Friday, November 20, 2015

The Corrupting Influence of Vilification

What happens when the criminal can't be the villain?

This is the third posting that asks the simple question: Are we looking at an issue from the proper perspective?

Sometimes the words chosen to describe an issue can create a blind spot.  When that happens, one can end up developing a policy that is totally appropriate but totally inadequate.  The policy only addresses the portion of the issue that the language allows.  However, the language does not facilitate the perception of the totality of the problem. 

Consider three words used to describe a financial transaction where one individual makes a payment to another that is not legal: bribery, extortion, and corruption.  Which word is chosen is related to and influences one's judgment about who is undertaking villainous behavior and whose behavior is too virtuous for them ever to be the villain.  Self-interest can play a major role in the definition of the villain and the choice of words to describe the action.


The Foreign Corrupt Practices Act (FCPA) is an excellent example.  It is designed to pursue a worthy objective but makes the absurd assumption that all corruption originates from the private sector.  That is an easy mistake to make if one assumes that anyone who pursues a profit objective is villainous.  
It helps if one is in a position to ignore potential villains either for convenience or out of self-interest.  It is very convenient and self-serving for the public-sector officials to ignore corruption on the part of other public-sector officials.  They can anticipate that those other public-sector officials will return the favor.

The media has an incentive to write sensationalist, supposedly investigative articles.  There is very little downside to inaccurate reporting if they can paint a picture of villainous activities.  All they have to do is identify who their target audience considers a villain.  Not surprisingly, often they share their audience’s prejudice regarding who is villainous.  Few people in the media or the general public seek information that challenges their preconceived notions of who is villainous.

The net effect is that policy prescriptions often end up only addressing half of the issue.  All the parties involved in a corrupt transaction are acting corruptly.  It is foolish to think that a policy that only punishes one of the parties involved can succeed.  The inherent result of such a policy is to provide an incentive to one of the corrupt parties to continue their behavior.  Without balance, a policy directed at bribery, for example, can end up compounding the misallocation of resources.

The back story

The May 9th, 2015 edition of the ECONOMIST magazine had a number of articles addressing commercial bribery.   The articles provide the back story, but there is a more recent update on some of the relevant information in an October 19, 2015 article in the WALL STREET JOURNAL. 
The WALL STREET JOURNAL article is entitled: “Wal-Mart Bribery Probe Tails Off.”  The government has been working on this probe for over three years and it is not yet over.  Indications are that the probe involved some two dozen prosecutors, agents and investigators from the Justice Department, the Federal Bureau of Investigation, the Securities and Exchange Commission and the Internal Revenue Service’s criminal investigations unit. 

As the WALL STREET JOURNAL article summarizes, “A high-profile federal probe into allegations of widespread corruption at Wal-Mart Stores Inc.’s operations in Mexico has found little in the way of major offenses, ….”   The emphasis is on “summarizes” because although no major offenses were found there were some minor offenses uncovered in Mexico. 

As is often the case when such accusations are leveled, the investigation took on a global scope.  In India there are reports that the corruption involved thousands of small payments to low-level local officials to help move goods through customs or obtain real-estate permits. The vast majority of the suspicious payments were less than $200, and some were as low as $5, but when added together they totaled millions of dollars.

The ECONOMIST magazine provides some idea of the scale of resources used to investigate the charges.  In an article entitled “Corporate bribery: The anti-bribery business” it states: “EVEN for a company with Walmart’s heft, $800m is a sizeable sum. That is what the giant retailer will have spent by the end of this fiscal year on its internal probe into alleged bribing of Mexican officials,”
“By the time bribe-busters at America’s Department of Justice (DOJ) are done with their own investigation, which began in 2012, Walmart’s bill for lawyers’ and forensic accountants’ fees will be well above $1 billion—and perhaps closer to $2 billion. To that can be added whatever fines it may incur, any bills for settling related private litigation, and the harder-to-quantify cost of the tens of thousands of man-hours managers have spent on what has become a big distraction from everyday business.”

The anti-bribery business is truly big business.  There are undoubtedly many law firms, government officials and corporate compliance officers making a nice living off of the anti-bribery business.  However, it doesn't stop there.  The issue provides media talking points for commentators and reporters. 

Keep in mind that the Walmart investigation began in 2012 after the NEW YORK TIMES ran a couple of articles alleging that there was widespread bribery in Mexico.  The Justice Department investigation contradicted some of the allegations in the NEW YORK TIMES articles.  Yet, despite the shortcomings of the NEW YORK TIMES supposedly investigative journalism, they ended up being awarded Pulitzer Prize.

One suspects that neither the NEW YORK TIMES reporters nor the Pulitzer committee members shop at Walmart.  So, a couple of billion dollars of extra cost for Walmart is not coming out of their pocket.  Besides, Walmart, a chain store that serves the working class, is such a convenient target for elitists in the media.

There is a very real risk that the government's response to being unable to find evidence of major corruption, may be to throw more resources at the investigation.  After all, it is a little embarrassing for the government to admit that it has been hoodwinked into such an extensive investigation by an inaccurate press report.  Further, it is often the government solution to a program run amok to just throw more resources at it.  Spending billions of dollars to catch a few million dollars’ worth of corrupt activity is the sort of thing governments do.

The problem

It is not surprising that the government, when passing the Act, wanted to assume, or at least pretend, that the corruption always originates in the private sector.  That they closed ranks with their fellow government employees is not surprising.  If they did not, foreign governments, as well as their own citizens, might call into question their behavior.  It would get quite messy if foreign firms and governments started pointing fingers at the lobbying expenses that US government officials extort from them routinely.

However, governments can acknowledge that there is government corruption.  It just seems that the US is not good at it.  By contrast, the ECONOMIST on Oct 24th, 2015 had two articles that reflect what one finds when a more balanced and objective approach is taken to corruption.  The first article entitled “Business and corruption: Robber barons, beware” discusses the anti-corruption campaign in China.

As is the case with most articles in the ECONOMIST, the full complexity of the issue is addressed.  Nevertheless, the important thrust of this effort to reduce corruption can be summarized with a couple quotes.

“Businessmen targeted so far are mostly senior managers of state-owned enterprises (SOEs), not private firms. In China powerful SOE bosses are also important figures in the Communist Party….Some of those detained are linked to Zhou Yongkang, a former security chief and head of a corrupt network of officials known as the “petroleum mafia”….  Of more than 100,000 people indicted for graft since Mr Xi became leader in 2012, most are politicians and officials—not private businessmen” [emphasis added]. 

It is interesting how when government officials become corrupt they are referred to as businessmen.  One would think that the editors of the magazine would have found it awkward to have to create the distinction between private businessmen and government officials who they have referred to as businessmen.  There is no reason to refer to the corrupt government officials as businessmen other than a bias on the part of the editors that assumes that corruption is a business phenomenon.  They are much in error.  Corruption is very much a government enterprise where force can be employed as opposed to a business practice where transactions are voluntary.  It seems even when the truth is obvious it is hard to admit that government officials can be corrupt.

The second article was entitled “Corruption and natural resources: A fight for light.”  It discusses efforts of NGOs and governments to try to uncover corruption related to mining and energy production.  It notes that “WHETHER the awarding of a license, the sale of state production quotas or some other transaction, dealings in oil, gas and mining are notoriously prone to corruption. This is a problem in countries that have weak rule of law and rely heavily on extractive industries. Sub-Saharan Africa is particularly at risk: its ten largest oil-producing states derived 56% of their public revenues from oil exports in 2011-13.”

The efforts of the Extractive Industries Transparency Initiative (EITI) are complicated by the fact that often the corruption is executed through the establishment of nontransparent shell companies.  The lack of transparency makes it difficult to track the corruption.  Nevertheless, the article points out that “A new report by Global Witness details how in recent years $4 billion was siphoned off to opaque companies, some of them linked to current or former officials [emphasis added], in just a handful of deals in four African countries.”  Global Witness is a Non- Government Organization (NGO) that is trying to monitor the (EITI).

The two articles make it apparent that when one looks at the issue from a broad, global perspective, it is apparent that corruption is not restricted to the private sector.  There is also no logical reason to assume that when a corrupt transaction occurs only one party is acting inappropriately.  It seems more appropriate to assume that both parties are acting inappropriately.  Further, since money is being transferred from private companies to public officials, it would seem far more appropriate to question the motives of the public officials.  

Private companies are not inclined to go around the world with bags of money spreading it widely in order to corrupt governments.  In fact, private companies prefer to operate in countries with honest governments and often have extensive internal controls to avoid the inappropriate use of funds.
Even serious analyses can be led astray

While clearly a media firm, the ECONOMIST magazine often contains serious analyses of economic issues.  Their coverage is broader than just the Walmart case; they discussed Siemens and Alston as well.  Both their assembly of the relevant facts and their interpretations of their implications deserve consideration. 

In the initial article “Bribery: Daft on graft” the magazine pointed out that “A hard line on commercial bribery is right. But the system is becoming ridiculous.”  

The articles in the ECONOMIST make the case for a number of reforms:

“First, regulators should rein in the excesses of the compliance industry and take into account the cost to firms of sprawling investigations.

Second, governments should lower costs by harmonizing anti-bribery laws and improving co-ordination between national probes.

Third, more cases should go to court.

Lastly, anti-bribery laws should be amended to offer companies a “compliance defense.”

All of their recommendations definitely make sense, are much needed and are justified.  However, they are also representative of what can happen when serious analysts fall prey to the language and context of those with less serious and objective intentions.  The ECONOMIST articles have a blind spot that they share with the FCPA.  As a consequence, their proposals are appropriate but are not adequate if the objective is to reduce corruption.

The selection of the word “bribery” in the titles of the ECONOMIST's articles and FCPA’s assumption that they know the villain in such cases illustrate the problem.  If one substitutes extortion for bribery, it automatically changes the context of the issue.  The same would be true if the word corruption were substituted for bribery.  But, the title of the article reflects the assumptions of the FCPA. 

The need for balance

The ECONOMIST article explains the rationale for the desire to end bribery.  The article points out that “Bribery distorts competition and diverts national resources into crooked officials’ offshore accounts.” What it fails to explain is: when businessmen have to make payments to government officials in order to get the officials to do their job (e.g., decide whether to issue a permit, perform an inspection, or even note that paperwork has been submitted) how can punishing the businessmen solve the problem?  The government official is receiving a salary to do the job.  They are also benefiting from the payment.  The businessmen are only exposing themselves to the potential of being fined and branded as corrupt.

If the corrupt official is allowed to keep the money, they have every incentive to continue the practice.  On the other hand, the businessmen have an incentive not to do business in the area.  The absence of the businessmen who were thus deterred also distorts competition.  If the objective is to avoid distorting competition, all parties involved have to be given incentives not to participate in the corruption.  Fining the government officials or the governments involved in corrupt transactions makes as much sense and should be balanced with the fines leveled against the companies.

As soon as one begins to think about a balanced approach that involves recovering the bribes from government officials, it becomes apparent that there are major opportunities to structure the process in a way that is conducive to honest government.  While ultimately the objective is to recover the bribe from the official who took it, the fine need not be directly assessed against that individual.  That is only one approach.  It could also be assessed against the organization responsible for enforcing honest government.  As a last resort, it could be levied against the national government with the proviso that if it is not paid, tariffs on the country’s exports will be used to collect it.  That would make it apparent that the government of the US is serious about honesty in business and government.  If other countries followed suit, it would soon become apparent that honesty is a prerequisite to dealing in the global economy.


Vilification of one of the parties involved in a corrupt act while ignoring the other party does not promote a better allocation of resources.  While it may sell newspapers and be entertaining to some audiences, no one is made better off except the author and publisher.  A serious effort to correct the misallocation of resources that result from extortion, bribery and corruption requires a more balanced approach.

Government policies to address the issue should acknowledge and prosecute all the parties involved.  Honesty is as much a prerequisite of good governance as it is of good business practices.  It is na├»ve to assume that an effort that focuses only on one of the parties involved in corrupt act can accomplish anything other than promote a corrupt industry to deal with the corrupt acts.  That is exactly what we have gotten as an industry has developed around the Foreign Corrupt Practices Act.  What is particularly embarrassing is that serious analysts are questioning whether the US government has shifted from promoting honesty in business to using the Foreign Corrupt Practices Act as a method of developing its own corrupt extortion racket.  A more balanced Foreign Corrupt Practices Act might offend some foreign governments, but it would demonstrate good intentions on the part of the US policy.

Tuesday, November 3, 2015

Patriots and Tax Inversions

Governments can be unpatriotic when their self-interest is at stake
This is the second posting that asks the simple question: Are we looking at an issue from the proper perspective?
Is it the patriotic duty of corporations to pay taxes to the US government?  Alternatively, is it the patriotic duty of US government officials to create an environment in which corporations want to operate?  It seems fairly obvious that if the government creates an environment that drives corporations out of the United States it is doing a disservice to its citizens.  It is driving potential revenue sources and jobs out of the country.  The government is supposed to be serving its citizens, including the shareholders and employees of those corporations.  It is not just supposed to be serving its own self-interest at the expense of its citizens.   
By contrast, by law, corporations are supposed to serve their shareholders.  By providing products that consumers want, corporations are supposed to make a profit that justifies the investment. The government of a country can benefit along with its citizens from its unique ability to create an environment that is attractive to corporations.  The US government is failing to create an environment that attracts businesses.  In fact, it is clearly driving them out of the country.
So, how one views the relationship between patriotism and tax inversions depends upon whether one defines patriotism in terms of advancing the well-being of the citizens of the country versus advancing the financial interests of the government.
An Example
For the next couple of days newspapers, editorials and politicians will generate a great deal of chatter about Pfizer's attempt to acquire Allergan.  The WALL STREET JOURNAL broke the story about merger talks between the two companies.  Unfortunately, much of the chatter will focus the tax implications.  The acquisition is large enough to allow the merged company to incorporate under either US or Irish law.
What will be ignored is a fiduciary duty of the Board of Directors of Pfizer to act in the interest of the shareholders and the government's responsibility to enforce that fiduciary duty.   If the merger with Allergan is in the best interests of the shareholders, the US government should fine or remove the Board if they do not execute the merger.  If the merger is not in the best interest of the shareholders, the government has a legitimate role in blocking it.  However, the government has a tremendous profit incentive associated with blocking such a merger and move to Ireland.  Given the government's profit incentive, it is unlikely that the government will enforce the fiduciary responsibilities involved.  So, for the purposes of this blog, let us set aside the issue of an irresponsible government that fails to enforce that fiduciary responsibility.
The back story
Pfizer is not a stranger to controversy surrounding tax inversions.  This is the second attempt to acquire a foreign firm that is large enough to justify moving its headquarters out of the US.  The previous initiative failed.  As an investor, the previous initiative seemed to have no strategic value other than the tax implications.  By contrast, Pfizer's current attempt to acquire Allergan can be justified based upon the difference in the growth profiles of the two companies.  However, like most large mergers, Pfizer will have to overcome the differences in the management cultures and operating practices of the two corporations.  Thus, Pfizer strategy, like all large mergers strategies, is an extremely risky initiative.  The combined tax benefits and business benefits (as perceived by Pfizer's management) require close examination.
One of the benefits of the merger would be that as a foreign company Pfizer will be able to invest in the US on better terms than it can as a US Corporation.  That anomaly arises from Pfizer's desire to use profits from its foreign operations to finance its investments.  Because US companies are taxed on profits earned in foreign countries when those profits are returned to the US, they are given an incentive to reinvest those profits outside US.  No similar disincentive to US investment exists for a foreign corporation.  So, we are left with the question: Is it unpatriotic for Pfizer to try to find the least-cost way to invest in the US, or is it unpatriotic for the government to create a system whereby in order to do that Pfizer has to leave the US?
Pfizer’s Board has a backup plan that responds to its fiduciary responsibility.  Unfortunately, it is less beneficial to the US than the potential merger and inversion.  It is my contention that if this merger fails, Pfizer will break itself up into two or three component corporations.  Each of those corporations will then be small enough to be potential targets for acquisition by foreign firms. Foreign takeovers of U.S. firms, which have the same effect of preventing the government from taxing world-wide earnings, are booming.  Foreign acquisitions of US firms exceed $379 billion so far this year.  That is roughly double the amount of deals in which U.S. companies bought foreign rivals, and it is above any recent year before Treasury acted against inversions.
A misinterpreted, unpatriotic policy folly
There are many politicians who want to double down on a failed policy. The policy will not generate the revenue that self-interested government officials want to collect.  Capital markets are far too global for such a shortsighted policy to work.  Even countries with highly repressive governments like Russia and China have been unable to stop capital flight.  However, such unpatriotic policy failures can, and are, succeeding in moving control of U.S. businesses offshore.  This is neither in the interest of the government nor of the general population, both of which could benefit from having these corporations operating under US laws and generating US jobs and revenue.
It is not just policy wonks and populists that fail to appreciate the issue.  The WALL STREET JOURNAL on October 29 had an article entitled “Taxes Drive Potential Merger of Pfizer, Allergan.”  The article started by stating “Pfizer in early talks to acquire Ireland’s Allergan, thrusting drug maker into rancorous debate over corporate taxes….Pfizer Inc. is pursuing what could be the biggest overseas takeover to lower U.S. corporate tax liability, showing that efforts in Washington to stem such deals have amounted to little.”
The problem with this statement is that Washington's effort to stem the flow of such deals does not amount to little; it is having a major impact.  It is neither the impact that the government wanted nor is it the impact US citizens should desire.  It just makes it more difficult for US corporations to efficiently allocate capital across their global operations.  Further, it does it in a very unpatriotic way by making it more difficult for US firms to figure out how to pursue investments in the US that the company could fund from profits earned overseas.  It thus makes US corporations less competitive globally because of the obstacle it places in the way of their allocating foreign profits to US investments.  Since US corporations do a substantial amount of investing, it also means it is putting the US economy at a disadvantage in terms of accessing the foreign earnings of those corporations.
Ask a different question
At the extreme, one could argue that the US government has forgotten that it governs only as long as it retains the consent of the governed.  The Berlin wall could not contain the East Germans.  Syria cannot retain its citizens.  US citizens residing abroad are renouncing their US citizenship in record numbers, and Mexicans find legal and illegal ways to get into the United States.  Why would the US government be so foolish as to assume that the same does not apply to corporate entities?
If anything, individual citizens are far less mobile than corporations.  Citizens are born in this country, and have family and cultural ties to the country.  By contrast, domestic corporations are just the way to organize capital.  That capital can be easily organized in any country that creates an appropriate operating environment.  Furthermore, those who own the capital can as easily invest in foreign corporations as in US corporations.  If anything, capital is more mobile than people.
Nevertheless, there is benefit to the citizenry of the country and to its government if businesses, including multinational corporations, provide a source of revenue for the government and employment for the citizenry.  Thus, the appropriate question to ask is what steps the government as a patriotic entity should undertake in order to be an attractive place to form a business.  The US government for many decades succeeded in doing that.  However, it currently imposes a fee on multinational corporations that is not justified by the benefits that accrue to a corporation as a result of being a US Corporation.
The rule of law and deep capital markets in the US are definite advantages for corporations.  But, as the rule of law spreads and other capital markets develop, the US will have to rethink how much it can tax corporations for those advantages.  Truly patriotic government officials would realize that tax inversions are a failure on their part.  They are depriving their citizens of employment opportunities and the ability to invest in domestic corporations as well as to feel confident they have made the best use of their capital if they invested in US corporations.
From a policy perspective, the US government should be asking itself what it could do to make corporations want to stay in the US.  It should be asking how I can create an environment that will attract the revenue and employment of major multinational corporations.  Instead it is trying to figure out how to force them to stay in the US.  What could be more unpatriotic than to unnecessarily employ force rather than govern with the consent and in the interest of the governed? 
From the perspective of someone contemplating investing in Pfizer, the question is: will shareholders be better off with the merger with Allergan or should the company be divided so that it can be sold off to foreign investors in pieces?  Given the risks associated with large-scale mergers such as Pfizer is contemplating, it is a legitimate question. 

Tuesday, October 27, 2015

Educational Loans: Dare We Ask Who Benefits from the Subsidy?

Sometimes it pays to ask the right question.

This will be the first of a few postings with the same general theme.  The theme is that often the solution to a problem that policy makers are addressing is totally dependent upon how they couch the question.   


The US will never get the right level of investment in education and a justified public subsidy to post-secondary education until we eliminate the problem of the free rider. When addressing subsidies for post-secondary education policy makers should first compare who benefits from post-secondary educational loans to who bears the risk of those loans.  If they did, they would realize that analyzing who benefits is a prerequisite to addressing the appropriate level of expenditures for education and the appropriate participation of the public sector.  They would also realize that it is clear that the educational establishment should be bearing some of the risk.

Think Out-Of-The-Box

In many instances we seem to have no problem understanding that loan guarantees represent a subsidy.  For example, during the financial crisis much was made of the subsidy to banks from the implicit guarantee involved in too-big-to-fail.  So, analyses of the subsidy implied by loan guarantees are quite common in political and policy debates. Yet, we seem to be totally unable to view student loans in the same light.  But, that's not the worst of it.

We also know that the benefits of loan subsidies do not all flow to only one of the parties involved.   For example, right now the Republican Party is split on the issue of the import-export bank.  Some libertarian-leaning Republicans are offended by the implicit subsidy to large employers and refer to it as corporate welfare.  The import-export bank finances and guarantees that a purchaser’s debt will be paid.  It is the purchaser’s borrowing that is subsidized, but there is little doubt that the manufactures benefits from being able to sell to a purchaser who might not be able to purchase without the subsidy.  It is the benefit to the producer that results from subsidizing the consumer that we totally ignore when it comes to education.

One does not need to go to policy issues to find evidence that producers benefit from making credit readily available to consumers.  We have numerous examples of large corporations making it quite apparent that they believe they received benefit from loans to customers.  We have no problem understanding that an automaker may choose to loan money to the auto purchaser because of the benefits to the auto company.  Similarly, many large corporations make it a normal practice to loan money to their customers.  General Electric's finance division originally started out with that focus and grew into a totally separate product line.  General Electric is not alone in doing it.  Many other companies from industrial firms (e.g., Boeing and Westinghouse) to consumer products companies (e.g., auto manufacturers and now even Apple) have financial operations designed to finance the purchases of their customers.   We seem to be totally incapable of even asking whether to some extent we should be applying the same logic to higher education. 

Focus on the Complete Problem

Right now there are numerous proposals for how to address the growing levels of student debt.  Every candidate has a proposal; some of which are totally absurd.  Others very successfully address the problem as that particular politician sees it.  Unfortunately, most politicians see the issue in terms of the votes they might be able to gather from different proposals.  If the academic institutions or their unions are strong supporters, the politicians have an incentive to overlook the subsidies’ benefit to producers.  But even if the politicians are not suffering from a conflict of interest, they do not bother to think about what the problem is they are trying to solve. 

The issue of how to fund education gets broad coverage.  The coverage often ignores the issue of who is getting the benefit of the subsidy involved in government loan guarantees.  Even BARON’S magazine in a 9/14/2015 editorial chimed in.  Not surprisingly, the editorial advocated a market solution, “Monetizing HigherEducation: Can Investors Replace Government Lenders?”  The editorial, at least, articulates what it sees as the problem which it summarizes as: “…there’s too much easy federal money floating through the education economy to tempt many students.”  However, as close as that comes to addressing the issue, the thrust of the editorial is not aligning the subsidy with the beneficiaries.  Rather, it just focuses on substituting private-sector money for public-sector funding.

There is some merit to trying to make educational funding more dependent upon voluntary actions instead of the forced contributions of taxpayers.  However, as long as there is any logic for subsidizing education, the market cannot solely support educational funding.  It does not take a lot to undo whatever benefit the market might yield.  For example, the Wall Street Journal on 9/24/2015 in an article entitled “Debt Relief for Students Snarls Market for Their Loans,” reports how thoroughly markets can be sabotaged even by efforts that are designed to have a minimum impact.  It reports that even subsidies restricted to need-based repayment schedules have short-circuited the bond market for student loan-backed securities.  One does not need a vivid imagination to realize that a general subsidy for education could result in even more sub-optimal market performance.

What most people addressing the issue failed to distinguish is whether they are concerned about the amount being spent on education versus who is financing the education.  They are two different issues.  

Consider All the Possibilities

With each possibility (i.e., spending too much or spending too little on education) there are possibilities of some individuals spending too much or spending too little.  Consequently, there are four possible scenarios:

First, we could have a situation where not enough is spent on education, yet those paying for it are paying more than is justified.  Put differently, there is a free rider who is benefiting from education but not paying for any of it.  For example, students and/or the public sector may be contributing more to post-secondary education than is justified by the benefits they receive.  At the same time, the total amount spent on post-secondary education may be less than optimal.

Second, we could be not spending enough on education because no one is spending as much as would be justified.  The benefits from education materialize in a different time frame from the cost.  If there is no mechanism for financing that mismatch in time, education may be underfunded regardless of the magnitude of the benefits.  The BARRON'S piece referenced above addressed the issue of this mismatch in timing by proposing an alternative to public-sector financing.

Third, we could be spending too much on education, yet have some of those who benefit from education not paying what would be justified.  This situation would imply that those not benefiting from education are subsidizing those who do.  The third scenario would imply that an elite that benefits from post-secondary education is forcing the general population and students to over spend on education despite a lack of benefits commensurate with the return.

Fourth, we could be spending too much on education because everyone involved is paying more than is justified.  This would imply broad-based irrational behavior on the part of everyone involved in higher education.  While not inconceivable, it is a very unlikely scenario.

Define the Problem

In order to consider which of these possibilities may exist, one has to establish a definition of what is a justified expenditure for education.  It seems reasonable to say an expenditure is justified if it will return benefits as great or greater than the expenditure.  However, at the individual level, the expenditure is justified only if the return is to the individual or institution making the expenditure.  For example, a student’s expenditures should be roughly equivalent to the benefit the student derives from the education.  Therein lies the rub. 

It is generally agreed that education has what economists refer to as externalities.  Translating the jargon, that means that education has benefits for people other than the individual receiving the education.  For example, there are general benefits to having an educated population.  So, clearly a government subsidy is appropriate.  Almost all societies recognize that benefit and strive to provide universal elementary and, in most instances, secondary education.  To some degree, that same argument regarding general benefits applies to college and postgraduate education.  However, much more of the benefit of post-secondary and graduate-level education is captured by the individuals involved in the process.   So, anyone addressing financing a post-secondary and graduate education needs to look closely at who are the principal beneficiaries.

Prioritize the Issues

When one approaches post-secondary and graduate education from the perspective of the potential beneficiaries, it raises two important questions.  First, are the public-sector subsidies (loans, loan guarantees, grants, and budgetary expenditures) appropriate given the amount of general benefit to society?  After all, we all participate in providing the public-sector subsidies. 

The second question is: are all parties who benefit from the subsidies sharing in the cost of the subsidy to an extent appropriate given the benefit they derive?  While the second question may seem like one of the equity, it is much more important than that.  If there are constituencies which derive substantial benefit from public-sector subsidies without experiencing a commensurate amount of the cost, it will always be in the interest of those constituencies to cloud the issue.  They have a strong vested interest in arguing that the public-sector subsidies are not sufficient. 

It is also worth noting that when there is a participant in the educational process who is receiving benefit beyond their contribution to the subsidy, it introduces an inherent contradiction.  If there is a free rider benefiting from the subsidies, then either less will be spent on education than is justified by its benefits (because the free rider is not paying for the benefits received) or the public-sector subsidies will be inflated beyond what is justified by the social benefit of education (because somebody has to pick up the cost that results in the free benefits received by the free rider).   

Thus, it is fruitless to try to address either the level of educational expenditures or the amount of public-sector money that should be dedicated to post-secondary education without first addressing the issue of how the benefits of the subsidies are distributed.  It helps to set aside the equity issue.  Setting aside equity does not mean that one can ignore the issue associated with having someone who barely got through high school and is struggling to make ends meet pay taxes to subsidize a highly paid professors and the graduate education of someone who will likely have a much higher income. Rather the point of avoiding the equity issue is to focus on the fact that getting the subsidy right is a precondition to simultaneously achieving both the right level of subsidy from the public sector and the right level of total expenditures on post-secondary education.

Not All Subsidies Are Created Equal

Subsidies for post-secondary education can be structured in many different ways.  In fact, the government pursues a number of different subsidy strategies.  In terms of understanding the implications of different subsidy strategies, one should differentiate between subsidizing demand versus subsidizing supply.  Ultimately, the form the subsidy takes will determine who receives benefits.  But, to understand the distribution of benefits, one should first analyze the differences in the impact of the two different strategies.

In a competitive market, if one subsidizes supply and production is allowed to increase, it will increase the quantity available and/or reduce the price.  The relative influence on quantity and price depends upon the elasticity of demand for the product.  In other words, it depends upon whether purchases of the good are sensitive to its price.  With a subsidy of supply, the amount produced is the driving variable with price changes being a response to the increased amount produced.  In a post-secondary education market public subsidies are generally done in order to achieve both objectives (i.e., increase the availability and lower the price of post-secondary education). 

The ability of the educational establishment to constrain supply is the only limitation on the ability of supply subsidies to both increase the amount of education while reducing its price.  Thus, supply subsidies have to be structured in ways that avoid promoting supply constraining institutions.  Accreditors or College Certification Boards, unions, grants based upon inappropriate criteria (e.g., research activities, faculty qualifications, student/faculty ratios) need to be carefully examined, and subsidies should be structured to avoid encouraging them.  In fact, as an alternative to increasing subsidies to education, public policy directed at eliminating supply constraints created by the educational establishment should be considered.

By contrast, if one subsidizes demand in a competitive market, the increased demand will drive up prices and, depending upon the responsiveness of supply, increase production.  Since increasing the price of post-secondary education is seldom considered a worthy objective by anyone other than the educational establishment, government subsidies should focus on increasing the supply.  This is a marked contrast from the US emphasis on student loans as a solution to the increased cost of higher education.  The problem is that politicians cannot resist the ability to control who they make post-secondary education available to.  The very fact that control is so prized by politicians is an indicator that deficiencies in demand are not a problem.  By subsidizing additional demand they just ensure that the demand will outstrip supply and increase prices.

The Role of Educational Loans

Given the differences in the impact of subsidizing supply versus subsidizing demand, it would seem appropriate for the government to significantly scale back its subsidies to higher education that take the form of student loans.  At the same time, it is clear that there is a need for a mechanism to finance the difference between when the costs of higher education are incurred and when the benefits are received.  It is not automatically apparent that the public needs to be directly involved in that financial transaction.  It would seem far more appropriate for institutions of higher it learning to assume some responsibility for financing the demand for their product. 

A public-sector subsidy is still appropriate to the degree that education benefits the general public to a greater extent than would be financed by the private sector.   If supply subsidies are judged inadequate, the public-sector subsidy could take the form of loans to the institutions of higher learning.  Those loans could be commensurate with the amount the institution of higher learning loans to students.  This approach would meet the financing requirements.  It would also allow the students to assume responsibility for costs that will result in future benefits they will receive. 

At the same time, it would leave responsibility for loss on the loans with the institutions that derive substantial benefit from having demand subsidized.  If the post-secondary education does not result in enough benefit to enable the student to pay back the loan, the institution that provided the education should accept responsibility for its failure.

There might be a concern that some colleges would choose not to participate in the program (i.e., some colleges may choose not to borrow the money).  But all government subsidies designed to increase the supply of education could be made contingent upon participation in the loan program.  It can also be made a requirement for certification from the accrediting organizations and College Certification Board.  Student loans have a role in making post-secondary education available to those who might otherwise not be able to afford it.  For that reason alone, the public sector would be justified in denying any subsidies to institutions that did not participate in the program.

It is worth noting in passing that there is no reason why the government would have to require that student loans from the institution exactly match what they borrow.  A condition of the loan to the institution could be that half of it be used for student loans or could equally feasibly be that two dollars in student loans are required for each dollar of borrowing.  Starting out with the match would seem reasonable, but over time one would expect that the ratio could be fine-tuned.  The very process of fine-tuning would be a way to address the need to simultaneously fund adequate post-secondary education and match the public-sector expenditure to the benefit that the general public derives.  It should be noted that this approach could be tried by any state that has student loan programs. 

The Urgency

This it is not a problem that can be ignored.  First, as is widely reported, there is intense pressure on political candidates to make all sorts of unreasonable promises regarding how they will address the student loan problem.  Not surprisingly, as good candidates, they are making such promises.  The danger is they may try to fulfill those promises.  That politicians want to address the student loan problem would be good if their proposals reflected a thorough understanding of what the problem is, but that is hardly the case.  Their approach seems to be, when something is not working spend more on it. Wall Street Journal investigation that found that in a single year the government sent $16 billion in aid to students at four-year colleges that graduated less than one-third of their students within six years.  The basic structure of student loans needs to be rethought.

Second, as noted in an opinion piece in the Wall Street Journal entitled “Washington’s Revenue Windfall” (8/18/2015), “The Congressional Budget Office … cites a $30 billion, or 51%, spending increase for the Department of Education—‘mostly because of an $18 billion upward revision in the estimated net subsidy costs of student loans and loan guarantees issued in past years.’  The opinion piece’s conclusion is that the government’s “takeover of the student-loan business is costing far more money than advertised, probably due to growing defaults.”  Clearly, there is a budget issue and the risk that the cost of student loans will crowd out other worthy expenditures.

Third, the government is accumulating a huge potential liability that could become a mandated future expenditure. As has been reported in the Wall Street Journal for example in “Duncan Puts Pressure on Colleges” (10/21/2015), “…as student debt has climbed to $1.2 trillion, but graduation rates remain not much better than a “coin toss,” Mr. Duncan has said.  Mr. Duncan is the Education Secretary.  The concern is not the rant of an outsider seeking to undermine education.

Fourth, the misplaced incentives created by the current system are widely recognized.  For example, Mr. Duncan in the article cited above states: “government, at both the federal and state level, along with accreditors and Congress, need to flip the current incentives in higher education,” Mr. Duncan said. “In the current system, only students, their families and taxpayers lose when students do not succeed. That simply doesn’t make sense.”  Currently, about one in every five student loans is in default.  Students, families and taxpayers are being asked to bear burden of debt beyond their financial capabilities.

Finally, and most importantly, the ability of the US to compete in a global market will depend upon it being able to generate an educated, productive labor force.  That can only be done if all participants in the process are contributing appropriately to the success.  It seems to an outsider that the only impediment to achieving that objective is a vested interest of the current free riders benefiting from the subsidies the public-sector must supply to the post-secondary educational industry.  So, it is time for the educational establishment to step up to the plate and recognize that they have to take some responsibility for the value of their product if they expect public-sector subsidies to continue.  Having post-secondary educational institutions accept the risk associated with the return on the investment in post-secondary education would be a good start.

Saturday, October 17, 2015

Getting History Right

Lumping the stimulus and bailouts together is a mistake

In “Don’t Look Back in Anger at Bailouts and Stimulus” (WALL STREET JOURNAL, Opinion, Oct. 15, 2015) Alan S. Blinder and Mark Zandi provide a valuable service by trying to sort out fact from fiction surrounding steps taken during the financial crisis.  They are undoubtedly correct in their subtitling of their opinion piece: “Without the emergency measures of 2008-09, the U.S. economy would be far worse off today.”  However, they do a disservice by lumping together monetary policy initiatives and fiscal policy initiatives and not separating them from initiatives directed at financial stability.

It pays to look at each separately.  Part of the authors’ motive for writing the opinion piece is the difference between the public's perception of the initiatives versus the actual impact of the initiatives.  Given that focus, it seems reasonable to start with the initiatives directed toward financial stability since they seem to be the subject of the most marked misinterpretation.

If one were to pick a poster child for misinterpretation, it would be TARP.  As such, it can be representative of the initiatives to promote financial stability.  It is worth noting, however, that TARP was only one of many programs directed toward financial markets.  They range from other asset purchase programs to extension of FDIC insurance to non-bank liabilities such as money market funds.

All of them had as their guiding principle Bagehot’s dictum regarding the appropriate central bank posture during a financial panic.   The dictum is often summarized as lend freely at a high rate of interest on good banking securities.  Following the dictum is essential to the central bank’s roll as lender of last resort.  Those who object to the Federal Reserve's role as a lender of last resort would benefit from a fuller understanding of the context in which the dictum was developed.  The dictum was designed to provide guidance for ending a financial panic, but quoting it just in that context without noting the full statement is a disservice.  A more accurate characterization would add “and you are sure to make money.”  One should keep in mind that when Bagehot wrote LOMBARD STREET: A DESCRIPTION OF THE MONEY MARKET (1873) he was addressing the operation of the Bank of England which was a profit-making institution.  The advice was not designed to bailout anyone: it was designed to end panics and make money in the process.

Consequently, as early as October 2, 2010 it was possible to write a posting for The Hedged Economist entitled “TARP: A ,success not being acknowledged.”  That posting could cite data that made clear that efforts to ensure financial stability were far from a bailout.  Clearly, they were going to make money for the US government's Treasury.  Those who stick with the bailout terminology are clearly under the false impression that loans, regardless of the terms, represent a subsidy of some sort.  Lending money to individuals or organizations who can provide collateral and pay it back with interest is simply good business, not a subsidy.

Separating out monetary policy also clarifies who is receiving benefits.  Lumping zero interest rates and quantitative easing in with the TARP loans is absurd.  The principal beneficiaries of zero interest rates and the lower long-term interest rates generated by quantitative easing can legitimately be described as having been bailed out.  They have been bailed out in the sense that they are the beneficiaries of zero interest rates. 

Financial institutions are hardly the major beneficiaries of zero interest rates.  After all, the regulations under which they operate guarantee that they will hold a substantial amount of the low-interest government debt.  The WALL STREET JOURNAL on 10/15/2015 in an article entitled “$1.17 Trillion at Zero Percent Interest” pointed out: “Investors are handing the federal government a lot of free money.”  If anyone is being bailed out by zero interest rates, it is the federal government.  The near zero interest rates give the federal government the option to borrow the money that they lent to financial institutions at a profit.  Granted, the government could just as well have printed the money, but zero interest rates gave them an additional option.

It would be very easy to lose sight of the macroeconomic role of monetary policy by pursuing a totally useless witch hunt for who benefited from zero interest rates.  It is worth noting, however, that it is widely recognized that the macroeconomic benefits of expansionary monetary policy are often purchased at the expense of the banking industry.  The banking industry's current net interest margins strongly reinforce the impression that the benefits of expansionary monetary policy occur despite their negative impact on the banking industry.

Lumping the financial and monetary policy initiatives in with the fiscal policy effort is even more unfortunate.  The fiscal policy initiatives that spanned two administrations constitute a mixed bag even when taken alone.  The Hedged Economist spent all of September 2010 on postings addressing fiscal policy.  At the time, it was appropriate to refer to them as a failure.  But, they were a failure in terms of their own definitions of success.  They were not a failure in the sense of having no merit.

Alan S. Blinder and Mark Zandi provided one of the better analyses of the potential impact of the fiscal policy efforts.  At that point, their analysis was projecting what they felt the impact of the fiscal initiatives would be. Their analysis was the subject of postings on the Hedged Economist on 9/15 and 9/28/2010.  The postings explained reasons to believe that they were overestimating the impact.

At the time it seemed they were overestimating the potential impact.  The reason for feeling that was the case is summarized by the quote below, especially the portion of the quote highlighted in bold type:

“My concern is that the public will judge the effectiveness of fiscal stimulus by the Recovery Act. Stimulus started with Bush's approximately 200 B tax rebates to middle and lower income tax payers. But, the total over the two administrations is going to come in being well over a trillion dollars, probably in excess of $10,000 per household. Some partisans will also stick in any deficit and come up with multiple trillions….From my perspective, the issue is whether the multiplier stays linear as the size of the stimulus grows.

If the quote seems questionable, consider this: the opinion piece makes a comment that “But it was no coincidence that the Great Recession ended in June 2009, just four months after the Recovery Act’s nearly $800 billion-plus stimulus package was passed.”  It is clearly falling into the trap of assessing the fiscal measures as if the Recovery Act was the only fiscal initiative.  Further, while it contends that it is “no coincidence” that the recession ended four months after the Recovery Act, it fails to explain how the Recovery Act could produce that result before it had been implemented.

One does not have to disagree with their belief that fiscal stimulus contributed to the recovery.  Even if one agrees, as I do, that the beneficial impacts of fiscal policy are real, it is clear that demonstrating that relationship is far more complicated and subtle than recognizing the success of financial and monetary policy.  Further, the cost benefits analysis of fiscal stimulus is different from an acknowledgment that there were some benefits. 

Consequently, it would benefit Alan S. Blinder and Mark Zandi’s efforts to ensure that history gets this right, if they would focus on the most obvious successes.  That is especially true given that the most obvious success is the financial stabilization effort, and it is also the one most frequently mischaracterized as a bailout.  Fiscal stimulus has a natural constituency among liberals.  Monetary policy similarly has a constituency among monetarists.  But the only constituency for the financial stabilization efforts is the facts.