The trend toward excessive debt leverage is probably due more to the Fed’s implied support of credit markets over the past 25 years than tax policy. If the Fed is going to bail out bad debts, the trade-offs between equity and debt become a one-way bet for existing owners and management. The incentive for corporate business is to load up on cheap debt and gamble the capital on risky projects. It’s another case of “heads we win, tails the taxpayer loses.” The capital financing decisions of firms should reflect the risks facing the firm and the optimal ownership structure of the firm and industry, not its tax advantages as determined by political motives or moral hazard engendered by Fed policy.
In the case of homeowners, the mortgage deduction has increased the debt loads for all real estate mortgages by raising the purchase prices of home. Because interest payments are tax-deductible, mortgages are subsidized by tax deductions. But this just causes house prices to rise as people can afford to borrow and pay more. So, the money we save with interest deductions is more than offset by the increased principal amounts we must borrow to buy the house! Home owners now have higher debt loads and less equity, meaning they are less able to absorb price declines and less able to convert equity to debt in times of trouble. Tax policy that favors debt over equity helps leverage risk, but also reduces the adaptability of the economy to change. With debt we get more risk and less flexibility. The results of excessive debt in the real estate sector speak for themselves.
My last principle flows from the objective to distribute the risks and benefits of wealth creation:
3. Tax policy should reinforce the objective of risk management through the diversification of risk and the widespread accumulation of returns. The imperative to participate in capitalism through equity should be promoted, not impeded.
Our most intractable economic problems are those of maldistribution. Misguided tax policy has done much to aggravate these problems and contribute to the divergence of incomes and wealth. For example, if savings and capital accumulation help spread the benefits of economic growth and enable citizens to more efficiently insure against risks, why do we tax dividends, savings, and capital gains at both the corporate and individual level? Why not remove these taxes completely for middle and low-income levels? Why do we place such onerous restrictions on tax-free accounts for retirement, health care, and education, when these private funds can directly reduce the burden on social insurance and public goods provision? Why do we punish savings with a monetary policy that keeps interest rates so low?
Inequality has been blamed on a host of factors, mostly targeting the indifferent or conspiratorial rich, but, as I have argued, I believe most income disparities can be attributed to technology and the changes it has wrought. The global winner-take-all economy cannot really be blamed on the winners, but it does demand a policy corrective in some form (such as a wealth tax). Whatever form this corrective takes, it will surely incite a resurgence of conflict between those who stand to win and those who stand to lose. If we do not provide the corrective, however, the economy will become chronically unstable and we will all likely suffer in one way or another. A class crisis either takes the form of a political revolution or an economic and social disaster. It would be better if the problem were addressed with a deliberate and principled strategy that does not condemn us to an endless pendulum swing from one policy to its opposite.
5.4 Risk, Insurance, and Entitlements
As discussed previously, the management of economic risk and uncertainty is one of the primary functions of a democratic society. Our attempts to manage risk through Social Security, Medicare, Medicaid, and other social insurance programs, such as unemployment and state disability, have proven to be neither optimal nor efficient. On the other hand, the private market for these goods has been found wanting and distorted by government regulation and intervention. The conventional defense of social insurance programs deems that they have been found to be necessary. The need and demand for economic security is real, but the methods for providing it offer a wide array of policy choices. The opposition to, and difficulties enacting, entitlement reform are mostly political in nature. Loss aversion dictates that we cannot eliminate program benefits without providing a more suitable substitute for participants who have planned on these benefits. In discussing economic security and entitlement reform, the first caveat to consider is that there is no free lunch. What I mean is that economic security, whether provided as a public or private good, is not free—our choices involve trade-offs. The basic trade-off is over who controls the rationing of scarce healthcare and old-age benefits: the individual or the state? I will argue here that a wise combination of the two is the best solution.
We have previously explained in Chapter Two why self-insurance is superior to private insurance, which is superior to social insurance, under the explicit objectives of risk management. We face an additional challenge with our entitlement programs because they are not really insurance pools. They are pay-as-you-go transfer systems (PAYG), which present a host of financial problems.
First, the PAYG system does not save and reap the benefits of interest compounding, so there is no true "investment return" on Social Security or Medicare contributions. Second, because funds paid in by workers are immediately paid out to beneficiaries, the system relies on demographic dependency ratios. Presently, there are three workers paying into the system for each beneficiary. Within twenty years that ratio will fall to 2 to 1, implying that the taxes on every two workers will have to be enough to completely support one retiree. Third, redistributive programs exact high moral hazard costs by creating disincentives for saving, depressing national savings for productive investment, and depriving people of the necessary incentives to economize on healthcare.
We must dispel the fear invoked by the idea that these programs can or will go bankrupt. There is no debt constraint on the U.S. Treasury when it comes to paying off dollar liabilities, so any obligations of the U.S. government will be paid without question. Instead, we should be worried about the U.S. economy’s ability to create the goods and services that retirees need to purchase. If the economy does not supply these in abundance, prices will skyrocket and entitlement benefits will be inadequate. The danger comes from imprudent social insurance programs that do not pay for themselves over time and soak up valuable resources from other productive segments of the economy. So, it goes without saying that these programs need to be reformed and rationalized to economic and financial realities. Social Security is the easier fix because it makes perfect sense to raise the retirement age and perhaps means-test benefits. Benefit calculations can also be adjusted to reflect real cost of living changes.
With publicly-subsidized healthcare there are no market incentives to restrain the primary cost drivers. Think about it: we have removed the negative feedback processes we discussed earlier that help keep goods markets in equilibrium. The hospital, drug company, or doctor can raise prices, but that does nothing to depress demand because the patient never sees or pays the price directly. The reality is that there are no real, posted prices. Imagine going into a supermarket where there are no prices on the goods, and when you get to the checkout, you’re given a total bill for $5000 dollars for your basket of groceries! (Or maybe the supermarket will bill you a month later, after you've eaten all the food, just to avoid riots at the cash register.) If we expect a market to work, all participants must have access to accurate price signals in order to make efficient choices. (The airline industry may need to take this cue too.)
The better long-term strategy to mitigate the shortcomings of entitlement programs is to substitute self-insurance and private insurance markets for the bulk of entitlement needs. We have already covered the difference between private and public goods here. Private goods are provided in abundance by private markets—just visit your local grocery or department store. Similar private market options can be provided with regard to both retirement and healthcare needs. This, despite the fact that democratic governments around the w
orld have responded to citizen demands to make these public goods. If we choose to have government provide these goods while restraining the private market, there is no escaping the fact that they will be delivered less efficiently and there will be less to distribute. In order to provide a good, it must first be produced, and the public sector does not efficiently produce or distribute goods. Granted, this is one of the more controversial issues in our current politics, because our political efforts to convert these private goods to public goods through excessive regulation have distorted supply and demand, hampering private markets. We must rationalize private markets so they function efficiently in providing for the needs of our population. We already provide for most of our retirement needs with private pension plans, private health insurance, and a slew of individual investment plans such as Health Savings Accounts, IRAs and 410(k)s. These should be expanded, with flexible rules that meet the needs of participants, not those of the tax collectors or bureaucratic administrators.
Medical care has been provided privately for almost the entire history of the U.S. There is no defensible argument that we now need public provision. The bottom line is that if we want first rate medical care as a nation, we will have to save enough and invest in the R&D and production of that care. As with Social Security, the problem is not how do we pay for it, but how do we insure a sufficient supply of goods and services demanded. At the individual level, we need to make the proper savings decisions to assume the bulk of our healthcare needs. There is no way government can deliver such goods out of thin air. Inadequate provision of healthcare goods and services means an undersupply that, with central control of the production and delivery, must be rationed by supply instead of price. This inescapable fact of rationing invites all kinds of arbitrary decision rules about 'who gets what' that violates our first principle of policymaking: to insure freedom of choice and freedom of action. To truly solve our healthcare needs we need functioning competitive markets, with real prices, so we may compare and choose from many choices in order to make rational decisions on how to best secure our long-term health while maintaining financial solvency. A rational market in healthcare goods will efficiently provide the goods we demand at the prices we are willing to pay. Then we can tweak the distribution of this abundance of healthcare goods without killing the golden goose that lays the eggs. In addition, we need a functioning insurance market that allows us to insure against unpredictable catastrophic healthcare contingencies. Nothing mentioned in the recent Patient Protection and Affordable Care Act (aka Obamacare) seems to come close to meeting these needs.
5.5 The Principal-Agent Problem
The principal-agent problem is an opaque issue that is not often discussed outside of economics. Markets, especially financial markets and democratic political markets, rely heavily on “agents” in order to function efficiently and effectively. An agent in this sense is nothing more than someone who executes a service for you in your interest. Our elected politicians and local city councils are agents, so are the managers and the Boards of Directors of the businesses where we work, or the bankers who manage our savings. The teachers who teach our kids are agents, as are the union leaders who represent teachers’ interests. The President of the United States is an agent who is sworn to uphold the Constitution and represent the interests of U.S. citizens in world affairs. The person or persons whose interest is being represented by the agent is called the principal. The principal-agent conflict is a general and pervasive one: how can we insure that agents act in the interests of their principals and not in their own self-interests, which may conflict with those of their principals?
This is no trivial matter. If an elected politician violates his campaign promises, our only recourse is to throw him or her out in the next election. If our banker takes imprudent risks with our savings, we may discover unexpected losses of those savings. And if the CEO of a public company misuses shareholder funds, we may discover our investment has been misappropriated. We’ve been cheated, even when it is done within the letter of the law.
There is no way to completely eliminate agency costs, just as there is no way to eliminate moral hazard in insurance pools. The best we can do is to align incentives between principal and agent, require transparency, and monitor and sanction agent behavior to minimize violations of the public trust. When it comes to controlling agent behavior, proper incentives are often more effective than regulations, as laws are easily subverted, while monitoring and enforcing compliance can be extremely costly. We cannot just pass a law, put a police officer on every corner, and expect good results. The agency costs that inflict the most damage on our society are those associated with corporate ownership and control, organized labor, financial markets, democratic politics, and the bureaucracy.
In democratic politics we have established a constitutional structure of checks and balances to guard against the concentration of political power and reduce the potential for governmental abuse. But even in a democracy we can see the after-effects of backroom deals, the power of incumbency (when those in power make the rules), and politicians’ persistent efforts to obscure the truth. Certainly transparency and accountability are critical to the democratic political process and often are the only means to expose political malfeasance. The traditional media, which has now been supplemented by alternative media, is tasked to perform this function. This is one reason why the overt politicization of media can be a detriment to a free society, as biased information either misleads or is ignored.
Beyond legal monitoring and judicial enforcement, we ultimately must rely on voters to control agents’ behavior in a democracy. True electoral competition is democracy’s saving grace, as rigged elections are its nemesis. Removing electoral barriers that favor incumbents can motivate candidates to restrain their own behavior while policing others. In other words, viable challengers are driven to keep an eye on incumbents’ actions in office and inform voters of any malfeasance.
In economic markets, we must also be mindful of how incentives operate through checks and balances. The checks and balances are provided by market competition and the "voters" are consumers, shareholders, and other enterprise stakeholders, such as workers and creditors. The major agency problem in the private sector has always been over how to govern the public corporation. In public companies, shareholders provide capital through equity ownership and then rely on managers and directors to act in their interests. This particular agency relationship invites conflicts of interest between managers and directors, and a lack of transparency for shareholders. Managers often appoint directors, who then pass judgment on managerial decisions such as executive compensation and perks. As the board of directors of a public company is meant to represent shareholders, this cozy relationship with management presents a conflict of interest.
The costs of monitoring directors or organizing and fighting management are often too great given shareholders’ small ownership interests. If management is violating small shareholders’ interests, it makes more sense to sell and move on. This collective action problem causes shareholders to manage their investment risks by diversifying their ownership interests across many different public companies. But this diversification strategy leaves a vacuum of control, with no one to rein in corporate management, creating incentives for mismanagement and inefficiency throughout the corporate business sector.
In order for market capitalism to work efficiently, while promoting wider ownership participation for all, corporate governance issues must be managed and minimized, and collective action problems must be resolved. One route is to impose independent directors elected by shareholders rather than appointed by management. Another has been to pass laws that ensure managers and directors are accountable to shareholders. Securities markets have long required adherence to reporting and accounting standards for publicly listed companies. Still, this hasn’t been enough to defend shareholder ownership.
We might go further by applying a democratic political model in certain aspects. Like univ
ersal suffrage in democratic politics, democratic capitalism requires universal participation in risk-taking enterprise through stakeholder ownership. Stakeholders include not only shareholders and management, but also workers, suppliers, and customers. The most effective way to internalize the principal-agent problem among these various stakeholders is through equity participation in ownership. Ownership assumes the risks of loss as well as rewards of success.
Likewise, the consequences of ownership also imply the exercise of control over the risks and rewards. (Owners are risk-takers, and no skydiver wants to risk jumping out of an airplane if they don't have control over who packs their chute!) Economic, or shareholder, democracy is different than worker-owned cooperatives because the former assumes specialization in management and diversification of ownership, two important characteristics that are sacrificed with worker cooperatives.
Just as with political democracy, fully developed institutions are necessary to ensure economic democracy. Thus, a free market democratic capitalist model must develop institutional structures that insure stakeholders are empowered to exercise their interests through ownership and control, which means they must have the legal means to do so. We need laws that strengthen shareholder interests and ensure that their representatives on the board of directors are reliable agents independent of management.
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