Saturday, June 24, 2017

Non-voting shares response

Todd Henderson and Dorothy Shapiro wrote me a thoughtful response to my post on non-voting shares. Todd and Dorothy:

Response to Cochrane

We are grateful for Cochrane’s thoughtful response to our op-ed in the Wall Street Journal. Space limitations prevent us from giving the necessary treatment to our ideas, but he is right to push us to be careful in our analysis, no matter the limits. We look forward to addressing his concerns and others in a forthcoming article.

In the meantime, here is a quick response to the thrust of Cochrane’s critique.

There is a logical inconsistency in Cochrane’s post—his “modest proposal” would require more legal change to accomplish than ours. (And we are the ones with a vested interest in more law!) For one, it’s not clear that companies would willingly issue non-voting stock in addition to voting stock (and in the right amounts)—this occurs very rarely in practice, if ever.

Second, even if the shares existed, Cochrane assumes that index funds would willingly buy them, although there’s no evidence to suggest that this would occur.

The hostile reaction from large passive institutional investors, including BlackRock and Vanguard, to the Snapchat IPO and other recent dual class stock offerings make it clear that passive funds wouldn’t buy non-voting stock willingly—institutional investors participated in those offerings under protest and have since been advocating for reforms that would prevent future non-voting offerings, even going so far as to lobby Russel FTSE to delist companies that have dual class shares.

It’s also unlikely that non-voting stock would be much cheaper than voting stock—empirical evidence has demonstrated that often, non-voting stock doesn’t trade at any discount to voting stock (such as when there's a controlling shareholder or the company is well run).

Even if passive funds could purchase non-voting shares at a small discount, it’s not obvious that they would have any incentive to do so. Index funds have the sole goal of replicating the performance of an index. Why would they want to get a different product for a lower price? This is especially true when doing so would cause them to give up power and influence over some of the companies that they invest in (for a small benefit that investors are unlikely to recognize).

So, under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them. Talk about a lot of law! (Read: coercion.) Not only would this be a more dramatic change than the one that we propose, it would surely lead to a worse world. As an example, there could be liquidity concerns—if passive funds wanted to sell en masse (as can happen when funds are tracking the same index), there would be no buyers. And, if passive funds instead wanted to buy, there would be no sellers (and in this situation, it's unlikely that the non-voting shares would really trade at a discount).

By contrast, our solution--encouraging (but not requiring) passive funds to abstain from voting—is much less intrusive. Rather than mandating the creation of a new market of non-voting shares, we advocate a voluntary legal change that would permit natural correctives to any corner solution. The concern seems to be that if index funds abstain, too much power will be vested in the hands of activists, not all of whom will be interested in long-term shareholder value. But if index funds are merely encouraged to abstain unless they have no strong interest in the outcome, then there is a natural, market-based corrective to this problem. If activists go overboard, then index funds will have a strong interest, and reenter the voting market at that time. In a sense, Cochrane’s critique is ironic: we are calling for less law. We want law to get out of the way, by letting index funds act naturally—to not vote when they have no interest in doing so, and where they have no comparative advantage in the process. (Our other alternative, a legal duty to vote in an informed matter, and not just blindly follow ISS and other proxy advisors, is a clear second best.)

***

A little response-response clarification:

I do not envision any coercion!  So I  deny "under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them."

Index funds need to wake up and ask for non-voting shares, and then companies will issue them. The funds get a discount and absolution from legal trouble. Or companies need to wake up and offer non-voting shares to index funds. The companies get a new source of financing.

The non-voting shares I have in mind need do need a lot of smart lawyering and contract writing by people like Todd and Dorothy.  I accept the point that current non-voting shares are not as protected as they should be, that the promise ``you get exactly as much money as the voting shares, and you can sue as bondholders do if you don't'' needs teeth.

Indeed, the market is hostile to non-voting shares because current non-voting shares are designed to concentrate control with insiders, not to create a vibrant outside market for corporate control. That's the last thing insiders want, and a reason that companies will be slow to offer such shares unless funds start demanding them.

Sometimes the world hasn't arrived by itself at the optimum, just because nobody thought of it, not because there is a market failure, and not because law has not compelled it. We live in a time of legal and financial innovation, not just gadget innovation.

And index funds not voting aggressively is not a screaming problem that can't take some time to sort out.

(How to start a fight in a libertarian bar -- "You're advocating government intervention! No, you're advocating government intervention! I probably should have left that out of the original, and there is not much need to spend time on it in further discussion. Laws and contracts and courts are all on the menu at the libertarian bar.)




Friday, June 23, 2017

Index funds and voting shares

Todd Henderson and Dorothy Shapiro Lund have an interesting OpEd in the Wall Street Journal, "Index funds are great for investors, risky for corporate governance." In brief, index funds don't participate heavily in monitoring companies, finding information about companies, or corporate control contests.

This point echoes larger complaints that with the spread of index funds there won't be enough active money to make markets efficient, and especially to make efficient the market for corporate control. One of the most important functions of a public market is, if you think that a company is mismanaged, you can buy up a lot of shares, vote out the management, and run it better. This is an imperfect system, to be sure, but note how many nonprofits (universities) and privately held companies, immune from this pressure, are run even more inefficiently than public companies.

Todd and Dorothy, law professors, after very nicely reviewing how funds currently deal with voting issues, seem to favor more law.
So how can the law ensure that these institutions make informed decisions about corporate governance? ... The first is to encourage them to rely on third-party corporate governance experts. It may be necessary... for the law to create incentives for institutional investors ...option three: encouraging passive institutional investors to abstain from voting altogether.   
Hmmm. When "the law," not a person or people, is the subject of a sentence, I get cautious. When the law wants "to encourage" people, my hackles rise.  The law "encourages" and "creates incentives" pretty bluntly. One example, though discarded, is a bit chilling,
 This could be accomplished by providing a legal cause of action to shareholders that are harmed by uninformed or conflicted voting decisions. But this would be a blunt tool for curbing abuse. 
Indeed it would.

But this is forgiveable. They are lawyers, so more law is the answer. We are economists, and law a necessary evil when contracts and markets fail. Is there not an economic solution, a Coasean way to slice the knot?

I think so. Companies should issue, and index funds should want to buy, non-voting shares.  Non-voting shares seem to be regarded as a little infamy of internet companies, used to keep control in the hands of founders. But a split between voting and non-voting shares seems ideally suited to a mass of indexing investors, and a few active, information-based traders and active corporate control investors. In this vision, most of those voting shares are in public hands, unlike the internet companies.  In fact, most corporate stock grants and options to insiders should be in the form of non-voting shares.

Non-voting shares are treated exactly the same for all cash flow purposes. They receive the same dividends, same rights in repurchase, same treatment in any reorganization. They just do not allow the right to vote.

Since index funds don't value the option to vote, they should want non-voting shares.

Wednesday, June 21, 2017

The optimal inflation rate

Anthony Diercks has a very useful review of the the academic literature on the question, what is the optimal inflation rate? He includes 150 papers, ordered from low to high inflation.


Broadly speaking, we start with the Friedman result that the optimal nominal interest rate is zero, so the optimal inflation rate is the negative of the real rate of interest. The optimal nominal interest rate is zero, so people feel no incentive to economize on money holdings, or devote effort to cash management, paying bills late and collecting early. Many sticky price models suggest an optimal inflation rate of zero, so you don't have to change sticky prices. Then,
Most all of the studies that have found a positive optimal inflation rate have been written in the last ten years. The increase in the number of studies with a positive optimal inflation rate can be explained predominantly by the rise of two modelling features: (1) inclusion of the zero lower bound and (2) financial frictions.  
The zero bound means the Fed may want some headroom, a higher nominal rate in normal times. (More on that issue in an earlier post here).

Then, economists get creative. Anthony provides a nice list of additional ingredients that have appeared in the literature:

Tuesday, June 20, 2017

Reis on the state of macro

Ricardo Reis has an excellent essay on the state of macroeconomics. "Is something really wrong with macroeconomics?"
In substantive debates about actual economic policies, it is frustrating to have good economic thinking on macro topics being dismissed with a four-letter insult: it is a DSGE. It is worrying to see the practice of rigorously stating logic in precise mathematical terms described as a flaw instead of a virtue. It is perplexing to read arguments being boxed into macroeconomic theory (bad) as opposed to microeconomic empirical work (good), as if there was such a strong distinction. It is dangerous to see public grant awards become strictly tied to some methodological directions to deal with the crisis in macroeconomics.
There have been lots of essays lately bemoaning the state of macroeconomics. Most of these essays are written by people not actively involved in research, or by older members of the profession who seem tired when faced with the difficulty of understanding what the young whippersnappers are up to, or by economic journalists who don't really understand the models they are criticizing. I am old enough to feel this temptation and have to fight it.

Many bemoan the simplifications of economic models, not recognizing that good economic models are quantiative parables. Models are best when they isolate a specific mechanism in a transparent way.

Critics usually conclude that we need to add the author's favorite ingredients -- psychology, sociology, autonomous agent models, heterogeneity, learning behavior, irrational expectations, and on and on -- stir the big pot, and somehow great insights will surely come. This is the standard third-year PhD student approach to writing a thesis, and explains why it takes five years to get a PhD.

Thursday, June 15, 2017

The Treasury Portfolio

Charlie Plosser makes the case that the Federal Reserve should hold only Treasuries in its asset portfolio, at Hoover's "Defining Ideas"

Background: The Fed is essentially a giant money-market fund. Its liabilities are cash and bank reserves. Its assets are .. well, they used to be entirely short term Treasury securities, but now include mortgage-backed securities. In the crisis, the Fed bought a lot of other securities. Other central banks buy stocks, and it's pretty clear if there were a recession tomorrow, after interest rates hit zero the next day, the Fed would go on a buying binge. The Fed is a government agency, but it is "independent," enjoying a lot of freedom to do what it wants no matter what Congress or the Administration want it to do.

Plosser's proposal,
 1.        The Federal Reserve should be required to maintain a Treasuries-only policy as it pertains to the conduct of monetary policy. 
2.         The Federal Reserve should be prohibited from purchasing non-Treasury securities, private sector securities or lending against private collateral except through traditional discount window operations with depository institutions. 
3.         Emergency lending under Section 13(3) of the FRA should be eliminated and replaced with a new Fed-Treasury accord...

The Fed may buy other securities, but basically has to swap them back to the Treasury or sell them within 60 days. If the government is going to subsidize credit to various industries, voters, and constituencies, then the politically accountable Treasury should do it, not the independent Federal Reserve. Charlie allows here that the Fed may be able to move faster in a crisis.

Why only Treasuries? Why should the Fed not always have greater power to guide the economy more forcefully by buying whatever assets it thinks need propping up? Because,

Monday, June 12, 2017

Living Trusts for Banking

One of the core problems of financial reform is how to "resolve," AKA bankrupt, a big bank -- how can equity holders be wiped out, and debt holders carve up the remaining assets. Big banks are supposed to craft “living wills,” really living vivisection guides, but that effort is clearly in trouble. This blog post expands on a different idea for bank resolution; let’s call it “living trusts” by a similar analogy to estates.


Here's the idea: Let a bank fund its risky investments 100% by issuing equity. The bank then simply cannot fail — it cannot go bankrupt, it cannot suffer a run.  As I've argued elsewhere, I think this is entirely practical.

But suppose it really is important for some reason to carve up bank liabilities into a small amount of highly leveraged equity and a large amount of run-prone short-term debt. Suppose it really is important for banks to "create money," and to take deposits, and to funnel those into risky, illiquid, and otherwise hard-to-resolve assets. Suppose that equity holders really demand highly leveraged high return high risk bank equity, not super-safe low return low risk bank equity, that the return on equity not its Sharpe ratio is a constant of nature.

OK. For $100 of assets, and $100 of bank equity, let, say, $10 of that equity be traded — enough to establish a liquid market. Then, let $90 of that equity is held by a downstream entity or entities— a fund, special purpose vehicle, holding company or other money bucket. I’ll call it a holding company, and return to legal structures below. The holding company, in turn, issues $10 of holding company equity and $80 of debt.

There you have it — $100 of bank assets are “transformed” into $10 of very safe bank equity, $10 of risky and high return holding-company equity, and $80 of short-term debt.

Now if the bank loses money, the value of the bank equity falls. But the bank is failure-proof and run-proof. Shareholders get mad, may throw out management, may even break up the company. But they cannot run, demand their money now, and force bankruptcy.

The holding company can fail however! Suppose he bank loses $20. The holding company owes $80 of short term debt. Its assets are worth .9 x $80 = $72. It’s insolvent. It fails. Holding-company equity holders are wiped out. Holding-company creditors get the assets, common stock in the original bank, worth $72/$80 = 90 cents on their original dollar.

It need not be that drastic. Its likely the previous short-term debt holders don’t want stock, and would want to sell it in a hurry. Dumping 90 shares on the market might be tough.

The holding company could do a 5-minute recapitalization instead. Holders of the $80 of debt get $60 of debt and $12 of new holding-company equity. The holding company is recapitalized by the flip of a switch.

The key: this resolution/recapitalization can happen in about 5 minutes.

Sunday, June 4, 2017

NoahLogic

My little foray here into the blogosphere sometimes leaves me in slack-jawed amazement at the leaps of illogic in the commentariat.

Such was the case last week, when Noah Smith writing at Bloomberg.com, took on a recent post of mine about food stamps. 

My post was about food stamps, and about the language that people use to hide agendas in the policy debate. Scott Simon at NPR thought he had a big gotcha by repeatedly asking Congressman Adrian Smith "Is every American entitled to eat?" because the budget proposal reduces food stamp payments. The title was "single payer food," as it seemed Scott's view of food was like many people's view of health care. 

This sent Noah on a tear about "free market purists" who disdain "single-payer" health care:
In a recent blog post, Hoover Institute senior fellow John Cochrane likens single-payer health care to single-payer food:
...
by drawing an equivalence between health care and food, Cochrane is ignoring the long history of economic research showing that the health-care market is very different from others.  
Here I am left scratching my head. I did not, in fact, "liken single payer-heath care to single-payer food." I didn't mention health care at all. How can a post about food stamps "ignore" research on health economics? And if you spend 10 seconds googling you will find I have addressed all these arguments in other writing that is actually on this topic. You might not agree with my answers, but I don't "ignore" them.

A bit of advice to Noah: OK, you can't be bothered to do any real research before mounting a personal attack on  Bloomberg.com. But try to make it all the way through a blog post before writing a takedown.

(Or, back in the old days, before writing that "Cochrane is ignoring" something, basic journalistic ethics would demand that you contact Cochrane for comment, at which point Cochrane could point out that no, he is quite aware of Ken Arrow's work and has responded to it in detail, especially when actually writing about health care, not food. Or an editor or fact checker would require that. Some news media still practice this kind of basic journalistic ethics. Bloomberg, we see, does not.)

***

However completely unrelated to the subject at hand, though, Noah does bring up some interesting issues regarding health care. I'm grateful for the opportunity to rebut, because, as a matter of fact, I have written about health care,  and the attack gives me an opportunity to recycle some great old prose to prove that point.

The issue at hand: Can markets work for health care and health insurance? Noah:
There are so many problems with the health-insurance and health-care markets that it’s little wonder that they operate differently from the markets for food or cell phones. 
That's a misleading comparison. Health care is a complex personal service. The right comparison is lawyers, accountants, tax preparers, contractors, car repair shops, architects, gardeners, interior designers, bankers, brokers. These are all cases in which people deliver a complex service, and they know a lot more than we do. We hire their expertise as much as a product.

Health insurance is insurance. The right comparison is car insurance, home insurance, personal liability insurance, life insurance, disability insurance, and more complex insurance associated with businesses, such as director liability insurance, product liability insurance, freight insurance, and so forth.

All of these we generally leave to somewhat free markets. Nobody thinks there needs to be a single-payer contractor. (Well, maybe Noah does. I can't wait to see what kinds of bathroom tiles ContractorCare will pay for.) Just what is it about health care and insurance that have an essential market failure, and these do not?

Noah summarizes a 1963 Ken Arrow essay about health care, which Noah cites as research showing that markets cannot possibly work. The objections:
.. the importance of moral norms.  People have all kinds of moral considerations associated with health care. They expect doctors to act honestly and selflessly, and not just seek profit
Any time economists start telling you to pass complex regulations to enforce morality, run in the opposite direction. The Obama administration had something with the idea of "science-based" policy. At least let's get the cause and effect science right before we start making moral claims.

Let's read economists about economics:
...incomplete markets. Can people really know all of the possible health conditions they might get, including how much they would pay to cure or treat each one? ... The answer is certainly no. 
...uncertainty -- in health care, people don’t know what they’re buying until it’s already too late to make a different choice. Unlike food, which you buy over and over, open-heart surgery tends to only happen once.  
...adverse selection. People with health problems are more likely to try to buy health insurance; and since insurance companies know this, they have to charge everyone more. 
....moral hazard. After you’ve paid for insurance, the insurance company has every incentive to deny as many claims as it can get away with denying
These are all the standard objections to markets. They are all theoretical possibilities, echoed in every econ 101 textbook. But are they true of health care and insurance? And so much so that the evident pathologies of a government run system is better? (Remember, the free market case is not that markets are perfect. It is the long and sorry experience that governments are worse.) And are they so much more true than they are of all the above listed complex personal services, that the latter can be left to markets but a vast government bureaucracy must not only provide for all but outlaw the private option?

As it turns out, I have written about these things, in "After the ACA" easily available on my website and rather relentlessly promoted on this blog, especially p. 184ff,
B. The Straw Man 
...Critics adduce a hypothetical situation in which one person might be ill served by a straw- man completely unregulated market, with no charity or other care (which we have had for over eight hundred years, long before any government involvement at all), which nobody is advocating. They conclude that the hypothetical justifies the thousands of pages of the ACA, tens of thousands of pages of subsidiary regulation, and the mass of additional federal, state, and local regulation applying to every single person in the country.

How is it that we accept this deeply illogical argument, or that anyone making it expects it to be taken seriously? Will not one person fall through the cracks or be ill served by the highly regulated system? If I find one Canadian grandma denied a hip replacement or one elderly person who cannot get a doctor to take her as a Medicare patient, why do I not get to conclude that all regulation is hopeless and that only an absolutely free market can function? Both straw men are ludicrous, but somehow smart people make the first one, in print, and everyone nods wisely

Thursday, June 1, 2017

A Revised Radical

A revised draft of "Michelson-Morley, Fisher, and Occam" is now on my webpage (Yes, new title.)

This paper argues that the long quiet zero bound is an important experiment. The zero bound or an interest rate peg can be stable, and determinate. Longstanding contrary doctrines are simply wrong -- the doctrine that interest rate pegs must be unstable, starting with Milton Friedman, or the new-Keynesian view that the zero bound will lead to sunspot volatility.

I struggle hard with the implication that raising interest rates will eventually raise inflation. I've posted the paper before, but if any of you are following it this is a big revision.

What happens to inflation at the zero bound, and with a huge expansion of reserves? The big surprise: Nothing. This dog did not bark.