Asymmetrical Information

From the desk of Mindles H. Dreck:

It's the equilibrium, stupid.

Or "From Israel to Double-Taxation of Dividends in a Few Easy Paragraphs"

One of John Nash's simple but great insights into 'games with N players' is that any persistent situation you observe is an equilibrium (he was then able to derive the math describing price and quantity, for which he ultimately won a Nobel Prize). "Duh", you may say. Yet few people apply that insight to current events, essentially arguing that an equilibrium can change without, if you will, a supply or demand shift.

I heard Bill Clinton make this argument a few months ago in his standard post-presidential ($130,000) speech, citing it as the basis of political and foreign policy success. He says that people will act properly if you can "show them it is in their own interests". I'm not sure I buy that. As a boss, I can tell you that a room full of people who assert they can't figure out a simple filing system will be able to optimize their attendance to a new and complex overtime policy faster than a roomful of University of Chicago econometricians. Understanding isn't always the problem. More often you need to change the rules of the game to change behavior. Woody Brock reminded me of this yesterday.

As a first case in point examine discussion of Palestine. Those sympathetic to Israel say Israel must retaliate against barbaric suicide attacks, and buttress their argument with simple game theory and the notion of not "rewarding terrorism". At the same time, Palestinian apologists suggest that suicide bombing is the only recourse available to the Palestinians, citing the territorial incursions of Israel and its clearly superior military and economic might. Israel's sympathizers will point out, correctly, that the winning strategy for Palestinians would be passive resistance (I've made this argument). Palestinian apologists suggest, as my friend Ted does, that the Israelis should "at last understand that while they can win battles, they cannot win the war so the best thing would be to call it off."

Are both sides pursuing a sub-optimal strategy? Nash would say no, this has been going on for years, they must be pursuing optimal strategies given the game in front of them.

What are these rules that make seemingly self-destructive behavior optimal? I would argue they have everything to do with the powers around the Middle East, most of whom have a vested interest in sustaining the Israel-Palestine issue either as a distraction from their own failed regimes or their desire to ethnically cleanse the Middle East of Jews, Americans and proponents of secular governments. Hence Iran and Saudi Arabia's funding of terrorist cells in Palestine and the Iraqi awards to suicide bombers. In my view, the continuance of the Palestinian issue is entirely exogenous power politics. The cries from the Middle East that Palestine must be resolved before Iraq or other terrorist-sponsor states are truly "stasist" voices, attempting to preserve the status quo. They have put the cart before the horse, for no solution can hold without removing the pressure from other states who have an interest in perpetuating the conflict. That is why peace talks and accords have failed and might likely continue to fail. Talks and televised handshakes don't change the rules. It is the resolution or movement of other problems in the Middle East (no small order) that is most likely to cause the Palestinian issue to find a new equilibrium. Hopefully a peaceful one.

Clinton's notion that people can simply be taught to behave differently is actually pretty condescending. It starts from the assumption that people are stupid or simple, much as the common European view seems to assume that we can't expect more from Third Worlders. I'm also reminded here of the offensive term "Paleo-stinians" coming in to common usage in certain comment threads. Is there a chance we could stamp that one out?*

Dividend Taxation and Avenues for Corporate Greed

Brock discussed this summer 's purge of corporate malfeasance and avarice. Are corporate executives uniquely greedy? Or is this situation also an equilibrium? Woody suggests we did indeed arrive at an equilibrium. Believe it or not, one of the factors he cites is double taxation of dividends.

Huh?

Actually, he's got a good point. Among other things, the tax efficiency of capital gains relative to dividends brought us to a point where all management incentives centered around stock price. A rise in valuations began to set rather lofty targets for annual increases in share prices, by legitimate or illegitimate means such as stock buybacks and statement manipulation. We became a nation of price speculators.

"But Dreck", you ask, "why does that create an equilibrium where dishonesty is more likely to surface?" It has to do with 1) model uncertainty and 2) the persistency of beliefs.

Model uncertainty refers to your ability to translate market information into a true price. The more a stock's return comes in the form of a dividend, the easier it is to discount. If all of the return is dividend, you price the stock like a bond. There is very little difference between the value of a bond from one market actor to another. The more your return comes from price appreciation - particularly hoped for multiple increases (i.e. an increase in P/E), the more disparity you will find between one investor's valuation and another's. At the extremes, imagine if I asked you to set a price for a bunch of Treasury bills due in a year. Easy, right? All you need is prevailing interest rates and a calculator - bango, the bonds are priced. That's model certainty. Now value a box full of Pokemon cards (or imagine you are a 17th-Century Dutchmen pricing a box of Tulips). Well, that depends on how much pressure kids are putting on their dads for a holographic Charizard a year from now. My guess is that each of you would come up with a different formula, and have relatively low confidence in it. That's model uncertainty.

Persistency of beliefs is the observed phenomenon that people don't change their mind too fast. Our identity is wrapped up in our opinions. In the stock market it is clear that bulls are "pathological bulls" and bears are "terminal bears." Furthermore, any increasing evidence tends to increase the intensity of one's view. Persistency of beliefs creates periods of self-correlated optimism or pessimism (bull markets and bear markets; positive or negative overshoot). Persistency of beliefs says that you will believe your uncertain model more when you get some positive feedback using it. You will also ignore evidence negating your model and discount the possibility that your model's success was random (by the way, if you've made it this far in this post, you will enjoy this book).

The theory of Rational Beliefs (discussed by me here and by Mordecai Kurz here) describes a general equilibrium in which massive stock market bubbles can exist. The greater the model uncertainty, the more likely persistency of beliefs will work their magic and the more likely a valuation bubble will occur.

The higher the dividend, the lower the model uncertainty. Having connected the reduction of dividends to the bubble, Brock says:

There is nothing new about the phenomenon whereby, when the going gets good, the greedy get going. Indeed, economic theory implies this should happen: As the level of an investor’s (or CEO’s) wealth grows in good times, then the degree of his risk aversion will decrease, via the standard Arrow-Pratt theory of risk-bearing [link mine - Ed.]. As a result, risk-taking behavior increases as the bubble grows. When taking excessive risks no longer suffices to sustain the illusion of rapid profit growth, executives become tempted to turn to alternative and often illegal modes of behavior. Given this time-honored logic, there is not much new in the spasm of greed that we have been witnessing.

Fed Chairman Greenspan put the matter very well in recent Congressional testimony when he pointed out that “greed” isn’t new at all. Rather, the avenues whereby greed can be realized have opened up in many new directions....

... our financial culture and tax policies caused a transformation from a society where shareholders were rewarded with dividends into one where they are rewarded with capital gains. When combined with the increasing use of stock options to compensate management, this development made it all but irresistible for executives to engage in earnings manipulations. The temptation was heightened as equity analysts began to view earnings growth as the sole criterion of corporate excellence. What now needs to be done is to alter the rules of the game such that, in responding selfishly and greedily to the new rules, it becomes in the self-interest of corporate players not to do what they have been doing. In modern game theory terms, we must transform the rules so that the new Nash equilibrium strategies of the players will generate an outcome that is socially preferable to the old one. Are we moving in the right direction?

Perhaps the most fundamental problem of all with today’s brand of US capitalism is the triple taxation of dividends: Dividends are taxed twice, once at the corporate level and once at the personal level. Even worse, the personal tax rate on dividends is nearly twice that of the capital gains rate. Over the past two decades, this reality has caused management to focus on earnings and on share price growth to an extent unimaginable in the past. This in turn created the incentive for the deceptions discussed above. Even worse, it has turned all of us investors into de facto price speculators! Indirectly, it has forced a misuse of retained earnings for excessive share repurchases, and/or corporate investments that have all too often proven misjudged.

We predict that all this will change. As baby-boomers start to retire, they will want stable, predictable dividend payments in exchange for holding stocks. They will pressure legislators radically to reduce the taxation of dividends. And CEO’s who don’t produce growing dividends for them will be toast.

Who's Greedy? Who's not?

As I mentioned earlier, taxation of dividends is not the only contributing factor to what Woody calls our "black eye". He cites a well-rounded list of "greed" factors:

1. excessive corporate leverage (often off-balance sheet and used, in part, to buy back shares and increase earnings per share)
   
2. a "Crisis of Short-Termism", his term for the Principal-Agent problem (lack of alignment of interests) of executives motivated by options
   
3. "Preposterous expectations" of returns exceeding growth in the economy over the long run
   
4. "Dismal" fundamental analysis (that would be my industry)
   
5. "Social Security and Medicare Fantasies":

   Speaking of greed, do today’s ever more numerous gray panthers seriously believe that they have “earned” thirty years worth of retirement on the golf links, to be paid for by their grandchildren? And what about the fantasy of ever more drugs and medical services to which they are “entitled”? Did even Jeffrey Skilling possess such delusions?

   
   
6. Government Accounting Chicanery
   
7. Trial Lawyers and Juries
   

That's a pretty good list. Who says corporate executives have the market in greed cornered? Which leads Brock to his preachy conclusion:

The root point here is that there is plenty of greed to go around. Thus far, it is only in the executive suite and in the stock market that society has witnessed a comeuppance. But the adjustment process has barely gotten off the ground, and in the next one or two decades, we will witness a widespread readjustment to reality throughout society, from CEOs to the elderly to overpaid athletes and to average investors. Things have been too good for too many people for too long.

The financial markets have adjusted rapidly, which is all to the good. Now market mechanisms are coming after the rest of y'all.....

*Just because I'm arguing here that the system encouraged suicide bombers, or encouraged greed doesn't mean I won't condemn their acts as immoral. I'm just saying that under the right conditions, you get more of them - its a cause, not an excuse. A cynical view of humanity, perhaps, but not unrealistic.

So call homicide bombers (and/or those who celebrate their evil) whatever you like but don't invent a racial epithet that seems to generalize your disdain to one of the most unfortunate groups of people on the planet.

Posted by Mindles H. Dreck at September 18, 2002 7:00 PM | TrackBack | Technorati inbound links