Asymmetrical Information

I remember a while back Krugman having some aside about a big gap that opened in the 1990s between stated corprorate earnings and backed-out-from-GDP-or-something earnings, but I can't find it again. Anyone know of this?

I haven't read the paper, I have only read the abstract. With that caveat:

The abstract acknowledges failures at Enron, WorldCom, and Tyco. It then states that evidence is inconsistent with a failed U.S. system, mentioning the improved ecconomy once and rising stock market prices twice.

Rising stock prices? Wasn't the problem that these companies were essentially stealling money? Maybe the stock prices are still rising because the companies are good at stealling. Sounds like a good investment to me.

I know rising stock prices do not prove bad governance, but do they really prove good governance? Consider: "Organized crime is not a big problem. For example, "Lucky" Luciano and Al Capone have both doubled in net worth over the past five years."

So the poor performance of the European and Japanese economies is evidence that the US doesn't have a corporate governance problem.

Seems like quite a stretch.

That's not really what it says. What it says is that if the US has a corporate governance problem, it's not evident from the stock market -- any five year period from the eighties onward that you analyze yields returns both better, comparably, than other markets, and consistent with the risk premium for well-managed companies. It also looks at productivity, which, if companies are really screwing the pooch, should be dropping the way it did in the late seventies. Instead it's rising.

Decnavda

All of these companies were going broke because they made bad business decisions. The proper thing to do was to declare bankruptcy and layoff the employees.

Rather than do that, the executives falsified their financial statements so that the banks wouldn’t foreclose and the companies could still get money from the investors.

Who were the major beneficiaries of this fraud? Surprisingly it was the employees. They got to keep their jobs another 12 to 18 months longer than they should have. The losers were the banks and the investors.

"It also looks at productivity, which, if companies are really screwing the pooch, should be dropping the way it did in the late seventies. Instead it's rising." If they're lying about their profits, why trust their productivity figures?

Not that it matters in the long run. The ones that actually increase their productivity or otherwise maintain real profitability survive, the ones that try to fake it will eventually run out of room and go down, putting the bad executives out of work. So it's a self-limiting problem - as long as the gov't doesn't rescue the failures.

That's now how productivity is measured . . . productivity is (roughly) GDP divided by man-hours worked. The CEO's don't get an input.

"What it says is that if the US has a corporate governance problem, it's not evident from the stock market -- any five year period from the eighties onward that you analyze yields returns both better, comparably, than other markets, and consistent with the risk premium for well-managed companies. "

Read it again. It says nothing about risk premiums. It compares returns over the two, five, ten, fifteen, and twenty year periods ending 12/31/02 and draws its conclusions based on that comparison and productivity.

"It also looks at productivity, which, if companies are really screwing the pooch, should be dropping the way it did in the late seventies. Instead it's rising."

Not only are the stock market returns very weak evidence, I don't see why productivity is such great evidence either. A company can be well managed, in the sense of running efficiently and being productive, yet poorly governed, in the sense that executives and the board are getting too much of the pie.

And here again Kaplan's standard is other countries, which have lots of problems of their own.

BTW, where is this paper from? Has it been published?

Jane, if they're cooking the books doesn't that affect the GDP?

The modern American version of capitalism is based on an entrepreneurial freedom that ensures high returns along with high risks. The changes in the 80's were necessary - management theory had little practical advice to offer except for Management by Objective (MBO).

The arrogance of MBO allowed executives to ignore the processes that occur at various levels within any competitive industry. It was easy to say something is wrong and here's what action we're going to take to fix it.

Fortunately, in high level manufacturing, a debate began in the 80's about quality and its effect on management. In addition, the benefits of statistical process control became apparent to those whose minds were not closed to alternatives. Most importantly, continuous improvement became a practical alternative to MBO and those with the courage to question their own management had a tool to lead the way.

This had a dramatic effect on productivity in highly competitive industries, automotive being the best example. Unfortunately, the transformation has been slower in other industries.

Corporate governance will take care of itself through competitive pressure. The authors of this article have done a good job of pointing out the obvious - our system has flaws that should not be the reason to throw the baby out with the bath water.

In the short term, the hardest thing to do is witness management errors that could be rectified now rather than later by a clearer understanding of business processes. When you come to grips with how this occurred, at least you can have the faith to know that things will get better ultimately.

My reading of it is "companies are making more money than they used to, and definitely making more money than Europe or Asia......so therefore corporate corruption can't be all that bad." Which doesn't seem to refute "corruption is skimming off profits" - maybe the "real" profit rate is a lot higher.

That's why I asked if anyone knew of that Krugman column, as it sounded like a way to empirically verify if the "corruption gap" between company profits and amounts delivered to shareholders has increased.

Ah ha, found it.

http://www.pkarchive.org/column/052102.html

You can see what he's talking about in this BEA table:

http://www.bea.gov/bea/about/0503meeting/Petrick.pdf

Note the huge gap between earnings and profits that opened up in 1998.

How bad is US Corporate Governance?
Prolly not as good as it was in the 80s, but maybe will get better. In the 80s there were free market controls, called Raiders (like Carl Icahn; or the leads in movies Pretty Woman & Wall Street), who bought poorly run companies and gave the owners a better return. “Poorly run” includes overpaying for the executives—letting the execs skim profits that should go to the owners (dividends & buybacks). Shareholders, with Congressional supported rules changes, allowed poison pills, etc., to protect and entrench the mediocre managers against the raiders; the explosion of top exec pay is influenced by this.

The success of American capitalism has been that, relative to other industrializing countries, the entrenched oligarchic class has been under more pressure to increase production. But the execs have also gotten higher rewards. I have no problem with huge rewards for good performance; I do have a skepticism in the system, even anger, when CEOs lay off workers and get booted with golden parachutes. This makes me feel the system is broken. Fixing it, without causing other problems, is another issue. Part of the solution should include layoffs, new unemployment, as part of the measure of how bad the company has performed.

If the company is performing well, it’s hard to claim the governance is bad. Well for shareholders is best seen in share price (+dividends); well for workers is wages, very bad for workers is layoffs. Since both employment and share prices have been mostly rising, except for the 2000 dot.com bubble, the governance compares favorably to other corporate regimes.
I didn’t mention above, but previously agreed that CEO turnover was a good measure of effective governance, the article agrees; so it’s a good article.
(now to read the article)
Yes, big equity linked pay is pretty darn good, both theoretically, and in practice. The article notes the market response and then legislative obstacles to raiders; it highlights equity pay in LBOs and basically claims such pay is responsible for better performance. It applauds the business focus on shareholder return as the right metric, specifically compared to other stakeholders [for business evaluation; the paper doesn’t address social evaluation].
It laments the huge pay of the top 10 CEOs, especially since they were already big shareowners, so likely more equity pay had little additional incentive, and were more likely just executive skimming.
It also points out that board members, in surveys, claim to support more of the right changes than their own boards exhibit.
The paper’s discussion about SOX is quite good, noting the new requirement for the CEO to disgorge profits if there was misconduct in the prior 12 months, making their equity less liquid, prolly good. Also 2 day reporting (instead of 10) to reduce insider trading, more accounting and auditing and liability. And, thus, insurance and law slingers to protect the heads – a noted cost.

The paper supports the usual suspects (for better performance) 1) board selection by nominating committee, 2) more equity pay for directors, 3) more director control of board meetings. It also notes other efforts, by exchanges & committee, to come up with guidelines.
And it thinks such guidelines mean the system will be getting better.
>>I think so too.

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