic observers." Overall, the media has presented Greenspan's book as part of a soul-searching quest for why he missed the greatest economic collapse in decades—a frame that is needlessly obsequious and suggests he was a bystander to the disaster, not a central actor.

And here's Matthew Iglesias:

I'm a little surprised to find myself saying this, but I think David Dayen's managed to be too soft on Alan Greenspan in his take on Greenspan's new book, The Map and the Territory. It's true that Greenspan's 2004-vintage pimping for adjustable-rate mortgages was bizarre and shameful, but I actually think we've seen plenty of evidence over the past five years that good old-fashioned imprudence and thin regulation can produce endless financial mischief even without unorthodox financial products. It's on the "thin regulation" front where Greenspan's new media push is driving me nuts. He's out essentially preaching the Gospel According to John Cochrane in which the actually existing Dodd-Frank financial regulation overhaul is a pointless increase in the regulatory burden, and really the entire crisis could and should have been avoided by imposing stiffer capital requirements (i.e., less borrowing) on the financial sector.

This rather conveniently ignores the period in history—a period that began in 1987 and didn't end until 2006—when Alan Greenspan was the most important bank regulator in America.

Who was letting banks lever up so much? Greenspan! Who was happy to see the growth of a "shadow banking" sector outside the ambit of traditional regulation? Greenspan! It's as if Richard Nixon wrote a book about how tougher security at the Watergate Hotel could have avoided a lot of problems for America.

Again, I am reminded of this great cartoon by Tom Tomorrow:

That cartoon was six years ago.  Funny thing is, our elites are still trying to cut social security benefits.

This guy is a monster, but he is still treated by our elites as one of the wisest of our wise men.

About that JP Morgan Settlement

Felix Salmon explains that the "record $13 billion settlement" really doesn't hurt JP Morgan at all:

If you have any doubt about this, just look at the accounting. WaMu had shareholders’ equity of some $40 billion, before it was bought, which JP Morgan paid $1.9 billion for. JPM valued that equity at $3.9 billion, so it booked a $2 billion gain the minute that the acquisition closed; it then said that WaMu would contribute about $2.5 billion per year in extra profits going forwards.

The point here is that JPM fully expected that legacy WaMu assets would generate some $36.1 billion in losses. Now that those losses are starting to appear, all that we’re seeing is the arrival of something which was expected and priced in all along.

Read that again.  JP Morgan paid $1.9 billion for WaMu, immediately booked $2 billion in profit, and said that the investment would generate an additional $2.5 billion in profit per year from its investment.

The better way to look at this is as follows:  JP Morgan bought an asset worth $40 billion, paying $1.9 billion up front and assuming a liability to pay $38.1 billion in the future.  The same as you buying a house for $400,000, putting $19,000 down and taking out a mortgage for $381,000.  All JP Morgan is doing here is paying down a piece of the debt.


The only difference here is that a lot of the WaMu debts were contingent - in litigation.  They could very well be settled for a lot less than $38.1 billion.  And if they do settle for less than that amount, the difference is profit for them.  A Reuters article points out that JP Morgan "stockpiled $23 billion in reserves for settlements and other legal expenses to help cover the myriad investigations into its conduct before and after the financial crisis."  What this means is that if they end up paying less than that amount, the difference is profit to the company.

In fact, the $13 billion covers more than just WaMu - it also covers contingent liabilities they assumed when they purchased Bear Stearns.  JP Morgan paid $1.5 billion for that company, which at the time had shareholders' equity of $12.6 billion.  Again, a settlement of those liabilities will more likely than not mean profit, not loss for JP Morgan.

And a small piece of the settlement - $2 billion - relates to JP Morgan's own wrong doing.  A slap on the wrist.

Trust me, JP Morgan is not suffering at all as a result of this settlement.  To use an old saying, they're laughing all the way to the bank.

Booman has the Better Argument Here, But....

Paul Rosenberg writes:

The false balance fallacy lay at the heart of the media’s deep reluctance to blame conservative Republicans for the recent government shutdown. As I recently wrote for Al Jazeera English, the media had to ignore nine bodies of evidence that clearly showed it was Republicans, not Democrats, who caused the shutdown. Thus, instead of reporting as much context and as many perspectives as possible, the media’s embrace of false balance severely constricts the range of facts and viewpoints it explores—the exact opposite of what it’s supposedly trying to achieve.

President Obama is a walking embodiment of this fallacy. He is so eager to embrace Republican ideas—Bush’s TARP, tax cuts in his stimulus bill, the Heritage Foundation’s individual mandate, “cap and trade,” austerity, making permanent the vast majority of Bush’s tax cuts,etc.—that he embraces objectively bad ideas, divides his own base, and doesn’t even get any political benefit from it.  For one thing, he doesn’t give Republicans an opportunity to fight for their own ideas—to demonstrate to their own base that they stand for something that is in dispute.  Rather than make them more willing to compromise with him, this increases the pressure on them to fight. We’ve seen this over and over again throughout the Obama presidency, but Obama never seems to learn. His very zeal in seeking compromise only makes it that much harder for Republicans who need to fight him. So it’s really not all that surprising when they turn around and accuse him of being “unwilling to negotiate,” however misleading that may be.

To which Booman replies:

Rosenberg comes closer to hitting on something important when he notes that Obama has forced the Republicans to abandon some of their substantive policy ideas simply by being willing to adopt them himself. This is certainly the case with cap and trade and the individual mandate. But, it should be remembered that cap and trade and the individual mandate were never really sincere Republicans positions. They were positions they adopted to give themselves an excuse for not supporting Democratic proposals for tackling climate change and the millions of people who lack health insurance. By adopting those policies for the Democratic Party, Obama called their bluff. If they had been sincere about offering those ideas, the Republicans would have agreed to turn them into law rather than relabeling them tyrannical socialism.

What Rosenberg sees as some kind of pathological desire to find compromise, I see as a diabolical plan to destroy the Republican Party simply by being reasonable and offering them what they say they want. "You think everyone should be personally responsible enough to get their own health insurance? Okay, let's do that."

I think Booman has the better argument here.  But note that Heritage's individual mandate was implemented at the state level by a Republican governor, and worked quite well and is very popular in that state.  So I'm not so keen to argue they didn't really believe in it.

Of course, this only makes it more difficult to explain why the Republicans so radically changed their tune on the individual mandate.  At least, it makes it more difficult to come up with an explanation other than the real one - you know, the one that our elite media, so far, has been unwilling to  mention.

Which is, of course, that our President is a dark-skinned man with a funny name....

Specialization in High School

This morning Jonathan Berstein linked to this article in San Francisco Chronicle about the increasing demands for high school students to specialize, especially when it comes to sports. This is a topic on which I have a lot of interest in several respects: as a former member of a local school board, as a father of teenage sons, and from my own experience when I was in high school. And I must say that it is something that, as I've watched my sons grow up, has always bothered me.

I actually attended two high schools - my first two years in Massachusetts and my last two in Southern California. My sophomore year in Massachusetts, I was in the band and orchestra, sang in the church choir (also was an instrumental accompanist from time to time), played sports all year round (varsity football and golf, JV basketball and Babe Ruth league baseball in the summertime), was in the community service group Key Club, and held down a part-time job, all the while maintaining my grades. When we moved to California, there was a noticeable difference in the attitude of the community toward sports - it was already much more specialized than anything I had seen in Massachusetts, and the time demands were much greater (I will also say that the school I attended in California had a student body that was twice as large as that in Massachusetts). We arrived there the first week of August and I did attend football workouts for a couple of weeks - but there was also a well-organized junior golf tournament circuit there that I wanted to compete in, and there was just no way I was going to be able to do both. Since it was clear to me that I was way behind my classmates on the football front but could compete in golf, I dropped football after a couple of weeks. And as for basketball, well, there was a higher proportion of kids that were much taller than me than we had in Massachusetts (can I say that Irish and Italians are not known for their height?), and it was pretty clear that that was out of the cards as well.  Who knows - maybe if I was willing to give everything else up and focus on just one activity I would have been able to succeed in one of the big-time sports. But I just wasn't willing to do that.

Instead, I picked up a new activity - drama - and during my remaining years got more and more active there. I did have problems at first - golf, of course, is also time consuming and there were a lot of conflicts between the two during spring of my junior year - but I managed. And I did some community things as well.

And besides, none of these things was ever going to be a career of mine. My freshman year (1973-74) was the year of Watergate. I knew enough about what was going on that this was a huge event. And I knew that all the major players were lawyers. By the summer of 1974 I wanted to be a lawyer, too, and that's what I became.

My impression is that, in this day and age, it takes an extraordinary kid to be involved in such a broad swath of activities as I was.  And that's especially true when it comes to athletics.  If, for example, you have a particular talent for one sport,  there is an enormous amount of pressure to participate in that activity and that activity only, to the exclusion of all others.  And that pressure gets exerted at an earlier and earlier age.  And this, I think, is a terrible trend.

We are now in the midst of the baseball playoffs, and there have been a number of games this year that have been absolutely mesmerizing.  But I can just as easily be mesmerized almost childlike by a touching movie, a Bach concerto or a fast-paced mystery novel. Just last week as I was reading an article online I found myself transfixed by a chess game of Bobby Fischer from the 1960s, wondering "how the hell did he do that?"

I think that this capacity to be awed by so many different things is a product of the fact that I was able to participate in so many different things as I was growing up.  And I wonder if our kids today will be able to appreciate all the various wonderful things that life has to offer, when their ability to experience them as a child is increasingly limited.

Martin Wolf on Have the Conservative Won?

This morning Yves Smith linked to this interview between Bill Moyers and Martin Wolf, who is Wolf is the lead economics commentator for the Financial Times.  I heartily recommend watching the whole thing, but I though this bit at the end was very interesting (note: I created this transcript myself):

Bill Moyers: Would you agree that, despite what happened this week, in the political victory that President Obama seems to have won, would you agree that the conservatives have really won the argument about government?

Martin Wolf:  I think that is true.  What has surprised me it how little pushback there has been from the Democrat side in arguing that the government really did have a very strong role in supporting the economy during the post-crisis recession, almost depression, that the stimulus argument was completely lost, though the economics of it were quite clearly right - they needed a bigger stimulus not a smaller one, it helped but it didn't help enough because it wasn't big enough.  And they're not making the argument that government has essential functions which everybody needs in the short run - we can see that with the National Parks - but also in the long run.

The strength of America has been built, from my perspective particularly in the post-war period since the Second World War, on the way that actually the public and private sectors have worked together, with the government providing enormous support for research and development. It's been the basic support of Americas unique position in scientific research - you look at the National Institutes of Health, which are the most important medical research institutions in the world. These are all products of the willingness of the United States to invest in the long-term interest. Then there's the infrastructure, think of the highway program, which was the most important infrastructure project - under Republicans interestingly.

And those arguments seem to have been lost. So I am concerned that the government, that I think Grover Norquist once said he that wants to drown in the bath - if you drown the government in the bath in the modern world, we don't live in the early19th century, it's a different world - that the long-term health of the United States will be very badly affected. It's strange to me that a government that has obviously achieved very important things - think of the role of the Defense Department in the internet,  this is just one of many examples - it should be now regarded as nothing more than a complete nuisance, and the only thing you need to do is to cut it back to nothing.

And it does seem to me that the Democrats have, for reasons I don't fully understand, basically given up on making this argument. And so in a way the extreme conservative position has won, because nobody is actually combatting it. It's only a question of how much you cut and how you cut it, rather than, well what do we want government for?  What are the good things about it? What are the bad things about it?  How do we make it effective?  And how do we insure that it's properly financed?

There's a lot of meat in here, but essentially I agree with what Wolf is saying.  

The Social Security Disability "Problem"

Sixty Minutes - a program I stopped watching years - apparently had a story last night about the "rampant fraud" in the social security disability program.

Many have already jumped on CBS for its one-sided treatment of this topic.  This post on Media Matters has a good rundown of the responses. The basis of these claims is that all reputable studies show that fraud and abuse amount to about 1% of all disability payments made by the Social Security Administration.

In the fiscal year ending September 2012 - the most recent year for which figures are available - the system.paid out some $137 billion in social security disability benefits. A 1% error rate amounts to approximately $1.4 billion.

Admittedly, this is a big number.  But it looks big because the program is big.  I've said before, most private businesses would kill for an error rate of 1%.  This is a sign of unusually good efficiency and effectiveness.

And of course, this pales in comparison to other areas where fraud is rampant.

For example, a report issued in 2011 showed that the Department of Defense lost some $285 billion in contractor fraud over the three year period 2007-2009.  Just so you know, total defense spending over this period was about $2 trillion, meaning the error rate was about 14%.

And of course, who knows how much "abuse" there is in our domestic surveillance programs.  Given the small number of times it has actually worked to prevent terrorist attacks from happening, one could argue that the mere existence of the program is an "abuse."

But of course, nothing costs the government as much as tax fraud and evasion.

The IRS from time to time comes out with its report on the "tax gap," which is the difference between taxes people owe and the amount actually paid.  The most recent report was issued last year for FY 2006.  For that year the IRS estimated that the tax gap was $450 billion, out of a total estimated tax liability of about $2.7 trillion.  This is an "error rate" of 16.9%.  From the IRS webpage:

The tax gap can be divided into three components: non-filing, underreporting and underpayment.

As was the case in 2001, the underreporting of income remained the biggest contributing factor to the tax gap in 2006. Under-reporting across taxpayer categories accounted for an estimated $376 billion of the gross tax gap in 2006, up from $285 billion in 2001. Tax non-filing accounted for $28 billion in 2006, up from $27 billion in 2001. Underpayment of tax increased to $46 billion, up from $33 billion in the previous study.

Overall, compliance is highest where there is third-party information reporting and/or withholding. For example, most wages and salaries are reported by employers to the IRS on Forms W-2 and are subject to withholding. As a result, a net of only 1 percent of wage and salary income was misreported. But amounts subject to little or no information reporting had a 56 percent net misreporting rate in 2006.

Gee, I wonder what kinds of income are subject to "little or no information reporting."  Seems they have no problem collecting taxes from working people.

Of course, one of the big reasons for the tax gap is that Congress refuses to provide the IRS with the resources needed to close the gap. And the Republicans have proposed a 24% cut in the  IRS budget for the coming fiscal year.  I'm sure that's going to help.

Our media, like our Congress, seems intent on focusing how the little people are gaming the system.  But this is peanuts compared to the way the big boys are screwing us.