Re-Center the Stakeholder: For a New Capitalism

In the 70s, Milton Friedman wrote a famous essay that argued against the prevailing mode of social organization in corporations. At the time, the prevailing mode was one of stakeholder capitalism. Everyone who had a part in the corporation were important in how it ran, and the managers of the corporation were meant to balance the needs of everyone involved in the running of the operation. This meant that the workers, and the customers, and the managers, and the local community all were important. The owners were also important.

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 What Friedman argued was that everything except for the maximization of shareholder value was what mattered. As long as the corporation was making money for the shareholders, everything else was secondary. This was a popular view amongst those running corporations, but the new ideology took a while to trickle down to everyone. 

People had been used to the idea of a corporation that did a lot of things for its workers. Kodak, in Rochester, NY, built dance halls and movie theaters for the people who worked for them. When they polluted, they were anticipated to clean up the pollution. They sponsored little league teams. Alas, the forces that Friedman was writing for took over the view of what a corporation was supposed to do. Though the example of Kodak might be the high point of what corporations did, a lot of what they did for their workers specifically was to stave off the threat of unionization. As long as there were countervailing powers against corporations, they would then work towards making life better for everyone involved. Unions and government bureaucracy could make their lives worse and harder, so the incentives were shaped to make it work for everyone. 

Friedman was influential in changing this, but it was not just the one economist. There were a lot of social forces pushing for a rethinking of how the economic system was shaped. Thatcher came to power in the late 70s and Reagan came in not much later, and combined they created the world of big hair and big shoulder pads and Gordon Gekko saying, “Greed is Good”. The expansion in the 80s was the antidote for the stagflation of the 70s, and it justified for a time the ethos of doing everything for shareholders.

Though there was a crash in 1987, there was not much pushback against this idea as time moved into the 90s. Bill Clinton came into office and the internet boom happened, justifying not just a corporate turning away from social responsibilities, but also a turning away from the social responsibilities of the state. Clinton signed legislation to change welfare to become much less supportive of needy populations and signed bills to allow financial institutions to do what they pleased. His government ran a surplus on the back of the stock market boom that he enjoyed, and he enjoyed high approval ratings in spite of his personal discretion. 

The next decade passed to George W. Bush, who continued the move towards a social ethos of everything for profit and then let the rest of the chips fall where they may. He signed two bills cutting taxes on rich people even though he was also starting wars in the shadow of 9/11. 

Everything was working fine, until the crash in 2008. What happened was that people had been buying houses and those prices were going up and the financial system was taking the money generated and then speculating with it. This was all fine until prices stopped increasing, and people couldn’t afford payments anymore and the punch bowl was taken away. The financial crisis exposed the fact that people had not been taken care of during the long boom of corporate favoritism. Median incomes had been stagnant. Households were supported by more people entering the labor force, or through borrowing. The minimum wage had not been increased reliably, and it kept losing buying power. For most people, houses had been the majority of their wealth, and it was just wiped out. This led to a reevaluation of how corporations and the state needed to act towards the people who worked for them. Obama was elected with the idea of hope and change away from the scary downturn that at the time most people couldn’t tell you why it was happening but only that it was scary.

Alas, the promise of hope may not have been realized. The Obama agenda was stymie by the Republicans and then in 2010, seats started slipping away from the Democrats. This led in part to protests like Occupy Wallstreet, where the voices were loud in arguing for a more inclusive society, and a rethinking of the corporate form. We’re still far away from that, as the election of 2016 brought in Donald Trump, a personification of all that was bad about the 80s, as president. A new reevaluation will come, I only hope it is not with the next crash.

Looking Toward the Next Recession

I don't know when the next recession will hit. One of the things about studying economics is that it makes you less certain about making pronouncements about the world.

It is why Truman wanted a one-handed economist. That economist would not be able to talk about on one hand and then the other, being limited by only having one hand.

What I do know is this - we are running out of policy options to prevent it. 

I think this is why Trump is breaking norms to lean on the Fed. He wants rates lowered because either he or his advisors can see the rot that is underlying the system.

But he's trumpeting the good news. Jobs numbers are up. The unemployment level is flat. The stock market is up.

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Like I said though, we're running out of standard policy options. On fiscal policy, what can you normally do? You spend money. Shovel money out the door to people.

Get money in the hands of people who want to spend it. Bush did this. Remember getting a random six hundred dollars from the treasury over a decade ago?

That was nice. It wasn’t sufficient to stop the slide, but it was nice. I paid down my credit cards.

The problem with this is that there are still sufficient people in congress who speak ill of deficit spending in any form. 

Many came to power complaining about profligate spending during the last recovery. I guess if Trump does it it will be fine though.

Another way to combat a falling economy is to cut taxes. Instead of distributing funds, have people and corporations keep it in the bank.

Problem here is that we already did that. The tax law cut the top marginal rates and sliced the corporate rate. 

We saw a pop in earnings, this is what helped juice the market. It does not change the rate of growth though. It just raises the level.

If you own stock, this is good, but the vast majority of the securities in this country are ultimately owned by the top 10% - over 80% of stocks, and what the bottom 90-% own are mostly tied up in retirement funds.

The other way to juice the economy is through monetary policy. You lower the rate the central bank charges. You stop paying interest on reserves. This makes banks lower their rates.

Companies, in turn, see this cheap money and decide to make an investment in building capacity. Consumers make those big purchases, like houses or cars (or Boats!).

Problem here is that the interest rates the Federal Reserve sets, the federal funds rate, was stuck at zero for a decade. The recovery, over two presidents, has been the longest on record, but it was a shallow recovery.

Average growth was under 3%. That's better than a recession, but it makes you look at past expansions with envy. 

The rate now is near historical lows if you don't look at the recent recovery. There are very few investments that make sense now but are waiting for a quarter point drop in the fed funds rate to make your internal hurdle rate lower.

That leaves unconventional policy - quantitative easing or helicopter money or direct debt monetization to move the needle. 

The bottom line is that there are signals flashing now.

Manufacturing is slowing. The yield curve has inverted, meaning that it is cheaper to borrow money for a long time than a short time. 

This has in the past been a signal of slumping market confidence and recession on the way.

And recessions come. The mechanism may vary, but once the broad market turns, then it becomes a self-reinforcing process.

One thing the market does like is certainty, and that's the policy variable that our president is the worst with.

Globalization has grown and supply chains are put in place, and then he makes a pronouncement that changes incentives, until he changes his mind.

In a lot of ways, he is his own worst enemy, as these trade wars of his choosing are not fun and easy to win. 

Manufacturing is hard to bring back onshore. If it comes back, it will be capital intensive because the job market is tight, and hiring is hard.

This has been true for a while now. Look at manufacturing output versus employment for the last 40 years. They are moving against each other. 

We need to look to the past and be ready for a future that is uncertain. There will be a downturn, and of course the president will look for scapegoats.

The policy team will be unprepared for only finding that scapegoat. "If only Powell didn't raise rates in December!" They'll say as people go hungry and lose their houses, and die of preventable diseases.

We know where he won’t point the finger though.

  

A Manifesto for a Boring Financial System

Today, I sit and think about the role of financial markets in the economy. What do the stock markets and the bond markets and banks even do? How do they operate, and what kinds of risks do they pose? How do we stop these risks? Of course, I won’t stand up and leave the computer nor will you finish reading this essay with full knowledge of these complicated issues. If we as a discipline had finished up an completed our understanding of the role of these institutions and how to control them we would still have the market at Irving Fisher’s ill-timed comment right before the 1929 stock crash that “Stock prices have reached what looks like a permanently high plateau,” cementing his place in history as an anti-prophet. Of course, he did other things but if he is remembered to the laymen, it is for that utterance. But perhaps you can say that he was early, and the pride in his voice was there only because the discipline was young, and the practitioners thought they had all the answers. Alas, there were other names, more recognizable to today’s readers making similar claims that would not be born out in history. In another instance, we have the great historian of the Great Depression and later Fed Chair Ben Bernanke, in remarks on Milton Friedman’s birthday give the older economist a valediction: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again” (“Birthday”). In my education, I have circled back to this moment mentally many times and let it play through my hands and fall to the ground like sand. It amazes me and is a perfect bookend to Fisher’s remark. The over-enthusiasm of the earlier quote is the other side of the hubris of the latter quote. “Look,” the sages say, “there is no need to worry because we have all this figured out”. Of course, these remarks are only telling in retrospect. If the stocks had stayed at the high plateau, only economists would know Fisher’s name. If there wasn’t a housing crash caused in part by keeping those low and steady rates the Fed kept through the 2000s, Greenspan would still be the “Maestro” and we would continue to say that in awe instead without that hint of sarcasm I use when I say Maestro, and he wouldn’t have to have been hauled in front of Congress to explain that there was “a flaw in the model that I perceived is a critical functioning structure that defines how the world works, so to speak” (Naylor). There was a flaw, some sort of weakness that could pass along instability from institution to institution and bring down the whole financial system and the larger economy down, even after pouring trillions of dollars of cash and promises to back up the banks and investment banks leading to a slow recovery and giving political space to all sorts of unsavory characters. For me, there’s a direct line from the crash of 2008 to the rise of Donald Trump, and that’s not a good thing.

I want to pull back for a second from the financial crisis and think about what we mean when we say, “the economy”. At a macro-level, we can talk about contributions to the GDP, C + G + I + (X-M) and ask what is going on with each of those pieces. The talking heads can say that we have an economy in America that is about 70% driven by consumption. But the GDP is driven by final goods, and there’s so much that is not accounted in the GDP (and all the bad things that are counted in there) that looking from a top-down macro-level doesn’t capture what the economy really is, or if it captures it, it abstracts too much for the guy on the street to have a good sense of what is going on. I say this because what the economy really is is people making economic decision under uncertainty. Do you quit your job, and if you, will it be easy to find a new job? Do you move, looking for better opportunity? Should you start saving your money, thinking that there may be a downturn? There are organizations that try to quantify these questions. Both the Conference board and the University of Michigan survey Americans about how they feel about the economy and how they think the economy will act soon, asking questions like in the below figure from the ninth page of the Michigan survey.

fig 1

Of course there are all sorts of problems with survey data in that it captures what people think and not how they actually act, but we’re looking for leading indicators here, and the leading indicator at the current moment shows that for both of them, the sentiment is high. The American consumer in aggregate is on fire.  You and I don’t make these decisions in the aggregate though. We make these decisions on our own. I refinanced my mortgage last year, thinking that the rate would keep going up, and despite all my Fed tracking, the President and the economy put enough pressure on the rate-setting committee that they decided to not keep raising the rates. Now the market is saying that there will at least be a pause in the raising of the rates and that there might be a whole percentage point lowering of the federal funds rate. That means my mortgage is locked in at a higher rate that I would be able get if I refinanced now, and I still could if I wanted to pay more fees and reset my amortization table. I might move in a year, so I think I won’t approach that decision for now, and thinking historically, it is at 4.5%, which is low. What the economy is is people, operating under uncertainty, making these economic decisions. They play these roles as consumers, as workers, and as members of government.

I want to move now from looking at “the economy” now versus what it looked like right up until the crash. I have written elsewhere that I didn’t ever pay much attention to the economy at large until the financial crisis. I was cognizant of my role as a worker, but so much of what was happening in the real economy did not seem to have any sort of effect on the real economy, where I lived day to day. I made choices as if the baseline was nothing to worry about. When I was in undergrad, I figured it would be fine to major in English. I was aware of the boom and the bust in the dot-com era, but that didn’t touch me. Reflecting on this made me try to think about how the financial economy leaks into the real economy. There are polls of consumer confidence, and they do try to quantify these sentiments into one nice little number, but how are these sentiments created? To really think about this, I need to separate the person I am now from the person I was over a decade ago. What sorts of information does one person have if they are not keyed into to the financial news, and how do they interpret how the economy is and what the path will be? Talking informally to people this week, there are a couple of big indicators, and one of those is inflation. The price of gas is a big one. Though most of us go shopping in person or online, there is only one real price that you drive by every day, and that’s the gas price. If it goes up, there are stories on the evening news about how the new gas prices will hurt consumers, since it is a big enough part of their expenses, and one that can move with some volatility. In the lead up the crisis in 2008, the gas prices almost doubled. I remember gas at over $4.50 a gallon. This mattered because I was driving a 1998 Dodge Ram Pickup. That thing had a huge thirsty engine that only got about 12 miles to the gallon. To fill up the tank took thirty or more gallons, so a single fill-up cost almost a hundred and fifty dollars. I did not have that kind of extra money lying around, so I tried to get rid of the truck. When I tried to sell it, I found that people were not interested in paying much for the truck, so I donated it to get it off my hands because otherwise I would be fined for keeping it parked in city streets. In the run up to the crisis, as someone not really paying attention to the economy, the other number that would have been available would been the level of the stock market, but even that was not in my consciousness. Looking up the level of the DJIA in 2007-8, I was surprised to see that there was noted weakness in the spring, which would have been around the time of the insolvency of Bear Stearns and its being sold to Chase (“Historical Dow”). The Dow then recovered a bit and try as I might I cannot recall any concern that summer. I had been out of work. Teaching at a Catholic School in academic year 2007-08, I was not invited to renew my contract and a bit listless about what to do. I had liked teaching, but I needed to step away for a minute to reconsider my life path. It was in the summer of 2008 that I thought it would be a good idea to go into sales. I did some research and one of the easier industries to break through in would be automobile sales. So, I reached out to different dealerships and started doing research on some of the newest models that were going to be hitting the lots in the fall. I also remember seeing an article that the car sales were having their worst summer in a long time. Persisting, and not letting that bother me, I was hired on at a Chevrolet dealership. 

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And then that fall, the leakage of the financial economy into the real economy became a tsunami.

There come times when you cannot take the economy’s working for granted because it makes itself know to you no matter how you try to ignore it. Though NBER would later date the start of the recession to late 2007, I was still looking at car sales as a good way to make some money quickly, even though sales had turned down some. In the middle of September, there was no ignoring the fact that something had snapped. We were required to be on site at the dealership for fifty hours a week, and those were the longest days, spending ten or twelve hours doing nothing, or going through the motions of some training game the managers had dreamed up, or calling everyone in our database to see how open they might be to coming down and looking at the new models. It was not an auspicious time to be making a career change, and the low traffic in the dealership meant that it was dog-eat-dog between the salespeople for the few people who did walk into the dealership.

But we had been able to take the economy for granted. When Bernanke apologized to Friedman for the Fed’s role in the Great Depression, it was with the acknowledgement that at that point, the economic problem had been solved. The last recession was small and concentrated in the stock market. One reason that it did not leak into the real economy was because of the spread of stock ownership, where the top 10% own over 80% of financial assets (“Duetsche” 42). What was different about the crash six years later was that it was tied into people’s housing, so there was a feedback effect from people not making enough to cover their payments to this meaning that the risk level were understated and the price of assets backed by the housing is overstated, so they fall in tandem with a horrible negative feedback effect.

What is interesting is that it really should never have happened. Regulations were put into place after the crash of 1929 and then during the New Deal to make sure that banking was boring. The problem with this approach is that corporations accumulate political power that is strongly correlated with their financial power. That, plus people forget the original justifications for the regulations on the book and it becomes fine to breach walls that were put into place to prevent the next crash – oddly enough the very stability of the system, the fact that it was working, is used as a justification to erode the protections. Stability, as the rediscovered economist Hyman Minsky would put it, creates its own instability.  One important thing to note is that the financial power of these institutions was huge. By one measure, in the run up to the crisis, over 40% of corporate profits were created by banks and other financial institutions. After dropping, they were back over 30% in a couple years (“Wall Street”). All of this is of course notable because in many economists’ models up to the crash, banking and financial institutions were not part of the model. Buyers of sellers of goods met each other in the market with no intermediary. 

Economists did not have these financial institutions in their models because financial institutions should be boring. They handle vast sums of money, and even if the just cream off a percent or two they do not think that you will miss those funds, but you do. There is no justification for the huge glass towers in midtown Manhattan other than the fact that we have allowed these institutions through their power to take these rents. They went from boring to being a huge amount of the corporate profits, by acting as middlemen in transactions that in theory at least would happen anyways. You can go to a textbook and see what a financial system that is boring should look like. The financial system should meet the needs of the real economy, and not be the driver of it. What are the needs? Companies need money. They might have a new product to launch or are investing their model in a new market, but they do not have the immediate liquidity. Companies do not like uncertainty. They may want to hedge their positions. Investors have money, and they may want a guaranteed return. Alternatively, they may feel like they can expose themselves to some risk to get a greater return. Financial products exist to make this all happen. 
If a company needs liquidity, there are two ways they can go about it. They can issue stocks which are usually a claim on the fractional percentage of the company’s profits, as well as a vote in the way the company is run. This basic model has been subverted some in recent years as some companies have issued shares with different claims on the profit or different levels of voting rights. The company gives up some rights to future cash flows with each share it offers, diluting the value overall of all the other shares. This share offering is beneficial for investors since in return for their cash up front, they have a claim on all future dividends, buybacks, and one-time cash disbursements that the company gives out to its shareholders as long as the company is in business and the shareholder owns the stocks.  The other way to get needed money is to offer bonds. Bonds are fixed term investments with a set return at the time of issuance. The buyer of these securities is guaranteed the nominal return of the bond’s coupon as well as the initial investment at the end of the maturity period of the bond (Ball 58). Both instruments trade on secondary markets, where based on changing interest rates and perceptions on the level of future cash flows, the price of these will be different from the initial price on offering. 

Consumers also might need money, no or in the future, so they can invest their current funds in one of these securities. Or they can go to a bank. A bank is an institution that accepts deposits and makes loans (Ball 222). In the United States, there are a lot of different kinds of banks, but if they are in the business of maturity transformation, we can talk about them in general. These institutions must have their own money to lend out. Investors in banks provide the initial capital, which is the backstop for all that they do. They then can take deposits and lend money. They can also borrow money from other institutions or the Federal Reserve to allow themselves the ability to make more loans. Banks make their money through fees and through the difference in the interest rates in which they lend and the interest rates at which they borrow. If the loans are good and the spread is wide enough, then there should be no problem keeping this system going. 

The final boring thing the financial system should be able to do is to eliminate risk. That’s not entirely possible, so perhaps it should be framed as the lowering of risk. Different financial products are available to buy and sell for both institutional and commercial customers that give the customer the right to buy or sell securities at a certain price. There are also financial institutions that package shares into mutual funds so that customers can be diversified and track an index without having to buy in and out of different securities. 

The problem is that it all stopped being boring, and that was by design of the actors in the financial system. They did what they could to increase risk and increase returns and ignored the simple fact that if you make derivatives out of mortgage backed securities, you would be in trouble if there was a lot of correlation in the change in housing prices nationally. Institutions ignored the lesson that if you borrowed too much money, then you diluted your capital base. Lehman Brothers by 2007 was leveraged over 30:1, meaning that they were only backed by 3% of their own capital (“Lehman”). That means that you as an institution can make money if the market is going up. You can make it hand over fist. It also means that if the market drops only three percent, your entire institution is not just illiquid, but insolvent. 

How do you make the financial system more boring then? The easy answer is grab a magic wand and decree that banks need higher capital levels, exotic derivatives are no longer legal, greater underwriting needs to be done on all loans. You wave that wand and you cap remuneration at banks and financial institutions to some percentage of the median. You wave that wand and outlaw the business model of private equity firms, who buy companies and load them with debt, and spin off their assets. Create the ideal classical world, one where Laurence Ball says is a place where “crashed are hard to explain” (71). You send people to jail for fraud. 

You wave that want and make these regulations global because what capital is good at is seeking the best place to make money for the short term. If you raise the cost of doing business in one jurisdiction, the capitalists will find the next best place to do business.

Ultimately, you want to do that because as long as we have capitalism around, we need to do our best that it works for people operating in the real economy. The more the real economy and the financial economy get separated from each other, the greater the risk of a great and debilitating crash that is exogeneous to the real economy. You end up with a situation where the options become framed as one of two choices, liquidation of the system or a propping up of the failed system so that it can recreate the conditions of the crash. Alas, none of us have that magic wand, but through national regulators and international agreements, capital requirements have increased such that the big banks are holding more dry powder, but it will not be enough. The seeds of the next crash are already being sown. The alarm is being raised by some economist or commentator, but they are being ignored because no one like to hear bad news and besides this time is different. But until we make and keep banking boring, each successive time will be different, but it sure will rhyme.

Works Cited

Ball, L. M. (2012). Money, banking, and financial markets. New York City, NY: Worth.
Bernanke, B. S. (2002, November 8). On Milton Friedman's Ninetieth Birthday. Retrieved June 30, 2019, from https://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/
Consumer Data. (n.d.). Retrieved from https://www.conference-board.org/data/consumerdata.cfm
Deutsche Bank's capital position. (n.d.). Retrieved from https://www.db.com/company/index.htm
Dow Jones Industrial Average Historical Prices, 2007-2019. (2019, April 17). Retrieved from https://knoema.com/jhxfibc/dow-jones-industrial-average-historical-prices-2007-2019
Naylor, B. (2008, October 24). Greenspan Admits Free Market Ideology Flawed. Retrieved from https://www.npr.org/templates/story/story.php?storyId=96070766
Stewart, H. (2010, September 19). Consumer Spending and the Economy. Retrieved from https://fivethirtyeight.blogs.nytimes.com/2010/09/19/consumer-spending-and-the-economy/
Surveys of Consumers. (n.d.). Retrieved from http://www.sca.isr.umich.edu/

Weissmann, J. (2013, May 11). How Wall Street Devoured Corporate America. Retrieved from https://www.theatlantic.com/business/archive/2013/03/how-wall-street-devoured-corporate-america/273732/