Misplaced Outrage - The UK Scandal That Isn't

So what do you think about the UK's MP expenses scandal that has forced the resignation of Speaker Michael Martin and several Ministers and MPs? The media reports talk of public outrage about these excesses and one poll shows the effect on UK voters. 63% have not been swayed by all this coverage and it won't change their voting preference, but a whopping 27% say that it has.

I think this whole controversy is deplorable, and a commentary on the quality of our media coverage. In an August 2007 post I disagreed with criticism of what we pay our lawmakers. I am strongly of the view that we should pay our apex lawmakers well, considering the enormous responsibilities and the public trust we place upon them.

That's not only fair but also expedient, as it will insulate them somewhat from the petty blandishments (like sports event tickets, rides on private jets, or stays in vacation homes of people seeking favors.) This won't prevent misdeeds by the heavily corrupt, but at least give the fundamentally decent lawmakers (hopefully the majority) the financial cushion to better follow their conscience. I'd also like to reduce the dependence of candidates to Congress (or Parliament in the case of UK or India) on special interests for raising funds for elections. This can be achieved, for example, by providing them public funding to contest elections, with the amount depending on their poll performance.

So how much should we pay them? I'd say $1 - $2 million a year to US members of Congress, and about 1 million GBP annually to UK MPs. For UK's 646 MPs it will work out to about 1 billion GBP including associate expenses, a drop in the bucket as compared to the UK central budget of 600 billion GBP. In the current MP scandal the total amount claimed by all MPs put together was 92 million GBP, not all of it improper. Given UK's population of 61M, that's less than 2 pounds per capita.

So yes, I consider this whole scandal to be a storm in a tea cup. And I know of no opinion leader or journalist of standing who has had the sense - or the courage - to pronounce it as such.

When Free Choice is Terrible

Thank God for the Republicans for opposing this. And may be some centrist Democrats, including the recently inducted Sen. Arlen Specter. I thought no sane, objective person could support the proposed Employee Free Choice Act (aka "card-check".) Yet it is favored by Jagdish Bhagwati and even more so by Paul Krugman, both outstanding economists. Apart of course by Obama and most Democratic lawmakers as a matter of political necessity to appease unions that helped in their election.

Despite its noble sounding name this deliberately misnamed Act subverts workers' free choice about whether to unionize or not. Instead of voting by secret ballot, this Act also requires unions to be formed and recognized if half or more of the workers in an establishment sign pledge cards in support of this. So say, Tony Soprano style thugs knock on workers doors, stare across the dining table and hold the pledge card for workers to sign. Those who refuse can be intimidated, and everyone knows who is unwilling, leaving them open to retaliation down the line, or ostracism by fellow workers, or other unpleasant consequences.

So how do Krugman & Co. favor this over a free and fair vote by secret ballot? They essentially say that the means however imperfect justify the end, which is more unionization. This in turn will improve the lot of workers by extacting concessions from employers, and better redistribute wealth, thus narrowing the gap between the classes. If such ends justify the means, how about allowing the poor to extort money from the rich, or burglarize their homes to achieve redistribution?

Thankfully, it looks like card-check won't be able to clear the Senate with a filibuster-proof majority. Though many people take it as a given, I question the value of unions in many situations, or at least the premise that the pros outweigh the cons.

Unions to me are the most needed when through collective bargaining they are a counterweight to (mostly tacit) collusion by employers to keep wages and benefits below what would prevail in a free market. One example is of US hospital chains that were hit with a lawsuit over colluding to keep nurses' salaries artificially low, despite a national shortage of nurses. Another is of players' unions in professional sports (even though players may be super-rich.) They bargain with a handful of sports team owners that collectively decide on salary caps or player pay structure. But such employer collusion is relatively rare, and generally illegal.

Other pluses of unions include workplace safety, health and social benefits that they can win from employers through collective bargaining and the threat of strikes. I'm certainly for such health and safety measures, but for most of them they are better realized through passage of broader laws applying to all, instead of individually won through unions with the most leverage for their limited set of workers. Thus we have OSHA, or the Workmen's Compensation Act, and even the Minimum Wage Act and can go further along this route.

On the downside unions can severely distort free market efficiencies, hurt consumers who are forced to pay higher prices, and reduce the international competitiveness of US goods and services. Unions are at least as much to blame as the management for the woes of the Detroit Big Three automakers. Wal-Mart opposes unionization (hopefully with entirely legal means) at a high cost to its image and political capital because it understands the threat to its competitive position.

Then there are illegal strikes like the 1981 Air Traffic Controllers strike, the 2005 New York city transit strike and fake "sickouts" by pilots and other airline staff. Except for the controllers whom Reagan rightly fired, the workers get away with holding the public to ransom and breaking laws aimed at protecting essential services. These, and even the legal 2008 American Axle strike where a few UAW workers crashed GM production seem like acts of collective extortion rather than collective bargaining.

Still, in a free society and functioning democracy I realize the need to allow the creation and existence of unions, even if (like trial lawyers) they do more harm than good. Only they should be created where workers exercise genuine free choice through vote by secret ballot, not through the charade of a deceptively named law.

Laws Gone Wild - Banning Old Age

To me this is another of the flawed anti-discrimination laws leading to absurd consequences. I'm talking of the Age Discrimination in Employment Act (ADEA) of 1967 and its subsequent amendments.

We hear much more about countering discrimination against minorities and women, and resultant affirmative action. Despite vigorous denials from its liberal advocates this often becomes a drive to fill quotas. Barack Obama last month quoted some gender disparities in pay and top executive positions to imply unequal treatment of women. Now if there is any real bias or violation of the principle of "equal pay for equal work" I'm all for vigorous corrective action. But just the numbers being thrown around do not establish this, and there are more benign explanations.

The fact that many working women opt for a better balance between work and family, and take some years off to raise children can explain their making 78 cents for every dollar that men make. Similarly, there may be very few women who are prepared to put in 14 hour workdays to have a shot at the corner office. That, rather than a glass ceiling, may largely be why only 3% of Fortune 500 CEOs are women. To use these statistics to equate salaries or senior executive elevations among the genders may very well be reverse discrimination against men.

Other countries like India have quota-based intake of disadvantaged groups (like caste-based reservations) into government or public sector jobs, or into many educational institutions. So similar US practices do not surprise me as much as the "protections" against age discrimination. In India I never questioned the logic of having a mandatory retirement age. It used to be 58 years for most government jobs, and was subsequently raised to 60 years. For a few, mainly high positions, it extends to 62 or 65 years. After that, retirees who are willing and able to work can seek employment as contractors or consultants, or even be re-employed in the public sector as special cases. Private companies are free to have or not have mandatory retirement policies.

These practices make a lot of sense. Employees are recognized for their years of useful service while accepting the effects of age, and are given a cordial send-off after reaching a threshold. They leave with their memories and morale intact, making way for younger, more vigorous successors. Employers are free to retain exceptional workers past that point. But the rank and file know and accept the retirement age as a natural conclusion of this stage of their careers. If they want to work more they'll see no shame or a blow to their self-image to seek lighter or different, less paying work that may be more suited to their present stage of life. Even usually more liberal Europe recognizes the right to set an age for forced retirement.

This was pretty much the case in the US as well, till the ADEA of 1967 was amended in a series of steps from 1978 till 1993 to bar mandatory retirement in most sectors. Remarkably, the biggest blow was struck in the sweeping restrictions of the 1986 amendment when a Republican (Ronald Reagan) was President. Ideology notwithstanding it's hard to resist signing legislation favoring a key voting bloc like seniors ahead of the next Presidential election (that was won by Bush Sr.)

Adverse consequences of the US ban on mandatory retirement (many of which I've seen at first hand) include:

• Older employees drawing the highest salaries have reason to stick it out as long as they can. Employers have to push them out for bad performance after documenting negative evaluations. Not only do the departing seniors feel humiliated at this ignominous end to their long career, but this can also hurt employees morale all around.
• Managers in these situations have to give negative evaluations and terminate employees which subjects them to needless stress. Incidents of workplace violence and other fears of retaliatory action make the managers' job even harder.
• Reducing "natural" turnover adversely affects the career prospects of promising younger employees, which can create friction among employees and again affect morale.
• Older employees who manage to coast or "get by" are not replaced for many years by better, cheaper and more energetic younger employees. This makes for suboptimal company performance that aggregates to a drag on the economy, making it less competitive.

Bad, populist laws like these are politically hard to resist and block. Worse, once they are passed they're almost impossible to undo. Anyone attempting to do so despite the merits is likely to be painted as "anti-senior " and risks political suicide. So despite the pressures it is still much better to stop such laws before they are enacted.

I hope lawmakers (particularly Democrats) draw this lesson while considering the proposed Employee Free Choice Act ("Card Check Law.") This awful law being pushed by unions and liberals would allow unions to be formed without needing workers to vote their preferences by secret ballot. But that's another story.

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?

Mumbai Pre-Wedding Celebration Pics

Anita and I returned from Delhi to Pune on Jan 4, and Sheena joined us there a day later. Over the next three days all was fine and stable at my in-laws and we then headed to Mumbai to attend the wedding festivities spread over 3 - 4 days of our (Anita's) niece Ira.

Anita and I stayed in Mumbai with her cousin Ashok and were (as usual) very well looked after, while Sheena stayed in the suite in NSCI Club that was reserved for Ira, the bride. There were lots of fun events and we thoroughly enjoyed ourselves. It was also a great opportunity to hang out and reconnect with Anita's extended family and friends.

We (mainly Sheena) took many pictures. I'm adding the link here to the ones taken Jan 8 - 10 in the lead up to the actual wedding day of Jan 11 that will be posted separately. There are 200+ pictures of which a handful have been labeled.