Asymmetrical Information

From the desk of Jane Galt:

A number of you have

A number of you have emailed to ask what I think of the Paul Krugman article. I know you're all expecting me to dump all over it, but I quite agree with a lot of it. It's been obvious to me for quite some time that the level of many CEO salaries was based less on their personal acumen, and more on their ability to build a captive board that ratified insane stock options. And other unsalutary developments, about which I'll explain more later.

Some of the sections are terrific, such as this able summation of the theories behind rising inequality:

In the middle of the 1980's, as economists became aware that something important was happening to the distribution of income in America, they formulated three main hypotheses about its causes.

The ''globalization'' hypothesis tied America's changing income distribution to the growth of world trade, and especially the growing imports of manufactured goods from the third world. Its basic message was that blue-collar workers -- the sort of people who in my youth often made as much money as college-educated middle managers -- were losing ground in the face of competition from low-wage workers in Asia. A result was stagnation or decline in the wages of ordinary people, with a growing share of national income going to the highly educated.

A second hypothesis, ''skill-biased technological change,'' situated the cause of growing inequality not in foreign trade but in domestic innovation. The torrid pace of progress in information technology, so the story went, had increased the demand for the highly skilled and educated. And so the income distribution increasingly favored brains rather than brawn.

Finally, the ''superstar'' hypothesis -- named by the Chicago economist Sherwin Rosen -- offered a variant on the technological story. It argued that modern technologies of communication often turn competition into a tournament in which the winner is richly rewarded, while the runners-up get far less. The classic example -- which gives the theory its name -- is the entertainment business. As Rosen pointed out, in bygone days there were hundreds of comedians making a modest living at live shows in the borscht belt and other places. Now they are mostly gone; what is left is a handful of superstar TV comedians.

The debates among these hypotheses -- particularly the debate between those who attributed growing inequality to globalization and those who attributed it to technology -- were many and bitter. I was a participant in those debates myself. But I won't dwell on them, because in the last few years there has been a growing sense among economists that none of these hypotheses work.

Although I would like to point out that one of the reasons he won't dwell is that he was firmly behind the "skill" theory, which doesn't track with the data. And personally, I think the theory he seems to prefer now is a little. . . well, iffy:

Some -- by no means all -- economists trying to understand growing inequality have begun to take seriously a hypothesis that would have been considered irredeemably fuzzy-minded not long ago. This view stresses the role of social norms in setting limits to inequality. According to this view, the New Deal had a more profound impact on American society than even its most ardent admirers have suggested: it imposed norms of relative equality in pay that persisted for more than 30 years, creating the broadly middle-class society we came to take for granted. But those norms began to unravel in the 1970's and have done so at an accelerating pace.

I'm afraid I just don't believe that people refrained from, say, making themselves enormous compensation awards in the 60's because they felt it wouldn't be cricket, but feel no shame about doing so now. This relies on a somewhat utopian view of corporations:

Exhibit A for this view is the story of executive compensation. In the 1960's, America's great corporations behaved more like socialist republics than like cutthroat capitalist enterprises, and top executives behaved more like public-spirited bureaucrats than like captains of industry. I'm not exaggerating. Consider the description of executive behavior offered by John Kenneth Galbraith in his 1967 book, ''The New Industrial State'': ''Management does not go out ruthlessly to reward itself -- a sound management is expected to exercise restraint.'' Managerial self-dealing was a thing of the past: ''With the power of decision goes opportunity for making money. . . . Were everyone to seek to do so . . . the corporation would be a chaos of competitive avarice. But these are not the sort of thing that a good company man does; a remarkably effective code bans such behavior. Group decision-making insures, moreover, that almost everyone's actions and even thoughts are known to others. This acts to enforce the code and, more than incidentally, a high standard of personal honesty as well.''

John Kenneth Galbraith's "New Industrial State" is not exactly a quotation to fill me with confidence in what comes behind, since it is arguably the worst of Galbraith's breathtakingly bad books on economic theory. (His economic history books, such as the Great Crash of 1929, are much better.) And Krugman himself seems to be confusing GM's press releases with their actual behavior. Managerial self-dealing was rampant in the 50's, 60's and 70's, the era of takeovers done for no reason other than to build personal fiefdoms; expense accounts that would make a con man blush; and tax-deductible everything.

On the other hand, I flat out disagree with this:

Economists also did their bit to legitimize previously unthinkable levels of executive pay. During the 1980's and 1990's a torrent of academic papers -- popularized in business magazines and incorporated into consultants' recommendations -- argued that Gordon Gekko was right: greed is good; greed works. In order to get the best performance out of executives, these papers argued, it was necessary to align their interests with those of stockholders. And the way to do that was with large grants of stock or stock options.

I don't disagree that economists said this, but Krugman's implication is that they were wrong. They were right. They still are. What they didn't do was predict the ways that certain regulatory schemes -- schemes, I might add, that were passed to curb the inequality Krugman is lamenting -- interacted with this theory to produce a disaster. The law capping the deductibility of cash or stock compensation at $1 million pushed CEO compensation into stock options. This was compounded by the fact that stock options are tax favored, for both company and employee, over other forms of compensation.

This had several effects. Some seem to have taken unconscionable risks because options are a different security from the one investors hold, one that encourages risk taking behavior since executives have unlimited upside if the price rises, but the downside is the same whether the stock price holds steady or falls to 2 cents. It exacerbated an already strong trend towards earnings management, since executives generally want to liquidate their options as soon as they mature, and therefore needed, each and every quarter, to keep earnings from the precipitous slump an earnings restatement can produce. It also pushed a lot of compensation off-balance sheet, making it easier to raise it to unconscionable levels.

Now, many of my interlocutors will say that this doesn't matter, because investors will just back the options out and produce a "real" EPS number. I believe this is mistaken in several ways. First of all, during the bubble, many investors were trading on something other than a full understanding of the numbers. I was at a dinner last week, listening to several financial professionals agree with each other that it was ludicrous that people should trade stocks based on research done by investment banks, when the conflicts were obvious. Well, yes they were, to us. Not to my mother, or the millions of investors like her. Not to mention the fools who mortgaged the house to day trade. Many of the spectacular rises in price were produced by those folks, buying what they didn't understand. Executives with stock options profited handsomely from this sort of trading.

The other reason this doesn't hold is that the balance sheet is where the majority of people are going to look for executive compensation. Stock option grants are delayed compensation, and don't show up on the public radar until the executive cashes in some years later. Thus, any present grant is a painless gift for the board to make to the CEO; no one's going to complain until it's too late.

However, none of this invalidates the general theory that stock aligns CEO incentives with those of the shareholders better than does cash salary; it does. The companies of those halcyon days Krugman is recalling were logy with corporate fat, brought on by the astounding disconnect between what was good for the shareholders, and what was good for the managers who owned not very much corporate stock. Economists were trying to revitalize our economy by getting rid of the compensation structure that made management uncompetitive, and in fact I would argue that they succeeded in doing so. That they did not anticipate a market structure and tax/regulatory scheme that would give CEO's the ability to game the system to award themselves outlandish loot, does not make the theory a failure. It's more an indictment of the regulatory scheme than the theory.

Parts are also disingenuous:

It was one of those revealing moments. Responding to an e-mail message from a Canadian viewer, Robert Novak of ''Crossfire'' delivered a little speech: ''Marg, like most Canadians, you're ill informed and wrong. The U.S. has the longest standard of living -- longest life expectancy of any country in the world, including Canada. That's the truth.''

But it was Novak who had his facts wrong. Canadians can expect to live about two years longer than Americans. In fact, life expectancy in the U.S. is well below that in Canada, Japan and every major nation in Western Europe. On average, we can expect lives a bit shorter than those of Greeks, a bit longer than those of Portuguese. Male life expectancy is lower in the U.S. than it is in Costa Rica.

Still, you can understand why Novak assumed that we were No. 1. After all, we really are the richest major nation, with real G.D.P. per capita about 20 percent higher than Canada's. And it has been an article of faith in this country that a rising tide lifts all boats. Doesn't our high and rising national wealth translate into a high standard of living -- including good medical care -- for all Americans?

Well, no. Although America has higher per capita income than other advanced countries, it turns out that that's mainly because our rich are much richer. And here's a radical thought: if the rich get more, that leaves less for everyone else.

Now, first of all, the median is also higher than anyone else's median, which means it isn't just the rich getting richer. And second of all, I'm told that if you back out immigrants, Americans do, in fact, have the highest life-expectancy in the world; the 15% of our population that was born somewhere else has a dramatically lower life-expectancy than the native born. If you back out the effects of our sedentary lifestyle, it's even starker. It's not as if Krugman, an economist, is unable to compare median incomes, or look at the difference in health care outcomes for the native-born, both of which are obvious reality checks.

There's also the fact that after spending a lot of time comparing personal income data and concluding that the rich are getting richer, he then declares we're not allowed to compare income data between the US and Sweden, because it's not a good measure of quality of life. There's some validity to this, but if the problem is difficult when making comparisons between nations, it's even more difficult when making comparisons between eras, as Krugman is doing.

Has the qualitative life experience of the rich really increased, while the poor stayed stagnant? Since the 50's? 60's? 70's? I would argue it's the reverse. The head of GM's life is not, qualitatively, much better than that of the head of GM in the 50's. The poor, on the other hand, have more space, better food, more and better clothes, color televisions, VCR's, automobiles. . . items that were beyond the wildest dreams of the poor in the 1950's. The numbers may have diverged, but I would argue that the quality of life is converging. Consider that many of the things the poor routinely own mimic the servants available only to the very rich until a short time ago: answering machines and cell phones to substitute for butlers and personal secretaries. Cars to substitute for the coach and four. Appliances to substitute for the cook, parlormaid, laundress, and scullery maid. Television and movies to substitute for the performing arts. Exact reproductions that make the Great Masters available for any livingroom wall. You can make your own list.

CEO compensation is an easy, and correct, target. Others are less obvious: sure, a one-time capital gains tax on rich Americans who renounce citizenship because of the tax burden sounds nice, but I have to tell you, the more I look at the nasty states around the world, the gladder I am that I live in one that lets its citizens leave at any time, for any reason. You don't have to be a libertarian to feel that way. (I should also point out that it wasn't, to my recollection, a "capital gains" tax; it was a plan to liquidate the assets of said citizens, and then charge them a capital gains tax. . . tactics which do give a little whiff, though Krugman may call it hyperbole, of Nazi Germany. Essentially they were saying that they were going to seize the property of anyone who decided to emigrate, sell it off, and then award some fraction of the proceeds they deemed "fair" to the owner. Since this is, in fact, what Nazi Germany and a number of other unsavory regimes did in order to maintain their control over their citizens, the comparison is hardly unjust.)

Nor am I enamored of the "correlation equals causation" argument by which liberals attempt to generate a causal relationship between the lower income inequality of the 50's and 60's, and the growth of the economy during that period, which, as far as I know, have at best little to do with each other. This is beneath an economist of Krugman's stature.

And the policy segment is, well, disappointing.

The problem with raising taxes on the rich is that you don't get the folks you want to get: the CEO's pulling in billions. What you get is the folks making 300K as a corporate lawyer in Atlanta, or what have you. Sure, you don't feel sorry for him if you make 50K as a lathe operator, but if it's not fair for you to pay more of your income in taxes than he does, surely it's not fair for him to pay more of his income in taxes than Jack Welch. Ditto the estate tax. Krugman cleverly elides the highly disproportionate share of the estate tax that falls on estates in the lower end of the range. Both occur for the same reason: these are people in a high bracket, but not a high enough one to afford massive tax planning. Jack Welch can take his income in any time period he wants, in any form he wants. He has a fleet of tax lawyers to help him do so. The poor bastard pulling down 200K as a CIO faces a tax rate that can easily top 50%, and can't afford to shift income to shelter it in tax-free munis, or as capital gains. Nor can he set up a trust to make sure that his zillion useless descendants never have to worry about where their next meal is coming from. Krugman wonders why tax cuts sell politically? Well, that's why. Not many of us think we're going to be Jack Welch. But a lot of us can imagine being successful enough to pull in 200K -- and getting kicked in the teeth by a tax system designed to "soak the rich".

("Just close the loopholes!" I hear you cry. Not possible. The more complicated you make the tax code trying to "close the loopholes", the more loopholes you create, and the more it favors rich people who can afford experts to sort it all out. Don't ask me -- ask your accountant. He'll tell you.)

I really am sympathetic. I think CEO compensation is outrageous. And as I was watching a documentary on television the other day on the houses all the Vanderbilt heirs built, I thought "this is really revolting." Those enormous palaces built just to show other people that you were the sort of person who can afford to build an enormous palace and crust it with marble. . . well, I can see why the anarchists wanted to blow it all up.

But I also don't believe it's a failure of social norms; I think that's a flood of Kennedy nostalgia talking. Nor do I think, as Krugman seems to, that this just provides proof that people whose politics I disagree with are evil, venal fools. Although you'll probably be unsurprised to hear that I do think my political opponents are partly responsible: I think a lot of it has to do with regulation.

Some of it is the regulation of CEO pay and associated items, most of which were designed to limit the phenomenon that they instead exacerbated: the cap on the deductibility of cash compensation; the corporate raiders who were supposedly looting companies for their own benefit, but who actually had provided a powerful check on the self-dealing of top executives.

Some of it is the creation of locii in the economy, through regulation, where people could make truly vast fortunes with very little effort. I am thinking, in particular, of product liability lawsuits and especially class actions; and investment banking.

Because the myriad of SEC regulations presents an insurmountable barrier to entry for most new entrants into the investment banking business, and because of regulations regarding fees that limit competition, investment banks were able to charge fees of 7% of each IPO. Roll that around. 7% of IPO's that could top $1 billion, for several hundred hours' work. When you look at that kind of money, it's obvious: of course research was abused; of course banks flogged off crap on unsuspecting retail investors. We're talking hourly rates of close to $1 million. That's a lot of money to walk away from on principle.

Without the SEC, investment banking business would probably barely exist; a couple 100K to help do the valuation, a couple 100K to register the security on the electronic exchange, and hey, you're good to go. Ditto M&A; without the SEC, that work would mostly fall to the lawyers, not the bankers, and the bankers certainly wouldn't make the kind of fees they do now; valuation is not rocket science.

Now think about class actions. Hourly rates there are also outrageous, easily topping $10K an hour, sometimes venturing into the millions. Often, this is for suits of trivial benefit to the alleged plaintiffs, such as the one that got me a $3 coupon from some fast food restaurant I'd never heard of for some alleged abuse I don't recall.

Of course, not all our newly rich are investment bankers or trial lawyers. But a lot of them are, and they're getting richer all the time.

That's why I have to laugh when people point triumphantly to say, Jon Corzine, and say "More regulation must be called for! Even Jon Corzine is in favor." Well, of course he's in favor, sweety. . . more regulations mean more investment bankers making him more money. Just like you'd be in favor if the government was going to pass a law requiring everyone to buy some expensive product from some company you own. It's not proof of the majestic truth of the law, but of plain old government rent-seeking.

Interesting, isn't it, that the alleged champions of the people are the ones pushing laws to keep these chaps fat and happy?

Update Having skimmed through that long and pointless screed, you can now read Arnold Kling's better, more succinct write-up here.

Posted by Jane Galt at October 21, 2002 12:29 PM | TrackBack | Technorati inbound links