Restructuring Markets to Give People Better Lives

Markets are always somehow structured by government policy, and it matters significantly whether those markets are structured to benefit the wealthiest at the expense of everyone else.

The standard liberal approach to economic policy is to support government programs that counteract the inequities gen- erated by the market. Unfortunately, this narrow focus on government programs has effectively given the right free rein to restructure the market to redistribute an ever-larger share of income to the rich and very rich. While tax and transfer policies are important, if liberals had not ignored, or in many cases supported, the ways in which the right was restructuring the market, the existing levels of poverty and inequality that the government needs to address would be far lower.

In other words, liberals need to spend at least as much time on the rules that structure the market as they do on government programs that redress the problems it creates. This is because the idea that the extremes of wealth and poverty we see are inherent outcomes of the market is wrong. These extremes are the result of the way in which the market has been structured by the government.

Let’s start off with, perhaps, the most explicit example of this structuring: patent and copyright monopolies, which are entirely a government invention. There is nothing “free market” about Bill Gates’s enormous fortune. It’s because the government will arrest anyone who mass produces computers with Microsoft software without first paying the company licensing fees.

The Microsoft story is not unique. Huge sectors of our economy exist in their current form because of government-granted patent or copyright monopolies, including the pharmaceutical industry, the medical equipment industry, and the entertainment industry. These monopolies are not just long-fixed rules of the game. Government policy has made them both longer and stronger over the last almost four decades.

This government hand is seen clearly in the prescription drug industry, which has caused renewed outrage among the public in recent years. Spending on prescription drugs hovered near 0.4 percent of GDP, with no discernible trend from 1960 to 1980, when the Bayh-Dole Act was passed into law. It passed the Senate by a huge, bipartisan 91-4 margin and was signed into law by President Carter.

Bayh-Dole allowed private companies to obtain patent rights on research sponsored by the government. Prior to Bayh-Dole, the government retained control over research that it funded. The change was especially important for the pharmaceutical industry, because the government funds a large amount of bio-medical research through the National Institutes of Health (NIH) and other agencies. Since Bayh-Dole became law, spending on prescription drugs has skyrocketed to more than $440 billion in 2018 (2.2 percent of GDP); more than five times the share of GDP it took up in 1980.

We have benefitted from increased private spending on research as a result of Bayh-Dole, but granting these monopolies was only one of many possible mechanisms to provide incentives for new innovations. This is simply not the free market; it is deliberate government policy.

The implications of this point are enormous. Another important example: We continually hear the refrain that workers need more education and skills to succeed in the modern economy, but the extent to which the economy rewards education and skills is also a matter of government policy, not the endogenous course of technology. If we envision a world with no patent and copyright protection, we would not have a slew of Silicon Valley millionaires and billionaires nor NIH alumni becoming biotech tycoons.

Of course, it is important that we have incentives for innovation and creative work, but the point is that government policy can make those incentives greater or smaller. If we want more equality, and arguably a more efficient economy, we could make patents and copyrights shorter and weaker and have more direct funding to put research and creative work in the public domain immediately after it is produced. The Human Genome Project is one model, where results are posted nightly. If we did this with research into drug development, new drugs could be sold as generics, costing a tiny fraction of the price of patent-protected medicine.

[…]

Finance is another area where government policy structured the market to support a bloated industry, one that creates large fortunes for a small number of people. The most dramatic incident in this respect was the massive bailout for the industry after the financial crisis. The magic of the market would have sent Goldman Sachs, Citigroup, and other financial behemoths into bankruptcy.

Instead, Congress and the Federal Reserve Board raced to supply the necessary loans and guarantees to keep the major banks afloat. (No, we did not risk a second Great Depression without the bailout. The Federal Deposit Insurance Corporation could have kept the normal flow of payments going. And we learned the secret to escaping a severe depression almost 80 years ago with the start of World War II. It’s called “spending money.”)

Beyond the bailout, government policy has structured finance to support an incredibly inefficient industry that unnecessarily makes some people very rich. Government policy literally rewrote the rules on bankruptcy to support mortgage-backed securities and derivative trading. Also worth noting is the fact that the financial industry would be dramatically downsized if financial transactions were not exempted from the sort of sales tax imposed on most other items in the economy. Again, it is clearly the rules that government puts in place that give so much money to the big winners in finance, not anything intrinsic to the market.

Trump’s Failure on Trade, The Issue His Working-Class Voters Largely Elected Him With

One way to increase the American economy’s demand — or the power to buy things in the economy, which is something that most workers (their wages largely stagnant) could have used much more of in the last 40 years — is through lowering the trade deficit. A trade deficit is currently reducing demand because that gap in American spending is creating jobs and demand in a foreign country such as China instead of the U.S.

Lowering the trade deficit to 1 percent of GDP from 3 percent of GDP would grant about the same increase to demand as a $400 billion stimulus package would.

Trump told his working-class voters that he’d improve trade inequities and therefore help them by reducing the trade deficit, which of course like many of his declarations turns out to have been a sham.

The latest data from the Commerce Department shows that the trade deficit rose again in 2018. The full–year trade deficit was $621.0 billion (3.0 percent of GDP), up from $552.3 billion in 2017, and from $502.0 billion in 2016, the last year of the Obama presidency. If we pull out oil and other petroleum products, the trade deficit looks even worse, increasing by more than $77 billion from 2017 to 2018.

The picture doesn’t look any better if we look at the specific countries that Trump has vilified. The trade deficit in goods with Mexico has increased by $17.6 billion or 27.5 percent since Obama left the White House in 2016. The deficit with Canada, Trump’s “enemy“ to the north, has increased by $8.8 billion, an increase of 80.0 percent. The trade deficit in goods with China has risen by $72.2 billion since 2016, an increase of 20.8 percent.

[…]

The new China agreement does almost nothing about currency values, the most important determinant of the trade balance. After running around the country for two years complaining about China’s currency “manipulation,” there are no provisions in his new pact that would force China to raise the value of its currency against the dollar.

The sharp rise in the trade deficit in the last decade had a devastating impact on manufacturing workers and whole communities in large parts of the Northeast and the Midwest. We can’t hope to reverse this damage, as those jobs will not come back.

However, we could design a trade policy that would move us toward more balanced trade and create millions of relatively good-paying manufacturing jobs. Unfortunately, Trump’s policy seems to be going in the opposite direction.

Instead of Only Taxing the Rich More, Change Pre-Tax Income Distribution So They Receive Less

Instead of just trying to tax the rich more, it would be better to prevent the distribution of income from being so unjust to begin with. Markets have been rigged in numerous ways to redistribute income upward to the wealthiest members of society.

Given the enormous increase in inequality over the last four decades, and the reduction in the progressivity of the tax code, it is reasonable to put forward plans to make the system more progressive. But, the bigger source of the rise in inequality has been a growth in the inequality of before-tax income, not the reduction in high–end tax rates. This suggests that it may be best to look at the factors that have led to the rise in inequality in market incomes, rather than just using progressive taxes to take back some of the gains of the very rich.

There have been many changes in rules and institutional structures that have allowed the rich to get so much richer. (This is the topic of the free book Rigged.) Just to take the most obvious — government-granted patent and copyright monopolies have been made longer and stronger over the last four decades. Many items that were not even patentable 40 years ago, such as life forms and business methods, now bring in tens or hundreds of billions of dollars to their owners.

If the importance of these monopolies for inequality is not clear, ask yourself how rich Bill Gates would be if there were no patents or copyrights on Microsoft software. (Anyone could copy Windows into a computer and not pay him a penny.) Many other billionaires get their fortune from copyrights in software and entertainment or patents in pharmaceuticals, medical equipment and other areas.

The government also has rules for corporate governance that allow CEOs to rip off the companies for which they work. CEO pay typically runs close to $20 million a year, even as returns to shareholders lag. It would be hard to argue that today’s CEOs, who get 200 to 300 times the pay of ordinary workers, are doing a better job for their companies than CEOs in the 1960s and 1970s who only got 20 to 30 times the pay of ordinary workers.

Another source of inequality is the financial sector. The government has aided these fortunes in many ways, most obviously with the bailout of the big banks a decade ago. It also has deliberately structured the industry in ways that facilitate massive fortunes in financial engineering.

There is no reason to design an economy in such a way as to ensure that most of the gains from growth flow upward. Unfortunately, that has largely been the direction of policy over the last four decades.

Investor John Bogle’s Legacy

Bogle steered many people away from the exploitation that is all too prevalent in the financial system by encouraging usage of index funds, and his legacy deserves praise for that.

Bogle’s great innovation was to minimize the cost of managing individual accounts. The key Vanguard asset is an index fund. It does minimal trading, it just tracks the market. Bogle argued, supported by much evidence, that the vast majority of investors are not going to beat the market. This means trading costs are simply a transfer to the folks running the account. Since most of us have people we would rather give money to than our stockbroker, we are better off just having an index fund.

And it does make a huge difference. Many of Vanguard’s index funds have costs of less than 0.1 percent annually. By contrast, many actively traded accounts will have fees and service charges in the range of 1–2 percent annually. This adds up over time. If you invested $1,000 that got a 6 percent nominal return, it would grow to $5,580 at Vanguard after 30 years. At a brokerage charging 1.0 percent in annua,l fees it would grow to $4,320. At a brokerage charging 2.0 percent annual fees, it would only grow to $3,240. And the gap is all money in the pockets of the financial industry.

While his low-cost index fund was a great innovation in finance, he did not personally get rich from it. He organized Vanguard as a cooperative. The people who invest with the company effectively own it.

The Failed Investments of Ivy League Schools and the Future of Hedge Funds

If the elite universities had simply invested in index funds that matched the stock market average instead of hedge funds, there would be much more money to grant to disadvantaged youth and to valuable research initiatives. Those universities have all that prestige and influence, and they even have a tax exempt status — and pound for pound they still did worse than a good average investor would have.

The New York Times highlighted the findings of a remarkable study last week. The study, by Markov Processes International, examined the 10-year returns of the endowments of the 8 Ivy League schools. The study found that all 8 endowments had lower returns than a simple mix of 60 percent stock index funds and 40 percent bonds. In some cases, the gap was substantial. Harvard set the mark with its annual returns lagging a simple 60-40 portfolio by more than 3.0 percentage points.

[…]

And, just to be clear, the Markov comparison was overly generous to the universities. Their benchmark comparison of a portfolio of 60 percent stock and 40 percent bonds is in fact far safer than the alternative investments they hold. If they actually equalized risk, the comparison portfolio might be 80 percent or even 90 stock, making the Ivy league endowment returns look even worse.

The Ivy League schools are not the only big institutional investors who are turning to alternative investments. State and local pension funds also play this game in a big way. The beneficiaries are more often private equity partners, but the basic story is the same: people who make themselves very rich by playing financial games. And, as with the hedge fund folks and the Ivies, they do not provide the promised returns.

And, there is considerably more money at stake with public pension funds. The cumulative size of the Ivy League endowments is just under $140 billion. While this is hardly chump change, state and local government pension funds have more than $8 trillion in assets. Most of this money is not in alternative investments, but if just 10 percent were placed with private equity funds and other alternatives, it would come to $800 billion.

There is much to dislike about the behavior of these financial actors. They routinely play games with the tax code and bankruptcy law to increase returns. It is standard practice for private equity funds to leverage their companies as much as possible to take advantage of the deduction for interest on corporate income taxes.[1]

They also strip valuable assets, such as the real estate on which stores and restaurants sit, so that they can book a quick profit while leaving the companies they control more vulnerable to a business downturn. Bankruptcy is a common tool, which they use to get out of not only interest payments on debt (presumably lenders knew the risks they were taking), but also pension and health care obligations to workers, and payments to suppliers.

[…]

In terms of inertia, people can point back to a period where the hedge funds did produce outsized returns, as did the private equity funds. People can think that the last decade or so is just an aberration, and that the good times will return.

While I can’t predict the future, there is a simple story that would imply the opposite. Both hedge funds and private equity funds prospered by finding seriously under-valued assets and then leveraging heavily to maximize their return. When there were few actors in the field, it was possible for some number of funds to make large returns this way. But now that there are many actors, with trillions of dollars to invest, seriously under-valued assets are few and far between.

This means that most hedge funds and private equity funds won’t be able to make outsized returns going forward. The high fees to the fund managers are a direct drain on returns that would otherwise more or less match the market average.

And just to be clear, we are talking about a 10-year period in which hedge funds have failed to match the market average. (It’s a similar story with private equity.) This is a long period, it’s not just a case of these funds having a bad year or two.

The Economy is Deliberately Rigged at the Expense of Most

The economy has been rigged to benefit the richest people at the expense of many of the poorest ones. The negative effects surrounding massive deindustrialization (most significant of which is likely tearing apart entire communities due to job losses and downward pressure on median wages) could have been significantly lessened with different governmental policies.

There have been several analyses of the 2018 election results showing that the Republican regions are disproportionately areas that lag in income and growth. In response, we are seeing a minor industry develop on what we can do to help the left behinds.

The assumption in this analysis is that being left behind is the result of the natural workings of the market — developments in technology and trade — not any conscious policy decisions implemented in Washington. This is quite obviously not true and it is remarkable how this assumption can go unchallenged in policy circles.

Just to take the most obvious example, the natural workings of the market were about to put most of the financial industry out of business in the fall of 2008. In the wake of the collapse of Lehman, leaders of both the Republican and Democratic parties could not run fast enough to craft a government bailout package to save the big banks, almost all of which were facing bankruptcy due to their own incompetence and corruption.

It is worth contrasting this race to bailout with the malign neglect associated with loss of 3.4 million jobs in manufacturing (20 percent of the total) between 2000 and 2007 (pre-crash). This job loss was primarily due to an explosion in the trade deficit. The latter was due to an overvalued dollar, which in turn was attributable to currency management by China and other countries, that kept their currencies below the market level.

While most economists now acknowledge the impact of China’s currency management, at the time there was a great effort to pretend that this was all just the natural workings of the market. The loss of jobs, and the destruction of families and communities, was not a major concern in elite circles, unlike the prospect of Goldman Sachs and Citigroup going bankrupt.

The decision to bail out the banks is routinely justified as being necessary to prevent a Second Great Depression. No one who says this has a remotely coherent story as to how the bankruptcy of these banks would have condemned us to a decade of double-digit unemployment.

We have known for 70 years how to get out of a depression (it’s called “spending money”). if the banks had collapsed, it would have undoubtedly worsened the 2008–2009 downturn, but nothing would have prevented us from boosting the economy back to full employment with a large burst of spending, just as the spending needed to fight World War II brought the economy to full employment in 1942.

Excessive CEO Pay Takes Money Away from Other Workers

The op-ed provides a good analysis of the problem with the economic structures that allow CEOs to be excessively overpaid — the substantial amount of money that the CEOs are overpaid with could instead be going to other lower-level workers. Wages in the United States have hardly increased in decades for most American workers, and the CEO pocket money would make a significant difference in their lives.

The problem is the structure of corporate governance. The people who most immediately determine the CEO’s pay are the corporation’s board of directors. These directors have incredibly cushy jobs. They typically get paid several hundred thousand dollars a year for perhaps 150 hours of work.

Members of corporate boards largely owe their jobs to the CEOs and top management. They almost never get booted out by shareholders; the reelection rate for board members running with board support is over 99 percent.

In this context, board members have no incentive to ask questions like, “Could we get someone as good as our CEO for half the pay?” There is basically no downward pressure on CEO pay and every reason to boost pay. After all, if you were sitting on some huge pot of other people’s money, wouldn’t you want to pay your friends well?

Of course, the CEO pay comes at the expense of returns to shareholders, and these have not been very good in recent years in spite of the best efforts of Trump and the Republicans to help them with tax cuts and pro-business regulation. In the last two decades, stock returns have averaged less than 4.7 percent annually above the rate of inflation. By contrast, in the long Golden Age from 1947 to 1973, real stock returns averaged 8.2 percent.

With the bulk of stock being held by the richest people in the country, there is no reason to shed tears for stockholders, but the fact is they are being ripped off by CEOs and other top management. Given the choice, we should prefer the money ends up in the hands of shareholders rather than CEOs. After all, people below the top 1 percent do own stock in their 401(k)s, as do public and private pension funds. By contrast, every dollar in additional CEO pay is going to someone in the top 0.001 percent of the income distribution.

More important than the money going to the CEOs is the impact that their outlandish pay has on pay structures in the economy more generally. When the CEO is pocketing $20 to $30 million a year, other top executives are likely earning close to $10 million and even the third-tier managers might be topping $1 million.

[…]

If a successful CEO of a large company was pocketing $2-3 million a year, instead of $20 to $30 million, the ripple effect on the pay of others near the top would leave much more money for everyone else. This gives us very good reason to worry about excessive CEO pay.

If the structure of corporate governance makes it too difficult for shareholders to collectively act to limit CEO pay, threatening them with a return to the pre-Trump 35 percent tax rate might give them enough incentive to get the job done. It has always been in the interests of shareholders to pay their CEOs as little as possible, just as they want to pay as little as possible to their other employees.

If shareholders pay a CEO $20 million more than needed to get someone to run the company, it has the same impact on the bottom line as paying $2,000 extra to 10,000 workers. No company deliberately overpays their frontline workers.