Asymptosis

The remarkable discussion on “national wealth” and the national accounts that is running over at Interfluidity (373 comments and counting…) in response to my last post prompts me to recount an anecdote that I think is germane.

I took exactly one accounting class in my life, at the NYU MBA school — essentially Accounting for Non-Accountants, teaching us to deconstruct corporate financial statements into cash flow.

There were two profs. (I don’t remember their names.) The lead was an old hand, a long-time member of the Financial Accounting Standards Board (FASB), and a real comedian. The young guy was the straight man and enforcer — assignments, testing, and nuts-and-bolts lectures.

The beginning of the very first lecture, given by the old guy, has stuck with me ever since. He started with an anecdote. (Here recounted from distant memory.)

When I was an undergrad (he said), I hung out with these economics types. I was thinking of buying a new car. They told me, “don’t do that! As soon as you drive it off the lot it’ll lose a third of its value!”

But anyway, I went ahead and did it. I went through all the paperwork with the salesman, signed on the dotted line, and he handed me the keys. “Here you go,” he said. “Drive it away.”

I looked at him like he was crazy. “I’m not gonna drive it away,” I said. “It’ll lose a third of its value!”

Ba dum ba.

Then he explained why he used that anecdote right up front, framing the whole (rather grueling) semester-long exercise to come: Accounting, he said, is an exercise in assigning value to things that are often (mostly?) deucedly difficult to e-value-ate. Whether it’s the value of that car (before and after it leaves the lot), or the “wealth of nations,” accounting is inherently a problematic exercise in estimation. We just do the best we can.

Based on a decade or so of wrestling with the national accounts, I’d extend that thinking further. Sure, estimating value can be very iffy, but that estimation is also, always, a function of the accounting constructs and architecture used to do that estimation. Simply put, the national accounts are an economic model of the national economy. The map is not the territory. The presentation is inevitably stylized, like a Mercatus or Peters projection — and the choice of presentation has similarly important rhetorical and political implications.

The implication: as with any economic model, to understand what you’re seeing, you need to look not only at the results presented within the model, but at the model itself. You need to (at least) consider not just potential errors within a model, but model error itself. To get very philosophical: National account structures are, ultimately, epistemological structures — systems for trying to “know” things.

The national accounts, by their very status and position, discourage examination of their model. The notion that they’re “just accounting,” adding and subtracting straightforward measures, reifies them, and the model they present. The assumptions underlying that model are rendered invisible, apotheosized as god-given truths.

National-accounting sages are very much aware of this reality. Check out Jorgenson, Hulten, Hall, etc. on the “zero-rent” economic model that lies (hidden) at the core of the national accounts as constructed. (They mostly argue: appropriately so.) Or spend some time in that Interfluidity comments thread. If you haven’t thought critically and carefully about the national accounts’ economic model, you don’t understand the national accounts. (I’m not, by the way, claiming that I do. Despite lengthy exertions. Necessary versus sufficient and all that.)

That old-hand FASBer imparted, I think, a profoundly important truth. I’ve been struggling with its implications ever since.

To put across exactly how important and profound that truth is, I’ll end by passing the baton to John Maynard Keynes in his essay on “National Self-Sufficiency”:

Once we allow ourselves to be disobedient to the test of an accountant’s profit, we have begun to change our civilization.

I only got a B+ in the course, by the way.

Modern Monetary Theory has been revolutionary in economics, and its influence is — beneficially — ever-more pervasive. It has opened the eyes of a generation to a clear-eyed, accounting-based methodology that trumps dimensionless theory, and has brought a deep, nuts-and-bolts understanding of money, debt, and financial institutions to a discipline where that understanding has been inexcusably absent. Witness: a whole raft of papers from central-bank economists worldwide embracing MMT principles (though often not MMT by name), and eviscerating decades or centuries of facile and false explanations of monetary mechanisms.

But MMT’s terminology and associated accounting constructs remain problematic and contentious, even among some MMT supporters like the splinter group, the Modern Monetary Realists. Some of this contention results from the usual resistance to new ideas and ways of thinking. But some arises, in my opinion, because MMT terms and accounting constructs are indeed problematic. (The terminological confusion even causes some to object correctly, but for the wrong reasons — and vice versa!)

These difficulties are apparent when you consider one of MMT’s central and oft-repeated mantras and accounting identities, here in its simplified form for a closed economy ignoring Rest of World, courtesy of the redoubtable Stephanie Kelton:

Domestic Private Surplus = Government Deficit

This suggests an important truth, as far as it goes: public (monetarily sovereign federal government) deficit spending creates private assets out of thin air. The government spends new money, created ab nihilo, into private accounts. +Private Assets. No change to private liabilities. So: +Private Sector Net Worth.

But it doesn’t actually go very far. That “private surplus” (a term that is absent from the national accounts, and from MMT’s ur-text, Monetary Economics by Godley and Lavoie) is not defined in accounting terms, except circularly and tautologically: it’s the amount that private assets increase as a result of government deficit spending. That makes the identity true by definitional tautology.

But contrary to what’s at least implied by the equal sign, deficit spending is not the only way that private assets increase, or even the primary way. It’s not the only source of private-sector “surplus” or “saving,” as is often suggested in MMT discourse. Not even close.

Start by thinking in terms of Household Net Worth. This measure has the virtue of encapsulating and telescoping all private-sector net worth, because households ultimately own firms, at zero or more removes, but firms don’t own households (yet…). Citibank may own some GE shares, but Citibank is ultimately owned by households. Because: firms issue equity shares; households don’t. It’s an asymmetric, one-way ownership relationship.

Then take a look at this paragraph from MMTers extraordinaire Eric Tymoigne and Randall Wray:

MMT does differentiate between saving (in the flow of funds it is the change in net worth: ΔNW) and net saving (saving less investment). Net saving shows how the accumulation of net worth occurs beyond the accumulation of real assets. For the domestic private sector, this comes from a net accumulation of financial claims against the government and foreign sectors.

Some of the problems with this paragraph:

• Pace T&W, there is no “saving” measure in the Fed’s flow of funds accounts (FOFAs) that equals ΔNW — whether you’re talking net or gross saving (with or without consumption of fixed capital), including or excluding capital transfers.

• The “net saving (saving less investment)” bruited in that paragraph is confusingly at odds with the existing definition of the term as used in the national accounts — gross saving minus consumption of fixed capital.

• “Net accumulation of financial claims” does not appear anywhere in the national accounts, and has an uncertain relationship with a measure that the FOFAs do provide: “Net acquisition of financial assets.” Are these the same measures? If not, what is their accounting relationship?

I find here a set of terms that I’m unable to resolve into a coherent set of accounting statements — despite years of diligent and highly motivated efforts to do so. (I’m an ardent MMT supporter; I wouldn’t be thinking these thoughts if it weren’t for the MMT cabal.)

The core problem is these measures’ opaque relationship to net worth, and change in net worth. The problem exists because they don’t incorporate the primary way that net worth (wealth) is accrued: market revaluation of existing assets, a.k.a. capital gains. Market runups increase private-sector assets, without increasing liabilities. Voila: higher private-sector net worth. “Money” created, ab nihilo.

MMTers seem to have these conceptual, terminological problems for the same reason as more traditional economists (and due to MMTer’s efforts at speaking in those economists’ language): they’re still “thinking inside the NIPAs” — despite MMTers well-founded devotion to the FOFAs.

The BEA’s National Income and Product Accounts, pioneered by Simon Kuznets in the 1930s, are essentially income statements. They are one of the primary data sources for the FOFAs. But the NIPAs have a key failing: they don’t include balance sheets (the essential second component of a coherent accounting, which the FOFAs add). And the NIPAs completely ignore (with good reason) existing-asset exchanges and revaluations.

Absent balance sheets, and accounting for existing-asset revaluation, it’s impossible for balance sheets — and net worth, period to period — to…balance. Economists who don’t deeply understand that — and I will assert that few economists do, because they’re conceptually trapped inside the NIPA’s balance-sheet-free definitions of income and saving — cannot form a coherent understanding of an economy’s workings.

In Monetary Economics, Godley and Lavoie (G&L) do show a deep understanding of revaluation’s importance — they give extensive coverage to the Haig-Simons accrual-based mark-to-market accounting approach that I also favor. But you’ll be hard-pressed to search Google for top MMT names (Wray, Tymoigne, Kelton, Fullwiler) and find asset revaluation, capital gains, or Haig-Simons accounting incorporated into their discussions of income or saving.

This even though the FOFAs (presented in the Fed’s Z.1 reports) provide exactly that: balance sheets and income statements based on Haig-Simons  accounting — using accrual-based, marked-to-market revaluation of existing assets — wherein the sum of accounted flows totals to balance sheets’ period-to-period net worth changes. See for instance the Household tables B.101 (bottom line: net worth) and R.101 (top line: change in net worth).

Those FOFA tables are the source of the Integrated Macroeconomic Accounts for the United States (IMAs), which unlike the NIPAs, conform (mostly) to the international System of National Accounts (SNAs). See for instance Household table S.3.a, which includes the income statement and balance sheet on a single page (bottom line: net worth).

You will find a similar Haig-Simons approach in Armour, Burkhauser, and Larrimore 2013, an analysis that merits significantly more attention, and replication. (The authors, inexcusably, have not made their data set available.) The FOFAs and IMAs provide the necessary revaluation estimates for such a replication, estimates which Armour et. al. achieve by their own methods (somewhat different from the Fed’s, but using similar indices).

This is all important because the widespread MMT statement (at least implied, and frequently explicit) — that government deficits are the source of private saving (or “surplus”) — is at least a poor explanation of economic workings, and at worst just wrong. Government deficits are a source of private saving.

The two primary sources of private assets (hence saving) are:

1. Surplus from production (how “surplus” is commonly used in the national accounts), monetized by the markets for newly produced goods and services.
2. Revaluation of existing assets — assets produced in previous periods — realized in the existing-asset markets.

I would even go so far as to say that these are the primary mechanisms whereby “money” is created. Deficit spending is small beer compared to cap gains. Asset markets go up, and there’s more money. This eschews the widespread confution of money with “currency-like things,” suggesting rather that all assets — which since they exist on balance sheets are necessarily designated in a unit of account — embody “money.”

As an aid to untangling the confusion that I still find inherent in MMT discourse, I offer up the following taxonomy of sources for household income. It’s explained in detail here.

Household Income Sources
Comprehensive Income (gross contributions to net worth, before netting out expenditures)	Non-Property Income (compensation for labor)	Other Labor Income	Social benefits and other transfers received (including employers’ social contributions)
		Primary Income	Primary Labor Income: Wages and salaries
	Comprehensive Property Income (compensation for ownership)		Primary Property Income: Dividends, interest, proprietors’ income, rental income, and operating surplus
		Other Property Income	Market asset revaluation (capital gains)
			Other changes in asset volume

Here’s what that looks like in an accounting statement, here using IMA data:

Before you raise objections, I point you again to further explanation of this construct, here.

Like Armour et. al., I use a measure labeled “Comprehensive Income” that includes accrued, marked-to-market capital gains. I go a step further, however, and propose another measure based on that, a residual of sources and uses: “Comprehensive Saving.” That measure has a singular virtue: it equals change in net worth.

“Primary income” — the vestige of the NIPA’s “income” measure that is carried over into the FOFAs and IMAs (but properly labeled as “Balance of primary incomes”) — is given as an addendum measure. The measure here varies from the FOFAs/IMAs only in that interest paid is not deducted from income; it’s tallied under Uses.

Comprehensive Saving does not, of course, equal government deficit spending. (Nor does Primary Saving.) Such spending contributes to private-sector saving, but it’s not even vaguely identical.

Before concluding, I’d like to touch on private-sector bank lending. (Modern Monetary Realists, are you listening?) Its direct effect on net worth is zero. It creates new assets — bank deposits. But unlike government deficit spending, it also creates equal and opposite offsetting liabilities on both the borrower’s and the bank’s balance sheets. Both balance sheets expand, equally on the left and right sides.

Borrower: +Assets (new bank account deposits)  +Liabilities (new loan payable)

Bank: +Assets (loan receivable)  +Liabilities (customer deposits withdrawable)

So the act of private lending itself creates new assets, but it doesn’t directly, in accounting terms, increase private-sector net worth.

But: borrowers use many of those loans to create real assets — goods, capital — that are then sold at a higher value (or marked to market at a higher value). That markup increases private sector net worth, and private lending is a huge catalyst for that process. But that is an economic effect, not an accounting identity.

So yes: private bank loans create new private-sector assets, and they have the indirect economic effect of increasing net worth, but they don’t, directly and in and of themselves, increase private-sector net worth. Government deficit spending does. MMTers are right that it’s special in that way.

What they’ve missed — or caused many of their followers to miss — is that it’s not the only thing that’s special in that way.

Really, it’s not even close:

Runups in stock and real-estate markets create new wealth, net worth, “savings,” money, out of thin air — just like deficit spending, but by a different mechanism.

The markets create money too.

Cross-posted at Angry Bear.

In my last post I pointed out that over the last half century, every time the year-over-year change in Real Household Net Worth went negative (real household wealth decreased), a recession had either started, or was about to.  (One bare exception: a tiny decline in Q4 2011, which looks rather like turbulence following The Big Whatever.) Throughout, click for source.

The problem: we don’t see this quarterly number until three+ months after the end of a quarter, when the Fed releases its Z.1 report for the the preceding quarter. The Q2 2015 report is due September 18.

But right now we might be able to roughly predict what we’re going to see four+ months from now, in the report on our current quarter, Q3, which ends September 30. We’re a bit over a month from the end the quarter, and we have some numbers to hand.

The U.S. equity markets are down roughly 7% year-over-year (click for source):

Total U.S. equities market cap one year ago was about $20 trillion:

So a 7% equity decline translates to a $1.4-trillion hit to total market cap, which goes straight to the lefthand (asset) side of household balance sheets, because households ultimately own all corporate equity — firms issue equity, and households own it (at one or more removes); people don’t issue equity in themselves, and firms don’t own people (at least not yet). It’s an asymmetrical, one-way ownership relationship. (Note: yes, the Fed accounts for household net worth on a mark-to-market basis.)

Total household net worth a year ago was $82 trillion. The $1.4 trillion equity decline translates to a 1.7% decline in household net worth.

Meanwhile household liabilities over the last four quarters have been growing at a fairly steady rate just above 0.2% per year. There’s no reason to expect a big difference in Q3.

This suggests a 1.9% decline in household net worth over the last year, based on the equity markets alone. (My gentle readers are encouraged to add numbers for real estate and fixed-income assets.) Add (subtract) 1.5% in inflation over that period, and you’re looking at something like 3.4% decline in real household net worth, year over year.

Unless the stock market rallies by 10% or 15% before the end of September ($2–3 trillion, or 2.5–3.5% of $80 trillion net worth), it’s likely we’ll see a negative print for year-over-year change in real household net worth when the Fed releases its Z.1 in early December of this year. And we know what that means — or at least we know what it’s meant over the last half century.

You heard it here first…

Cross-posted at Angry Bear.

 

 

I have a new post up that has implications for stock-market investment, so I decided to try posting it over at Seeking Alpha, where they’re paying me a few tens of dollars for the post (plus more based on page views — not much luck so far).

The post argues that year-over-year change in Real Household Net Worth has been a great predictor of NBER-designated recessions over the last half century. (It’s either 7 for 7, or 8 for 7, over 50+ years, depending on the threshold you use.) If you were following this measure, you would have gotten out of the market on March 6, 2008, avoiding a 50% drawdown over the next twelve months.

But the post goes farther, offering a somewhat monetarist economic explanation but using total household net worth as the measure of the “money stock.” Short story: if households have less (more) money, they spend less (more). Not exactly a radical behavioral economic assertion.

If you’re wondering how recent days’ market events have caused billions (trillions?) of dollars to “disappear,” and are pondering how to think about that, you might find it an interesting read.

Cross-posted at Angry Bear.

Imagine you had to choose, and could choose: you can spend your whole life and raise your family in either of two equally prosperous countries. In one country people work lots of hours to attain that prosperity. In the other country people work far less. You don’t know anything else about these countries.

Which would you choose? The answer seems kind of obvious, right? Equally prosperous, and less work for me and my family? Sign me up!

But that straightforward question is almost never asked, explicitly, in discussions of prosperity, growth, and national well-being. The most obvious measure of that difference — hours worked per capita — is buried, invisible, and unavailable in the various national data sets scattered around the web. (The typical national measure you see out there is hours worked per worker.)

For the curious, here’s how more-prosperous countries (OECD and a handful of others) sort on the “hard-working” scale:

This average includes the whole population — workers, children, students, retirees, etc. — so it’s an index of how much the average person has to work over the course of their life. (More hours during working years, less or none during non-working years; it’s an average.) 

There’s one main generalized takeaway from this that I see: The less-work end of the spectrum is dominated by western European countries. People there work far less hours in the course of their lives. People in “Anglo”-model countries work far more.

Going back to choosing a country: you also want to know how prosperous it is in pure money terms, using something like GDP per capita. Here’s that (I’ve excluded tiny, crazy-high-GDP Luxembourg here — think: banking — to show other countries more clearly):

If you’re a rational shopper, you’ll choose Norway (yeah, they’ve got the advantage of all that oil…), Ireland, the Netherlands, or another country in the upper left. If an extra $5,000 or $10,000 a year is worth sacrificing four or five extra weeks of work, choose the U.S. (Think: “buying” an extra month of time with your family, doing things you like and love, every year. You decide. But do I need to remind you that 1. Life is short, and 2. “Family values” really do have value?)

One perhaps-surprising takeaway from this graph: hard-working countries aren’t richer. QTC. Causation? It seems improbable that working less would cause higher prosperity. Higher prosperity could quite reasonably cause people to work less. (The good old substitution effect, income versus leisure.) But the most likely conclusion is that high productivity (GDP per hour worked) is the 800-pound gorilla when it comes to prosperity. Long hours worked have zero or negative apparent effect on prosperity.

(Interesting parallel: hours worked per household member in the U.S. only “explain” seven percent of the variance between household incomes. Whodathunkit?)

Rather than eyeballing that scatter plot, you might want a handy index of which country to choose. Here’s one approach to what I’ll call Work-Weighted Prosperity: GDP/Capita divided by Hours Worked/Capita. If people in one country have to work lots of hours to get that prosperity, it gets ranked lower.

The takeaway here? Move to Luxembourg and get into banking.

The curious among you are probably wondering about different countries’ working-age populations (doesn’t actually vary that much), and the percentage of working age that are working (varies somewhat more). Here’s the spreadsheet.

Cross-posted at Angry Bear.

In his dissent to Edwards v. Aguillard, Supreme Court justice Antonin Scalia made a neat distinction, sidestepping the issue of “legislative intent” that he finds so troubling:

it is possible to discern the objective “purpose” of a statute (i. e., the public good at which its provisions appear to be directed),

(The dissent is obsessed with “purpose”; the word appears 76 times therein.)

But in his dissent on yesterday’s King v. Burwell (Obamacare) decision, he chooses to ignore that statute’s obvious, objective purpose: to provide subsidies for buyers of exchange plans.

Rather than doing as he proposes, trying to “discern the objective ‘purpose’ of a statute'”, he seeks to deny the statute’s obvious purpose by determining the “purpose” of a few words therein — with a statement that can only be perceived as intentionally obtuse:

it is hard to come up with a reason to include the words “by the State” other than the purpose of limiting credits to state Exchanges

This very smart man could easily “come up with a reason.” Since those words contradict the obvious, objective purpose displayed by everything else in the statute, the words were accidentally misphrased. You might even go so far as to say that this is the obvious, “objective” conclusion.

Scalia would agree. In his dissent on the previous Obamacare challenge, he says:

“Without the federal subsidies . . . the exchanges would not operate as Congress intended.”

You may feel free to quibble over “purpose” versus “intention,” but the obvious, objective, intentional purpose of the statue was to give subsidies to purchasers of exchange plans.

Any attempt to deny or obscure that reality is pettifogging pedantry. Nothing more.

Update: Bruce Webb in comments shows just how objectively obvious the “purpose” is. The title of the statute’s opening section (emphasis mine):

Title I. Quality, Affordable Health Care for All Americans

Cross-posted at Angry Bear.

The meme is ubiquitous, and widely documented: Rich people work longer hours. Obvious implication: they deserve what they get, right? Ditto the poor.

Bunk.

Why? All the research supporting that meme looks at workers, not families. It completely ignores students, the retired, and anyone else who isn’t working. Alert the media: workers work and earn more than non-workers.

And, news flash: rich families are full of non-workers. If you look at families and their hours worked per person, you see a very different picture:

Here’s the same 3+ household data for working-age families only: those with a head of household under age 65.

Pretty much the same story.

This is all based on a fast-and-dirty random census pull of about 5,000 U. S. households, from IPUMS. It uses 3+ households as a proxy for families — probably not a bad proxy. A professional economist doing proper due diligence would fine-tune that, or even better turn to the Panel Study of Income Dynamics (PSID), which has better microdata to track families. Careful work would even allow them to track extended, multi-generation families, not just nuclear families living together. (Think: dynasties.) I’d expect the pattern we see here to be more pronounced in that view (though that’s just a surmise).

Here’s some more evidence, from across the pond:

Figure 1: Average hours of work across the distribution of earnings: UK, 2013

Figure 2: Changes in post-tax real hourly earnings and average hours for the median and top 1 per cent

Even as rich people’s incentives to work have skyrocketed, their hours worked have plummeted. This even though they’re far more likely to be doing interesting, engaging work in pleasant environments. Curious.

But still: low-income people work less. More of them are unemployed. Is that a surprise to anyone? (I’ll leave the “voluntary” argument to my gentle readers.)

There’s a stylized fact out there, universally repeated by economists and pundits, that seems to misrepresent the state of the world. There are some nice tractable research projects here for those who are paid to do such things.

Cross-posted at Angry Bear.

The OECD has posted this measure for most countries for 2013, so I thought I’d update this chart. It pretty much speaks for itself.

Cross-posted at Angry Bear.

The story hardly bears repeating:

Pricing is the ultimate miracle of Darwinian markets. Competitors who produce goods at lower prices thrive, expand their operations, and produce more. Those who charge higher prices (for equivalent goods) are driven to extinction when sensible purchasers abandon them for their more-efficient competitors. This inexorable mechanism drives innovation, investment, and productivity, and the eternal grinding evolutionary churn of “creative destruction.” Survival of the fittest makes us collectively fitter, and fills our wants and needs at ever-lower prices.

All of that, or course, requires price competition among producers. The ultimate bogeyman, choking that mechanism, is competitors colluding to fix their prices. If they agree not to compete with lower prices — collectively stealing higher profits from their customers — the pricing mechanism doesn’t exist, and its manifest benefits are denied us.

It’s a compelling and convincing story. But: The key word in that second paragraph is “agree.” It’s illegal, of course, for competing firms to explicitly collude to set higher prices. But price collusion occurs constantly at higher, institutional levels, where it is unstated, implicit…and profoundly pernicious.

The Economist highlights this reality in its recent package on family companies. We’re not talking mom-and-pop shops: this is about vast networks of corporations controlled and owned by small groups of families — especially common in Asia (South Korea!), but also in Europe. The small control groups at the top of these pyramids have every incentive to back off on price competition among their subsidiaries, reaping higher profits at the expense of their customers. And they have the wherewithal to do it:

Randall Morck, the academic, finds that in large parts of the world pyramidal business groups allow “mere handfuls of wealthy families” to control entire economies.

A stylized diagram depicts the rather obvious mechanism for this control and collusion:

With all competitors controlled, ultimately, by a handful of actors, price collusion seems inevitable.

Interestingly, The Economist continues:

This problem is particularly marked in developing countries, but is also common in much of the rich world, except in the Anglo-Saxon sphere.

In America, we do things differently. In a recent Slate article, Eric Posner and E. Glen Weyl explain our innovative, fiendishly clever, and truly “exceptional” mechanism for pyramid control:

Mutual Funds’ Dark Side: Why airlines and other industries keep prices too high

They cite a paper by José Azar showing that:

United’s top five shareholders—all institutional investors—own 49.5 percent of the firm. Most of United’s largest shareholders also are the largest shareholders of Southwest, Delta, and other airlines. The authors show that airline prices are 3 percent to 11 percent higher than they would be if common ownership did not exist. That is money that goes from the pockets of consumers to the pockets of investors.

We’ve all watched this airline-pricing scenario play out over recent months, with fuel costs plummeting while airfares remain unchanged.

More:

The investment management company BlackRock is the top shareholder of the three largest banks in the United States; BlackRock is also the largest shareholder of Apple and Microsoft. The companies that are the top five shareholders of CVS are also the top five shareholders of Walgreens. (And yes, one of them is BlackRock.) Institutional investors dominate the economy.

If you’re like me, you’re immediately wondering: Really, how does the price-fixing actually happen? The answer isn’t terribly surprising, or far to find (emphasis mine):

How exactly might this work? It may be that managers of institutional investors put pressure on the managers of the companies that they own, demanding that they don’t try to undercut the prices of their competitors. If a mutual fund owns shares of United and Delta, and United and Delta are the only competitors on certain routes, then the mutual fund benefits if United and Delta refrain from price competition. The managers of United and Delta have no reason to resist such demands, as they, too, as shareholders of their own companies, benefit from the higher profits from price-squeezed passengers. Indeed, it is possible that managers of corporations don’t need to be told explicitly to overcharge passengers because they already know that it’s in their bosses’ interest, and hence their own. Institutional investors can also get the outcomes they want by structuring the compensation of managers in subtle ways. For example, they can reward managers based on the stock price of their own firms—rather than benchmarking pay against how well they perform compared with industry rivals—which discourages managers from competing with the rivals.

(This is right out of Chomsky’s Manufacturing Consent: media corporations control news content by hiring people who they know will deliver the content, and message, they want. Those who do so are promoted and rewarded. They don’t need to tell them explicitly what to write.)

In America, you don’t find the explicit, extreme, and obvious family-pyramid control that’s so apparent in some other parts of the world. Control and ownership is more widely distributed across perhaps a hundred or a thousand families at the top. (Before you object: it depends on how you define “family” and “the top.”) How could price collusion happen among this larger group, with the inevitable incentives for some to defect with lower prices and take market share from the others?

Simple: America’s richest families have farmed out their collusion to institutional entities who control markets (and market pricing), with small groups of institutions controlling all the players in each industry.

The Darwinian view that underpins the “free market” belief system reveals a fundamental misunderstanding of a key evolutionary mechanism: groups can thrive and propagate at the expense of other groups, if members of one group are better cooperators. That cooperation can take myriad forms (both beneficial and pernicious to the common weal), and there are myriad evolutionary mechanisms by which that cooperation can arise. However it arises, in the case of price-setting within groups, we call that cooperation “collusion.”

In Posner and Weyl’s telling locution, “Competition among mutual funds cannot substitute for competition among corporations.” Ditto if you replace “mutual funds” with “private equity firms.” And likewise: competition among limited-liability corporations (Can’t pay off that loan? The people walk away scot-free) is based on incentive structures that are utterly orthogonal to those of independent butchers and bakers.

The agents operating those institutions know quite clearly which side their personal bread is buttered on. The families who ultimately own everything, meanwhile, are many stages removed from, largely unconscious of, any particular pricing decisions. But they can be confident that those decisions are being made in their families’ best interests.

Adam Smith, poster-boy for free-market enthusiasts, understood this reality better than most:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

He could not perhaps have conceived, however, how cleverly colluders would construct institutions that would achieve that price collusion, while masking and obscuring it even from their own eyes. He perceived the familiar “principal-agent” problem of joint-stock companies quite clearly:

The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own…. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

But he didn’t perceive these institutions’ potential for price collusion.

America’s founders, on the other hand, displayed and expressed a far deeper distrust of limited-liability, joint-stock companies. Charters for such companies were uncommon and extremely restricted in their scope (building a particular public work, for instance) well into the 19th century. “Any legitimate business purpose” is a very recent innovation.

But there’s another crucial innovation: corporations owning shares in other corporations (the very crux of modern pyramid-control schemes, familial and institutional). This was not even legal under state corporate charters until late in the 1800s. The ill effects of that rule change were not long in coming, and had to be addressed vigorously via the trust-busting and rule changes of the early 1900s. (See: interlocking directorships and The Pujo Committee.)

Proponents of free markets seem unaware that that “peculiar institution” – corporations owning corporations — is in fact very peculiar indeed. It is arguably the most destructive innovation ever to strike at the miraculous wonder of the free market’s pricing mechanism.

Further Reading

Anti-Competitive Effects of Common Ownership. April 15, 2015. José Azar, Martin C. Schmalz, and Isabel Tecu.

Concentrated Corporate Ownership. 2000. Randall K. Morck, ed.

Competitive Effects of Partial Ownership: Financial Interest and Corporate Control. 2000. Daniel P. O’Brien and Steven C. Salop.

Do Publicly Traded Corporations Act in the Public Interest? March 1990. Roger H. Gordon.

Financial transaction costs and industrial performance. April, 1984. Julio J. Rotemberg.

 

Cross-posted at Angry Bear.

This issue has been driving me crazy for a while, and I never see it written about.

When responsible people talk about the national debt, they point to Debt Held by the Public: what the federal government owes to non-government entities — households, firms, and foreign entities. (Irresponsible people talk about Gross Public Debt — an utterly arbitrary and much larger measure that includes debt the government owes to itself.)

Debt Held by the Public is the almost-universally-accepted measure of “the national debt.” That would be perfectly reasonable, except that…

Federal Reserve banks are counted as part of “the public.” So government bonds held by this government entity — money that the government owes to itself — are counted as part of the debt government owes to others.

The Fed has bought up trillions of dollars in government bonds since 2008, to the point that Debt Held by the Public has become an almost meaningless measure (click for source):

Here it is as a percent of GDP:

Debt actually held by “the public” equals 57% of GDP – and declining — not 73% of GDP.

I don’t know how economists or pundits think they can have any conversation at all about this subject, analyze it in any useful way, if they ignore this basic reality. Reinhart and Rogoff, are you listening?

Cross-posted at Angry Bear.