Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  2. This box draws on www.darvill.clara.net/emag/.

  3. Peter Temin with Louis Galambos, The Fall of the Bell System (Cambridge, United Kingdom: Cambridge University Press, 1987), 11. For an excellent journalistic account of the breakup of AT&T, see Steve Coll, The Deal of the Century (New York: Atheneum, 1986).

  4. Temin, Fall of the Bell System, 15.

  5. Fred Kahn outlined a more nuanced and uncertain view of whether Western Electric’s equipment manufacturing activities had the characteristics of natural monopoly. Alfred E. Kahn, The Economics of Regulation: Principles and Institutions, Volume II (Cambridge, MA: MIT Press, 1995), 297–305.

  6. A more detailed treatment of the history briefly summarized here can be found in Jonathan Nuechterlein and Philip J. Weiser, Digital Crossroads: American Telecommunications Policy in the Internet Age (Cambridge, MA: MIT Press, 2007), 57–64.

  7. Ibid., 62.

  8. Temin, Fall of the Bell System, 34–40.

  9. Richard A. Posner, “The Decline and Fall of AT&T: A Personal Recollection,” Federal Communications Law Journal 61, no. 1 (2008): 11–19.

  10. Ibid., 12.

  11. Ibid.

  12. Interview of Donald Baker, December 3, 2013, and Remarks of Donald I. Baker, Deputy Assistant Attorney General, Antitrust Division, Department of Justice, before the Federal Communications Bar Association, at the Army–Navy Town Club, Washington, DC, January 17, 1975.

  13. Posner, “The Decline and Fall of AT&T,” 14–15.

  14. Correspondence with George Hay, December 4, 2013, and interview of Bob Reynolds, December 6, 2013.

  15. Communication with Bruce Owen, December 8, 2013.

  16. Based on interview of Richard Levine (director of Policy and Planning at the Division during Baxter’s tenure), December 6, 2013.

  17. Coll, Deal of the Century, 211–229.

  18. Ibid., 172–199.

  19. This accounting of economists during the trial, leading up to settlement, is based on communications with Owen during November 2013 and through my interview with Bob Reynolds, December 6, 2013.

  20. The story about AT&T delaying its fiber optic rollout in the absence of competition was also confirmed in communications with Richard Levine, December 9, 2013.

  21. Ibid.

  22. Quoted in Michael J. Maubossin, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Cambridge, MA: Harvard Business School Press, 2012). See also www.fastcompany.com/3002729/facts-luck.

  23. Based on communication with Richard Levine, December 6, 2013.

  24. See generally, Litan and Singer, Need for Speed, 2–3.

  25. Robert J. Weber, “Making More from Less: Strategic Demand Reduction in the FCC Spectrum Auctions,” www.kellogg.northwestern.edu/faculty/weber/papers/pcs_auc.htm.

  26. I am especially indebted to Roger Noll, who provided invaluable assistance to me in developing this section on incentive regulation.

  27. Harvey Averch and Leland Johnson, “Behavior of the Firm Under Regulatory Constraint,” American Economic Review (December 1962): 1052–1069.

  28. Nuechterlein and Weiser, Digital Crossroads, 51.

  29. A version of Bailey’s argument was published in Elizabeth E. Bailey and Roger D. Coleman, “The Effect of Lagged Regulation in an Averch-Johnson Model,” Bell Journal of Economics and Management 2, no. 1 (Spring 1971): 278–292.

  30. This notion was explored by Paul Joskow, one of the leading experts on regulatory economics for decades while at MIT, and currently president of the Alfred P. Sloan Foundation. See Paul L. Joskow, “Inflation and Environmental Concern: Change in the Process of Public Utility Price Regulation,” Journal of Law and Economics 17 (1974): 291–327.

  31. M. E. Beesley and S. C. Littlechild, “The Regulation of Privatized Monopolies in the United Kingdom,” The RAND Journal of Economics 20, no. 3 (Autumn 1989): 454–472.

  32. Daigyo Seo and Jonghyup Shin, “The Impact of Incentive Regulation on Productivity in the US Telecommunications Industry: A Stochastic Frontier Approach,” Information Economics and Policy 23, no. 1 (March 2011): 3–11.

  33. Ai Chunrung and Salvador Martinez, “Incentive Regulation and Telecommunications Service Quality,” Journal of Regulatory Economics 26, no. 3 (2004): 263–285.

  34. See Paul L. Joskow, “Incentive Regulation in Theory and Practice: Electricity Distribution and Transmission Networks,” January 21, 2006, unpublished manuscript, 26–31, http://economics.mit.edu/files/1181. See also Paul L. Joskow, “Incentive Regulation and its Application to Electricity Networks,” Review of Network Economics 7, no. 4 (December 2008): 547–560. These essays provide an extensive guide to the academic literature on incentive regulation.

  35. Jean Jacques Laffont and Jean Tirole, “Using Cost Observations to Regulate Firms,” Journal of Political Economy 94, no. 3 (1986): 614–641.

  36. Joskow, “Incentive Regulation in Theory and Practice,” 18–19.

  37. Ibid., 16. See also Donald J. Kridel, “The Effects of Incentive Regulation in the Telecommunications Industry: A Survey,” Journal of Regulatory Economics 9 (1996): 269–306.

  38. Nuechterlein and Weiser, Digital Crossroads, 51–52.

  39. “Ronald Coase” in The Concise Encyclopedia of Economics, at www.econlib.org/library/Enc/bios/Coase.html. This profile draws heavily on this essay.

  40. Ronald Coase, “The Nature of the Firm,” Economica 4 (November 1937): 386–405.

  41. Ronald Coase, “The Problem of Social Cost,” Journal of Law and Economics 3 (October 1960): 1–44.

  42. Recounted by another Nobel laureate, George Stigler, Memoirs of an Unregulated Economist (New York: Basic Books, 1988), 76.

  43. Ronald Coase, “The Federal Communications Commission,” Journal of Law and Economics 2 (October 1959): 1–40.

  44. Thomas W. Hazlett, David Porter, and Vernon L. Smith, “Markets, Firms and Property Rights: A Celebration of the Research of Ronald Coase,” George Mason Law & Economics Research Paper No. 10–18, April 1, 2010 (quote in the abstract).

  45. This profile draws on www.gsb.stanford.edu/users/milgrom.

  46. David Balto and Hal Singer, The FCC’s Incentive Auction: Getting Spectrum Policy Right (Washington, DC: Progressive Policy Institute, 2013).

  Chapter 12

  Economists, Financial Policy, and Mostly Good Finance

  I now come to what is likely to be one of the more controversial chapters in the book, the one dealing with economists and financial policy. Given the many errors in policy in this realm that led to the financial crisis, it is only natural to ask whether economists have had any useful impact on financial policy and, in turn, in promoting business activity in finance that has contributed to the social good, or whether the verdict is all negative.

  I take a generally positive view in this chapter, focusing on some key financial policy decisions where I believe economists have been influential and where the business implications have been significant. Where policy mistakes have occurred, mainly in connection with the financial crisis, I do not believe it is fair to blame the economists (except for generally failing to see the crisis coming).

  This chapter differs from Chapter 8, which focused on business applications in finance stemming directly from economists’ ideas. Here we concentrate on financial policy as an intermediate condition, or platform, to use the metaphor of the earlier chapters in this section, and examine how those policy decisions affected the business landscape.

  There are two broad themes to the policies that most economists advocate for financial firms. Economists generally support more competition, and thus the removal of artificial barriers to entry (such as the Glass–Steagall Act, which once separated investment from commercial banking) or constraints on price competition. More competition benefits efficient firms and encourages innovative firms to enter markets that were previously closed to them.

  At the same time, however, most economists have not opposed, but rather have strongly supported, regulation aimed at ensur
ing that financial firms have sufficient capital, or shareholders’ money at risk, to discourage excessive risk-taking. Capital is also important for absorbing losses from loans or investments that turn sour, or losses due to other factors, such as movements of interest rates. Regulators set and enforce capital “standards”—essentially ratios of capital to assets—to help ensure both the stability of financial firms and the economy. As I discuss later in this chapter, regulators’ failure to carry out this essential function both contributed to the financial crisis of 2007–2008 and goes a long way toward explaining why it was so severe.

  Finally, one bit of disclosure at the outset: I have spent much of my professional life researching and writing about financial policy and, as you will see, in some cases I was directly involved in policy decisions or in group efforts to affect the outcomes of those decisions. Accordingly, I have a substantial record on these matters that anyone can discover through any Internet search engine, so it should not surprise you that I took a special interest in writing this chapter. If I have any bias toward the subject it is reflected in the economists’ consensus just described: to favor competition, but also to endorse effective regulation of capital supporting the assets of financial institutions, banks especially.

  Economists and Competition in Brokerage Commissions

  Economists and antitrust lawyers agree on at least one thing: that competitors should not be allowed to fix prices. Yet until 1975, the federal government, specifically the Securities and Exchange Commission (SEC), sanctioned the fixing of commissions that stock brokers charged their investor clients. The securities industry had argued up to that point that fixed brokerage commissions—a system dating from the founding of the once broker-owned New York Stock Exchange (NYSE)—were necessary to enable brokers to earn a reasonable profit. That argument is hardly surprising; it’s the motivation behind all price fixing.

  In retrospect, what is surprising is that it took almost two centuries for this practice to be seriously questioned by federal policy makers.1 In 1971, the SEC ended fixed commissions on large institutional trades, those over $500,000, and lowered that threshold to $300,000 the following year. It took the Commission three more years (on May 1, 1975) to scrap the fixed-commission system altogether. The SEC hurried to beat Congress to the punch, as legislation ending fixed commissions was then being seriously considered.

  Ironically, the NYSE itself unwittingly got the ball rolling that ended fixed commissions by asking the SEC in 1968 for permission to raise its minimum commission schedule.2 That petition came to the attention of the Antitrust Division of the Justice Department, and to Donald Baker, in particular. Baker, who I mentioned in the last chapter, then was the head of the division’s regulatory unit, and like any good antitrust enforcement official, he was offended by not only the brokers’ long-standing practice of setting minimum commissions, but by the SEC’s approval of the practice. Baker was the point person at the division in asking the SEC for hearings not only on the NYSE’s specific request, but on the underlying issue of why a fixed commission system was necessary or appropriate at all.

  Baker and the Division went farther. They asked an all-star line-up of leading economists at the time—Paul Samuelson of MIT, William Baumol (then of Princeton), Henry Wallich (then of Yale and later a governor of the Federal Reserve Board), and Harold Demsetz of UCLA—to testify before the SEC. All agreed to do so, and not surprisingly, all predictably said there was no justification for the fixed commission system. The division subsequently submitted a brief to the SEC citing their testimony and urging the commission to reject the NYSE’s request and simply abandon fixed commissions.3

  It is difficult to know how much influence the economists’ testimony had on the SEC’s decisions to unwind fixed commissions, but the urgings of such a distinguished group of economists certainly didn’t hurt. It is likely that the commission was also influenced by the behavior of large institutional investors, who were increasingly deserting the NYSE to execute their trades off exchanges, or over-the-counter (through telephone calls between brokers), to avoid paying the fixed commissions.

  When the commission finally moved on May Day in 1975 to end the system, the easily predictable good things followed. Charles Schwab was the first of many discount brokers to enter the securities brokerage business, offering to execute trades at much lower rates than full-service brokers. With unrestricted competition and new entry, commissions have dropped like a stone, by roughly 80 percent since 1978.4

  In sum, the elimination of fixed commissions was a boon for innovative brokerages and for investors. Well-established, full-service brokers lost revenue and profits in the process, but this is money they never should have had if the basic principles of market economics had been applied to the securities brokerage business from the outset.

  Economists as Detectives: Accelerating Automated Trading

  There are fundamentally two types of markets for securities (I’ll restrict my attention for convenience to stocks): broker markets and dealer markets. In broker markets, exemplified by the old New York Stock Exchange or the Big Board (which merged with Euronext in 2007 and then was bought out by the Intercontinental Exchange, or ICE, in 2013), a stockbroker acts as the investor’s agent and is obligated to get the best price for buying or selling stock on behalf of the investor. In the days before trading was automated—where offers to buy and sell are matched and executed by computers—floor brokers (acting for the brokers who received the original customer order) would offer to sell or bid to buy stocks on the floor of exchanges. A specialist broker-member would act as the auctioneer and in normal conditions would make markets, using his (rarely were there women) capital to buy and sell (if others wouldn’t) the limited number of stocks for which he was responsible.

  Some readers may be old enough to remember the chaotic scenes of this open-outcry system from the NYSE on the nightly news. Today, futures contracts for commodities are sold in such a fashion, but the floor of the old NYSE now handles only a small minority of the overall trading volume on that exchange since most trading is now completely electronic. It turns out that economists had something to do with how things got to be this way. That story is best understood if I continue reviewing some of the basics of stock trading first.

  In dealer markets, such as NASDAQ, brokers channel orders to buy and sell stocks to market makers or dealers who hold positions in the stocks that investors are interested in. The dealers buy and sell from each other, earning profits on the spread, or the difference between the prices that dealers are willing to pay for a stock (the bid) and what they are willing to sell it for (the ask). Investors really bear the cost of the spread, in addition to any commissions they pay to their brokers (who either may be dealers themselves or who route customer orders to dealers).

  NASDAQ is actually quite young relative to the Big Board, having been formed in 1971 to automate orders and to provide a computer-based method for disseminating stock quotes. NASDAQ (since merged with OMX) was a dealer market at the outset and remains that way.

  The NASDAQ market was also the subject of major private and public antitrust investigations and litigations in the mid-1990s; they were launched on the basis of a single economic study published in an academic journal. I played a small role in the public litigation when, as deputy assistant attorney general in the Antitrust Division, I briefly oversaw the division’s investigation of the matter (before moving on to another job in government). Nonetheless, what happened in this investigation during and after the time I was at the division remains nothing short of amazing, at least to me, and I want to try to share that excitement with you because it powerfully demonstrates how economists can influence policy and business, especially in unexpected ways.

  It all started with the publication of a study, in March 1994, by two young assistant finance professors, William Christie of Vanderbilt and Paul Schultz of Ohio State. The article reported the spreads on the 100 most frequently traded stocks in 1991 on the NASDAQ system, such as
Apple, Dell, Intel, and Microsoft.5 What they found was a surprise to say the least: The bid to ask spreads on these stocks were almost universally quoted in even eighths, or a difference of 25 cents per share. This contrasted with the same-sized sample of stocks of similar prices and market capitalizations on the NYSE and American Stock Exchange, in which the spreads were frequently quoted using the full spectrum of eighths, with spreads as small as 12.5 cents. The authors concluded that this “surprising result”—the even-eighth quote pattern on NASDAQ—reflected “an implicit agreement among market makers to avoid using odd-eighths . . . “6

  Those words implicit agreement were like a bomb going off in a room of plaintiffs’ antitrust lawyers, and shortly after the article became known, a class action private antitrust lawsuit alleging price fixing was filed against multiple market makers on NASDAQ. Shortly thereafter, the attorneys then came to the Antitrust Division with the article, specifically to see me and the career staff, urging us to mount a government investigation. (This frequently happens when private lawsuits are filed; the attorneys want the division to do a lot of their homework for them.)

  I must admit that when I was told that the consistency of the even-eighths quotes on many stocks that had more than a dozen market makers was evidence of price collusion, I was a bit skeptical. How could so many individuals actually fix the spreads? There were no smoking-gun meetings in hotel rooms where price fixing ordinarily takes place. But the circumstantial evidence of the Christie–Schultz paper was extremely powerful. The two economists showed that as a statistical matter it was extremely unlikely the even-eighths spread pattern happened by chance. The division decided to look into the matter more formally and thus opened an official investigation.

  What the lawyers found was nothing short of astonishing. Exchanges like NASDAQ were required by law to maintain tape recordings of the conversations of market makers, which the division’s lawyers obtained through the discovery process that is part of any public or private litigation. The NASDAQ dealers’ conversations revealed a clear and consistent pattern of intimidation of and threatened retribution against market makers who dared to quote a price on any of the 100 stocks that differed from the even-eighths spread (the conversations also were laced with profanity, which was a bit shocking, but then we realized that’s just the way traders talk). Those transcripts helped lead to a consent decree in 1976 between the Justice Department and 24 securities firms that were subject to the investigation. The decree banned the intimidation and set up strict compliance mechanisms to prevent reoccurrences. Two years later a broader set of 37 securities firms settled the private class action lawsuit for $1 billion.7 In addition to the settlement, investors immediately began saving money as soon as the Christie and Schultz study was announced in 1994: Average spreads on highly traded stocks fell in half, from an average of 30 cents per trade to 15 cents.8