Is "Trickle Down" Dead Yet?

The credibility of trickle down always gets my goat.  Trickle down is the theory that cutting taxes on the rich will benefit everyone because the rich will create jobs.  Economic theory a la Milton Friedman is often cited as supporting the theory because taxes are always inefficient.

Finally, some economists at the IMF have published a report that clearly describes why trickle down economics does not work.

Higher inequality lowers growth by depriving the ability of lower-income households to stay healthy and accumulate physical and human capital (Galor and Moav 2004; Aghion, Caroli, and Garcia-Penalosa 1999). 

Also...

Inequality dampens investment, and hence growth, by fueling economic, financial, and
political instability.

Jared Keller at the Pacific Standard further notes that the term "trickle down" itself was coined to lampoon President Hoover's policies during the Great Depression.

Governance and Economics and Complex Systems

I recently read a paper by Elinor Ostrom, who won the Nobel Prize for Economics in 2009.  Beyond Markets and States: Polycentric Governance of Complex Economic Systems (2010) presents an overview of the study of polycentric governance and the roadmap for future studies that are probably currently underway.  It can be thought of as a very substantive refinement of economics, where the units of study are groups of individuals who seek to manage public goods.  Sometimes they cooperate effectively, to provide services such as access to water to a city, while other times competition can lead to chaos.  Many situations and conditions can lead to more cooperation where the determining factor is whether the situation builds up trust or breaks it down.  I was personally excited that Ostrom referenced Kenneth Arrow as one of the first economists to discuss the importance of trust.

I was very glad to have read this paper.  I really think all economists, especially those who then go into policy-making really should be familiar with the work on polycentric governance.

A similar, perhaps parallel, topic is complexity in interconnected systems.  In an interconnected system, such as the economy, identifying the key decision-makers and their networks can be enlightening.  The rules governing the system may also lead to some decision-makers to have out-sized influence, leading to outcomes that no one necessarily plans out meticulously but are nevertheless inevitable.  I am still not clear on what discipline(s) this work is emerging in, but I'm definitely excited to learn more.

Public Corporations and Investors: Theory vs. Reality

It's conventional knowledge, in the business world at least, that a corporation's primary purpose is to maximize shareholder value.  A corporation can only hope to maximize benefits to everyone through maximizing shareholder value. This idea is often presented as a law of the universe as immutable as the laws of physics.  In The Shareholder Value Myth by Lynn Stout makes a persuasive case that maximizing shareholder value is not always the best for the corporation, the market, or society.  Stout is a law professor at Cornell specializing in corporate governance law.  She argues that corporations are not legally required to maximize shareholder value at the exclusion of other goals.  Furthermore, the focus on stock price leads corporations to destroy fundamental value in favor of short-term gains, which is against the long-term interests of many shareholders as well.  Instead, corporations should invest in their employees and their communities to maximize long-term benefits.

I recommend anyone who is interested in corporate governance, business management, economics, finance, or social entrepreneurship to read this.  It is a fairly short and quick read, but since many people still won't read it, I will summarize the main points here.




        Shareholder primacy is the principle that the corporation's sole purpose is to increase shareholder value because this maximizes the welfare of the corporation as well as society at the same time.  This means that a corporation's performance is based completely on one number, and that is the stock price.  Yes, it is very conceptually elegant, not to mention convenient, if this were true.  This idea became popular in the 1980's coinciding with the rise of neoclassical economic theory.  (Although there is nothing wrong with neoclassical theory itself, it is often misapplied.  More on this later).  Since then, conviction in shareholder primacy became so strong that everyone believes that corporations have a fiduciary duty to maximize shareholder primacy and that this duty is enforced legally.

It's Not Legally Required
        Lynn Stout's first point is that shareholder primacy is actually not a legal requirement.  The case that is typically cited to demonstrate legal fiduciary duty to shareholders is Dodge v. Ford 1916 where Dodge was a minority shareholder in Ford Motor Company.  The court ruled that Henry Ford could not reduce the dividends to shareholders such as the Dodge brothers to build more plants and pay his employees more while profit was increasing.  Stout argues that the ruling is outdated as well as irrelevant because

1. Ford was not a public corporation.  It was a closely held corporation where the majority shareholder (Henry Ford) had a duty to look out for the interests of minority shareholders (Dodge).  
2. The comment that supports shareholder primacy, "a business corporation is organized and carried on primarily for the profit of the stockholders" was a "dicta."  In other words, it was not part of the legal rationale for the decision and therefore does not set legal precedent.
3. It is an old ruling. 
4. It was a ruling from the Michigan Supreme Court, which is not considered an authoritative source for corporate law compared to Delaware, where many more companies are incorporated.

        Instead, directors of public corporations have protection under the "business judgment rule," where corporations can do anything as long as it is lawful and directors do not have personal conflicts of interest.

The Theory is Flawed
        Stout's second and perhaps more interesting point is that economic theory is being misapplied to corporate governance.  The theory behind shareholder primacy is that shareholders are the owners and thus residual claimants of a corporation's profits.  They are the principals while directors are the agents and therefore if the agents maximize the welfare of the principals, welfare should be maximized overall.  This idea was popularized by Milton Friedman, a prominent neoclassical economist.  However, Stout argues that the principal-agent relationship isn't really descriptive of the relationship between the shareholder and corporation because

1. Shareholders do not legally or practically own corporations.  In fact corporations own themselves.  Shareholders own a share, which is a contract with some limited rights.
2. Shareholders are not the residual claimants.  The idea that they are comes from bankruptcy law, where the shareholders get whatever is left over after other contractual obligations are fulfilled as a company is being liquidated.  However, a company being liquidated is completely different from a living company, which has to plan for the future.
3. Shareholders are not principals.  Corporations are created before there are shareholders, but principals should exist before agents.  
4. The share price alone (probably) cannot be used to measure the worth of a company.  First of all, it doesn't really make sense to use something that fluctuates constantly.  Second of all, because of frictions that come with doing business in real life, a corporation can cause many externalities (public harm) while privatizing the benefits.  These externalities ultimately lower the quality of life of the public, including shareholders.  Stout claims that externalities can and do harm the private sector as well, stunting the growth of the market overall.

Justifying Myopic Behavior in the Finance Industry
        Another very rich topic that Stout digs into is how the realities of the finance industry interact with shareholder primacy to encourage myopic behavior in corporations and investors.  Short-term investing has been increasing.  By 2010, public stock is held for four months on average compared to eight years in 1960.  Therefore, even though investors should theoretically be primarily interested in long-term corporate performance, clearly many are profiting from short term gains.  An investor who only plans on holding a stock for a short time can and do lobby for actions that increase the stock price in the short term, after which the investor sells, thus relinquishing her interest in the long-term success of the corporation.  In fact, it would be good for these investors if the stock price subsequently went down so that she can invest again and start the cycle over.  Myopic behaviors include cutting back on R&D or marketing or laying off employees to boost quarterly earnings reports.  They also include splitting up the company, selling off assets, and getting acquired.
       These things happen because shareholders (and thus investors) are heterogeneous in their expertise as well as incentives.  Also, information is expensive and time consuming, especially more qualitative information as opposed to prices.  Long-term investors profit from the overall performance of the market.  They will hold diversified assets in order to reduce risk.  As a result, they "suffer" from rational apathy.  There is too much information and their stake in each company is so small that it is not worth it to investigate whether a company's earnings went up because of myopic behavior or because of a particularly successful new product or operational improvements.  In contrast, shareholders who are more involved in corporate governance are usually short-term investors who profit from buying and selling.  They will hold relatively large stakes in a small number of companies, and it is in their interest to create "news" that will change expectations one way or another.  Yes, the market eventually "corrects itself," but the profits and losses from the error and subsequent correction are real.  Misallocation of financial capital, hurting employee morale, losing talent, slower innovation, lower quality products, reduced customer loyalty are sometimes also tangible and lasting effects.  Another dynamic that exacerbates the prevalence of these behaviors is that long-term investors such as institutional investors, who invest on behalf of pensioners for example, hire active managers to manage large portions of their assets.  These active managers are judged by their quarterly performance.  As a result, they are often short-term investors because those strategies are more reliable as well as profitable.


Recommendations
        Ok, that sounds like a hairy mess.  Stout's recommendations aren't as crisp as her analysis of the situation.  Even so, there are four potential solutions that stood out to me.

1. Stop promoting shareholder democracy and giving shareholders more power.  This is one of Stout's main recommendations.  Shareholders do not act like responsible principals and cannot be counted on for effective corporate governance.  For example, even after the Great Recession and subsequent bailout, shareholders opted not to diffuse the power of the CEO and chairman of JPMorgan Jamie Dimon, much less fire him. 
2. Her second recommendation is to encourage companies to maximize stakeholder value.  She introduces the concept of team production, which expands on maximizing stakeholder value as a more descriptive theory of how corporations create value.  Basically, value is created as corporations build trust and commitment among employees, creditors, managers, consumers, and the community.
3. Institutional investors should change how they evaluate active managers.  Stout did not focus on this probably because she does not think that institutional investors have enough incentive to reform this.
4. Make information cheaper for long-term investors.  Stout also does not focus on this possibly because it is unclear if it is technically feasible.  However, I am personally very interested in this kind of solution.

Talkin About the Issues

Thomas Piketty is talking about the issue of inequality in a book, Capital in the 21st Century.  Apparently it is popular, and there have been many articles written about it.

I wonder why this one has gotten so popular, and I wonder if it will help to change the dominant point of view that inequality is ok because the rising tide of capitalism raises all boats.  Definitely adding this one to my (imaginary) summer reading list.

http://www.slate.com/articles/technology/technology/2014/04/thomas_piketty_capital_in_the_twenty_first_century_surprisingly_entertaining.html

Kenneth Arrow Sez, Use Declining Discount Rates

Kenneth Arrow is the man.  More on this later

http://www.sciencemag.org/content/341/6144/349

http://www.rff.org/RFF/Documents/RFF-DP-12-53.pdf

Nuances About Economics

Ronald Coase was a famous economist who died recently.  He came up with the Coase Theorem, which is the concept that initial allocation of an externality or good doesn't matter if there are no transaction costs (a big 'if').  In fact Coase himself acknowledges that in real economic situations, transaction costs are almost never low enough for the initial allocation not to matter.  Nuances in economics are typically lost in politics.  He's frequently cited by the right wing as being against governmental regulation and pro market solutions for environmental problems.  

Severin Borenstein, a professor in the Haas Business School at UC Berkeley sets the record straight.  

http://energyathaas.wordpress.com/2013/09/09/learning-and-forgetting-the-wisdom-of-coase/

International Financial Crisis Seminar

I'm taking a seminar this semester on the International Financial Crisis with University of Michigan Professor Emeritus Robert Stern. We are reading Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan. Some of his arguments are very persuasive. I like how he presents the problems in the global economy in terms of systemic tensions. Although he doesn't exactly say it this way, my conclusions after reading some of his book is that no country in the world really knows how to shift to an economy where low-skilled labor is no longer really needed. In other words, in a world where you only need a few highly skilled people to produce the majority of goods, how do you still distribute the goods? Maybe finally, this is where communism comes in.

At the same time, perhaps the case is overstated. Clearly we still have plenty of things to do for low-skilled labor on farms and perhaps cleaning the environment. But there is much more money for skilled labor perhaps because there is not enough supply of skilled labor. At the same time, I'm not sure if this is correct because there is plenty of unemployed skilled labor as well as unskilled labor in Europe.

In Fault Lines, Rajan talks about how many financial crisis such as the Great Depression and Great Recession were related to expansions of credit for housing. Because housing itself is a necessity and that the education system in the US is funded by local taxes, housing is particularly important in the US for social mobility and neighborhood stability. It made me think about how many people make money from investments, but because of the transaction costs, it only makes sense if you have a certain amount of income. Perhaps there is a way to lower the entry costs so that there is more of a cushion for lower income households.

Where do we go from here? Unclear. I suppose we continue to muddle through.

Unleashing Big Money for a Green Economy

I just read the finance section of the Green Economy Report by the UNEP (UN Environment Programme), the Green Economy : Finance I am most interested in the section about new markets and instruments such as the carbon market, green bonds, and green property. The insurance industry is also an ideal vehicle for driving more environmentally sustainable decision-making.

To me, it is critical that assets controlled by the high net worth community, asset pools of insurance companies and pension systems, and the financial services and investment sectors get directed towards driving the transition to a green economy. I would like to do work or research on redirecting assets towards green industry and infrastructure, but I'm not sure where to start. I still need to figure out who works on this already.

Favorite Economist

I think I have a favorite mainstream economist now: Kenneth Arrow

Last weekend I went to Raven Used Books on Newbury Street. I got a book by Kenneth Arrow, the Limits of Organization. I just finished the first chapter, Rationality: Individual and Social, where he argues that "collective action can extend the domain of individual rationality."

Collective action is a means of power, a means by which individuals can more fully realize their individual values

I like how he frames the discussion about organization, trust, and social good.

I think everyone should read this in high school or maybe college. It would help people think about what markets, organizations, and governments are for. It is about ethics and how to form the value judgments about what we want as individuals and how we can cooperate.

Green Economy Labor Economics

Yesterday I applied for a research job at the UCB Institute for Research on Labor and Employment to do research on the minimum wage.

On their main page, they were spotlighting research by the Vial Center on Employment in the Green Economy. They just put out a new report that "California’s energy efficiency policies have a big job impact, but state needs to support more highly skilled and highly paid construction trades work force."

Debt and Politics

Economist article shaming Republicans.

Senate Democrats present an alternative.

UCB Professor Lee Friedman

Professor Lee Friedman is another economist who works on environmental policy. He works on a broader range of topics, though, than Professor Hanemann, and his research tends to be more applied. He specializes in applied microeconomics and environmental markets. I am most interested in his work on pricing in the energy market and carbon market to reduce greenhouse gas emissions. He teaches a core GSPP class, the Economics of Public Policy Anaylsis.

UCB Professor Richard Norgaard

Professor Richard Norgaard is one faculty at UCB whose work I am excited by. He is a founder of ecological economics and an Energy and Resources Group professor.

Among the founders of the field of ecological economics, his recent research addresses how environmental problems challenge scientific understanding and the policy process, how ecologists and economists understand systems differently, and how globalization affects environmental governance. He has field experience in the Alaska, Brazil, California, and Vietnam with minor forays in other parts of the globe.

His research seems to be more focused on the interactions of social systems, science, and governance than on the economic impacts of policies or setting up markets for managing resources. That may just be a more recent focus, though. He has written a lot about a coevolutionary interpretation of ecological civilization. This is the concept that the evolution of a species is the aggregate of the evolution of our values, knowledge, organization, technology, and environment. I am not sure how this line of research can help us evolve towards environmental sustainability or even how to conduct this research in a rigorous way, but it is an interesting concept.

Building the Case: Get Rid of Unnecessary Tax Breaks

Executive compensation is back up: it's a lot!

Equilar, an executive compensation data firm has found that median compensation for top executives at 200 big companies increased 23% from 2009 from $9.3 million to $10.8 million. Big executive payers are media companies, oil and commodities, and technology companies. As many people are aware, most workers are not getting raises this year and have not been getting raises for the past few years. Unemployment is still high. Profits are supposedly up, but it must be up for some sectors or maybe for large companies but still low for others. Profits on paper are also not necessarily a good indicator of how well a company is doing financially.

President Obama and the democratic party have thrown down the gauntlet about putting taxes on the table to reduce the deficit and balance the budget. I hope that people start paying attention to how well executives and certain corporations are doing so that we get tax policies that make sense. Not every tax break is good because not everyone needs a tax break. When people who don't need tax breaks get one, there is a hole in the revenues that needs to be filled by someone else's taxes.

Environmental Policy Research Interests

I am planning on approaching some professors at UC Berkeley about research positions. I think I might want to try to sample different projects so that I can get more experience.

I think I am most interested in environmental finance, technology policy, and wealth inequality.

Environmental finance
One thing I've been interested in for a while is the impact of cash flow constraints on environmental resource use in private industry. I think that we could use data from the 2008 financial crisis and look at changes in resource use. There has been a lot of focus on the impact on labor (unemployment) but not labor, energy, and resource use together. I am not sure what results I am expecting. We know that resource use went down, but the question would be whether all the decrease was due to lack of demand, lack of cash flow, relative surplus of labor, or shift in technological development.

Some more conventional lines of research in environmental finance would be evaluating asset and stock pricing according to environmental impacts, defining new financial instruments to fund sustainable business, and evaluating the impact of different accounting practices on environmental asset prices.

The kind of business I am most interested in financing are solar and wind power manufacturing, transportation projects, energy efficient appliance manufacturing, and building projects.

The Backstory : Aggressive Accounting

These days I've also been reading The Great Unraveling by Paul Krugman. It is his NYT columns from 2000-2002 mostly about how bad George W. Bush is. Today I was reading his columns about aggressive accounting and corporate governance. There are two things of note.

In 1995, Congress overrode a veto by Bill Clinton to pass the Private Securities Litigation Reform Act, which made lawsuits against companies and auditors "that engaged in sharp accounting practices."

In 1997-2000, after-tax profits stalled, but the S&P 500, the profits reported to investors grew 46%. Krugman attributes this to the changes in management theory and the advent of "principal-agent" theory. What's sad is that it is a well-meaning idea where managers' pay depends strongly on stock prices so that they have more accountability. I can see how before it may have seemed like managers were inefficient, maybe sometimes too generous to employees, and maybe out of touch with the needs of the company since they did not have as much invested in their own companies. Unfortunately, tying their compensation to stock prices gives them a big incentive to artificially boost those prices regardless of actual performance. The problem is that the real performance of a company will always be somewhat qualitative. It will always be some kind of combination of factors. Any quantitative measure can always be manipulated. That is something Deming said, too.

We are still trying to deal with the effects of these issues today. Back in 2001 I was still in high school and I had no idea who Paul Krugman was. All these things were happening, but I didn't really know. I just knew that Reaganomics and tax cuts are irresponsible. It is kind of weird to get the back-story now, especially knowing that I was there, too. It is a different sensation from reading about things that happened longer ago or in different countries. I am glad that I think I will have a better understanding of things happening going forward, but it's also a little strange knowing that millions of other people will continue to be unaware and just minding their own business as I was.

Economic Growth Theory vs Prosperity Without Growth

In Prosperity Without Growth, Tim Jackson, a member of the UK Sustainability Commission, presents a potential problem with the need for a constant rate of economic growth. I summarize his analysis in this review. In economics textbooks, growth is necessary and highly desirable to increase everyone's standard of living.

In economic theory, output is a function of capital, labor, and the state of technology.

Y=f(K,N,A)

However, it's generally rewritten as Y/AN=f(K/AN)

I=S -> I/AN = sY/AN = sf(K/AN)

If d = capital depreciation

Kt+1/AN = (1-d)Kt/AN + sf(K/AN)

Kt+1/AN-Kt/AN = sf(K/AN)-dKt/AN = 0 in steady state

sf(Kt/AN) = dKt/AN = I

if technology grows gA percent a year and the population grows by gN, then total investment must grow by d+gA+gN

Output must grow for investment to grow. In Prosperity Without Growth, Jackson points out that resource efficiency must grow faster than output, which implies output growth must become completely decoupled from resource use at some point. How can we do this? New business models? New technology? Information technology? Entertainment?

Economics 101: Investment and Capital Accumulation

This is the generally accepted theory that leads to the need for output growth to maintain a steady state economy and non-increasing unemployment.

The first step is agreeing that output (Y) depends on capital and labor. Capital (K) is the stock of existing machines and plants in the economy. Ok, I can see that. To make things simpler, the theory is commonly presented in terms of output per unit labor and capital per labor.

Y/N=f(K/N)

The next step is equating investment with savings. I=S. Then establish that savings is proportional with the output. Then

I=sY

Saving is done on the household level. Firms do the investment. The reason they are equal is because of the IS relation, where S=Y-C and Y=C+I. It is a little confusing about what this means on a practical level. When people buy stocks is that consumption or investment or saving? I think according to economic theory, it's consumption. Banks can lend money so that firms and people can actually consume more than they make. Could tuition be considered investment? Anyway, it seems difficult to really measure investment vs savings vs output since most businesses serve other businesses as well as people. Is all business spending considered investment? What if businesses save, too, instead of reinvesting all their profit.

Nobel Laureate Peter Diamond Withdraws Nomination from Fed Board

MIT professor Peter Diamond withdrew his nomination from Federal Reserve Board today and wrote an op-ed in the NYT. Republicans blocked his nomination ostensibly because they thought he did not have enough expertise in monetary policy.

Peter Diamond's specialty is macroeconomics and the labor market. His Nobel Prize was for his research on search costs in the labor market. Monetary policy is intricately linked with unemployment. In fact, perhaps the primary purpose of monetary policy is to maximize the number of well-paid jobs in the American economy. I just finished reading the core of the macroeconomics textbook so now I really see just how integrated employment and monetary policy are. It would be like telling someone they don't know enough about current because their expertise is in measuring resistance.

It really seems like such a travesty that someone like Peter Diamond can't even get nominated. It really discredits the idea that the confirmation process is merit-based. Also, from seeing him talk, I really get the sense that he is really such a professional, not an activist or a partisan. I am embarrassed that he is treated this way.

The Only Economics Class

Many people agree that it would be good for everyone to take an economics course in high school or in college. Usually, introductory economics courses only cover microeconomics, though. I have just gone through the core of the Macroeconomics textbook used in 14.02 (Principles of Macroeconomics at MIT). I think it would be more useful for the first economics course that people take to cover primarily macroeconomics, especially if it's going to be the only course in economics they ever take. The topics in microeconomics that should be covered are the supply and demand curves, the concept of marginal utility, and the production function. The rest of the course should be about macroeconomics. Macroeconomics would help people to better understand fiscal and monetary policy and how they impact unemployment and inflation. This would help people have a better understanding of current events and be informed voters.

The problem when people only take microeconomics is that people try to use the very simplistic results to make policy decision. For example, people conclude that markets are the most efficient methods to allocate resources so there should be fewer regulations. Price ceilings and floors always add deadweight loss so those should never be used either. Theoretical and empirical results from macroeconomics are much more directly applicable to explaining everyday events and informing policy decisions.