Change They Don't (Want Us To) Believe In

I was surprised to see these two articles by reputed and brilliant professors in "my" University of Chicago Booth School of Business. One argues against capping CEO / executive pay in taxpayer bailed out companies, and the other against the government spending as part of the Obama fiscal stimulus plan.

The first by Steven Kaplan appearing in a Feb. 17 Op-Ed in The Chicago Tribune warns that "Restricting bank executives' pay would stall recovery." He acknowledges that high and flawed financial incentives were at the root of high risk-taking and illusory profits that brought down these banks, and that the massive taxpayer bailout justifies "some" government say in executive compensation. But he then asserts, "Even though $500,000 is a lot of money, banking executives have a different salary market. They would find the compensation low, and that is likely to create four problems:

• Banks would avoid accepting government assistance unless the situation is grave. Only the worst firms would accept government help.
• Many executives would leave the "bailed-out" banks for jobs that pay more, and the best employees would leave the troubled firms at exactly the wrong time.
• It would be difficult to hire new executives because the best ones would choose other opportunities.
• Stronger firms that have accepted federal money would give it back to avoid the restrictions.

All these factors would slow the recovery of the financial system."

I find these arguments to be deeply flawed. To his first and fourth points, most banks seeking and continuing to receive government help, even the so-called stronger ones, have little discretion in the matter. They know full well that their failure to do so will expose them to a ruinous bank run or its equivalent with depositors. Their leeway can be further curtailed by imposing regulatory capital requirements that forces them to seek timely government help. Further, the push towards better governance and heightened awareness of potential conflicts of interest will make vigilant bank boards compel their management to do the right thing.

Mr. Kaplan's second and third points are anchored on a "greed is best" premise that the most suitable executives for bank turnaround are lured by outsized financial awards alone. But it is this brand of managers and the existing compensation structure that substantially contributed to the crises in the first place. They stood to make enormous fortunes by fudging numbers, taking massive gambles with other people's money and limiting themselves to short-term "on my watch" perspectives. Instead, we need managers who want to establish their legacy of building or rescuing great institutions. A lack of outsized compensation structure is more likely to attract these types of managers, encourage sounder decisions and reduce their temptation to gamble. Just compare the CEO salaries and the fortunes of Japanese and US automakers. Or consider if hiking the annual pay to a billion dollars will really get us a much better US President.

So I largely disagree with Mr. Kaplan though there is ambiguity in the stimulus amendment limiting top executive pay as reported in a Feb. 14 CNN story. That can lead to some loopholes and confusion even if the measure is directionally correct.

The other article is a Jan. 21 Op-Ed in the Wall Street Journal by Alberto Alesina of Harvard and Luigi Zingales of Chicago Booth. They repeat the Republican refrain of stimulating the economy by cutting taxes, homing in on the complete elimination of capital gain taxes in 2009, and to the exclusion of government spending. Here's a quick counter to their main contentions:

a) Regardless of it starting as a financial / credit crisis, the US economy obviously now fits their description of a "bad equilibrium." That's where layoffs and job loss fears lower consumer demand that makes firms cut back that causes more layoffs that... They concede government spending can change this "bad" equilibrium into a "good" one, yet they still oppose it.

b) Their proposed solution of tax cuts (eliminating all capital gains for investments "begun" during 2009, etc.) is an extension of the Bush efforts for the past eight years. Where did that get us? Plus they want to make all capital expenditures and R&D investments tax deductible. Wouldn't that mean losing a lot of government revenue on the bulk of such expenditures that the companies would have incurred anyway, incentive or no incentive?

They see their role here "... to courageously propose the right economic policy, even when it is unpopular." I wouldn't call it particularly courageous for business academics to write in support of the finance industry and business interests that directly or indirectly sustain them. My friend RS wryly alluded to this equation as one hand washing the other.

To be fair RS thinks highly of Luigi Zingales and his writings in general, and considers this particular WSJ Op-Ed by him to be an anomaly.

Other writings by the Chicago business professors are more insightful and objective, including those relating to the current state of the economy. For example here's a good commentary in the Feb. 12 New York Times by Doug Diamond, Anil Kashyap and Raghuram Rajan on the Geithner Plan. They express reservations about elements of the plan, in particular the public-private partnership to buy up toxic assets, though they don't come up with an alternative. That's why I find Paul Krugman (alas, not of Chicago) to be better. In his Feb. 22 Op-Ed in the New York Times (among other writings) he makes a clear and cogent case for the temporary nationalization of banks. I'd like anyone opposing his proposals including the Chicago crowd to address his arguments head on.

Prophecy Gone Wrong

My brother Viranjit, aka Kaku who is a high-tech engineer, has a surprisingly deep interest in socio-economic issues, with thoroughness to match. Seeing my last post about the Cato ad he explored "my" University of Chicago website and found two papers of interest for different reasons.

The first (and the one I'll focus on) is an authoritative paper opposing more regulation of the financial derivatives market, which includes sub-prime mortgages and CMOs. It was written about 10 years back by 1990 Nobel laureate (in Economics) Prof. Merton Miller.

He says that: a) Regulating this market further will impose an undue burden and stifle it, and drive away business from the US to overseas competitors. b) There will of course be winners and losers, but no chance of a system wide failure because of the strong and well capitalized institutions participating in this market, the tough oversight by the SEC, and the rigorous credit rating of the participants by S&P, Moody's, etc. c) The customers are mostly sophisticated institutions that need to freely use this market for hedging or risk-based investment purposes. They ought to know how the securities work and the attendant risks, and if they don't they'll learn to do so in a decade or so as the market matures. d) The valuation of these financial derivatives is typically very complex and dependent on the model being used, so it is very hard to specify disclosure requirements.

As Kaku says, "it is almost comical to see Prof. Miller's arguments so completely refuted by the causes of today's financial crisis" and wonders if "he is man enough to eat his words (which are still used as evidence by so many on the right)."

I've been taught by and interacted with Prof. Miller up close, and he was as fine, brilliant and witty a person that you could meet, with a heart to match. His paper here should not detract from his seminal work in finance that earned him the Nobel prize (including the famous Modigliani and Miller theorem of dividend irrelevance that's a staple in finance classes.) He passed away in 2000 at age 77, and so cannot retract his words.

I also think he deserves some benefit of the doubt as his stance was based on market conditions in the mid 1990's. He didn't see the explosion of sub prime mortgages and CMOs in the early 2000's that made Paul Krugman rightly and urgently call for more regulation, and for Greenspan to wrongly and disastrously oppose this. Had Miller been alive and observed the new developments, he may just for all we know have changed tack and weighed in on Krugman's side.

Here are the condensed reasons for blaming lack of regulations for letting the financial crisis occur, contrary to Miller's assessment:

a) The principal - agent problem. The "agent" here is the mortgage originator who gets paid on selling mortgages, even over-valued ones to financially unsound borrowers. Or it's the fund manager who makes large and risky bets on CMOs. If the bet pays off the fund manager gets filthy rich, and if it doesn't, it's the investor loses heavily and the fund manager pays nothing. In either case the "agent" has incentives not to act in the Principal's (investor's) interest.

b) The information asymmetry problem. The buyer or investor does not know or understand the risks involved in the funds like the originator does. This is especially true when the securities involved are highly complex and what is in them is not revealed. So the buyer is at a disadvantage unless regulations force greater transparency.

c) The time horizon mismatch. This can cause agents like fund managers with near term outlook to take risks or pump up short term performance that is not sustainable. The consequences eventually catch up with the investors, but by then the agent (hopes that he) has left.

d) Cozy regulator and rating agency relationships with their target entities. The S&P and Moody's are hired and paid by the very firms whose credit they rate - an inherent conflict of interest. Miller lauds "the two way nature of the flow of top regulators and top executives" within the industry, but this can be a curse instead of a virtue, as such connections weakens oversight.

e) Systemic shocks. Everyone is happy and buoyed up by bubbles in stocks or the rising tide of real estate prices. But a reversal of this trend causes a downward spiral that (absent of safeguards) sinks a lot of boats.

f) Letting the ignorant and the stupid self-destruct. This is a harder sell, but we may need laws to protect the ignorant from their own bad decisions, just as we have laws to compel use of seat belts while driving, or those banning the use of heroin or crack.

Moreover, special interests and right-wingers have bastardized the term "free markets." It should mean freely traded goods and services in a competitive setting without the burden of distorting taxes, duties or undue restrictions. What it shouldn't mean is lack of checks on deception, the selling of spurious products, withholding information about what's being sold, or failure to mandate safety standards. Regulations compelling transparency in where money is being invested and in the detailed disclosure of returns, and better scrutiny enhances free markets, not detract from them. It may also prevent the havoc wreaked by future Bernie Madoffs, or ill-conceived CMOs.

The other U. of C. paper that Kaku looked up is titled "Are CEOs Rewarded for Luck? The Ones Without Principals Are." Note the spelling of "Principals" as they're referring to main investors, not ethics. This topic needs a separate discussion, and this academic paper is (as typical) fairly long and involved. You can see the conclusions at p. 23 - 24: essentially that a major chunk of the CEO salary depends on luck (the fortunes of that industry rather than individual performance) and the problem is worse for poorly governed firms. It undercuts some big arguments for large US-style CEO compensation.

The findings aren't surprising. For instance, compare the salaries in past years of the CEOs of the Big Three US automakers with their Japanese (Toyota, Honda, etc.) counterparts who make a fraction of that. Look at the fortunes of these respective companies now. Still, there are defenders of the US (and detractors of the Japanese) system: see for example this Feb. 23 BusinessWeek article titled "Japan: No Model For Executive Compensation." I am underwhelmed by the logic and the case sought to be made out here, though.

Surprising Detractors Of Economic Recovery Plan

Yesterday in the Wall Street Journal I saw a full page ad by the conservative Cato Institute slamming the whole concept of Obama's economic recovery plan. This (apparently repeat) ad is signed by hundreds of economists and financial academics.

Denying the need for the "right" government stimulus plan seems so preposterous that I expected the signatories to be clueless economists from lightweight institutions. Or charlatans and political hacks who are selling debunked ideology for their narrow ends.

But I see Nobel laureates and prominent figures from top universities like "my" University of Chicago in this list. They include two renowned professors who were on my Ph.D. dissertation committee, and one of these professor's son-in-law who is a top academic in his own right. Why they have signed on is beyond me, as I totally subscribe to Paul Krugman's rationale of the need for massive governmental intervention to get us out of this economic crisis. Krugman actually argues that the current economic stimulus plan is too small and misdirected towards Republican causes to do the job.

On the Cato website there is more of this criticism of Obama and the Democratic efforts. On the lower right of this web page there is a YouTube presentation with sleazily deceptive arguments against the Obama / Democratic approach. Reagan's virtues are extolled while Obama's approach is likened (of all people) to that of George W. Bush whose overspending drove the economy to ruin.

I can't address all of the Cato fallacies here. But some comments:
(a) Heavy spending (and ill-conceived at that) in GWB's time could not counteract bad governance and lack of oversight that landed us in this mess.
(b) Japan's "lost decade" of stagnant growth in the 1990's is widely ascribed to its failure to quickly overhaul its ailing banks and credit infrastructure. That was a necessary condition that didn't happen, for other measures (like public spending on infrastructure) to work. Keep this in mind the next time you hear a Republican mouthing off on Japan's lost decade in spite of spending 6 trillion yen on infrastructure.
(c) We therefore need better governance and more regulation to complement a heavy fiscal stimulus.
(d) I'd heed Krugman and drop this nostalgia for Reagan. Even the "supply side" linkage that Republicans like to make between tax cuts and revenue increases in the Reagan era is misconceived.
(e) Reagan's nearer term focus and budget deficits created cumulative problems that haunted his successor.
(f) In the debate on stimulus options tax cuts have the value of immediacy as they get more money across to the consumer quickly. But the recession-wary consumer may save rather than spend most of it (a personal virtue but it defeats the objective of a stimulus.) Government projects and continuing grants to cash-strapped state and local governments on the other hand will spend the allocations dollar for dollar.
(g) To my knowledge none of the Cato signatories warned against the consequences of insufficient regulation of mortgage lenders, or deplored Alan Greenspan's role in opposing such regulation. Nor did they see the housing crisis and the bursting of the bubble coming. Krugman did all three and years ago, way before it happened. So to me he deserves his 2008 Nobel prize (officially given for unrelated research done decades earlier) as well as greater credibility than the Cato crowd.

While our University of Chicago is synonymous with the ideas of free markets and deregulation we had plenty of faculty teaching and researching the concepts of necessary government oversight and intervention, public goods and anti-trust responsibilities. I'm perplexed to see so many respected economists including some of my U. of C. professors having signed on to the Cato ad. I hope they have better arguments than the YouTube presentation on the Cato website.
Meanwhile, today's (Feb. 10) issue of The Journal has the more nuanced views of two other U. of C. economists, Nobel laureate Gary Becker and Prof. Kevin Murphy. In "There's No Stimulus Free Lunch" they concede that government stimulus measures can create net jobs and expand GDP, especially during a recession. At the same time they warn that such benefits will dissipate once the economy recovers and works closer to full capacity, and that such measures carry a price.

No one is arguing against that, or we'd have a permanent stimulus budget for every past, present and future year. The stimulus package is being worked now to fix our present recession and job losses. And that part about it not being absolutely "free", the question is, do we want to starve by forsaking a substantial lunch just because it carries a small price, or to go for it since the benefits far exceed the costs?