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Walter M. Cadette blames stock option accounting for recent corporate scandals.
corporate America appears to be overstating its earnings by at least 20 percent. About half of the exaggeration reflects the lack of any recorded expense for options; the other half, manipulated operating earnings....With an option, the potential for loss is quite small; if the share price falls below the option price, the option simply becomes worthless. But the potential for gain is huge. The asymmetry encourages executives to downplay risk, if not ignore it, in the quest for returns.
I actually think that there are a lot of incentives for executives to be risk averse, so that I do not think that the stock option asymmetry is quite as bad as Cadette makes it out to be. But not counting stock options as an expense leads to all sorts of abuses.
A stronger argument against the stock option accounting anomaly is contained in this paper by Bebchuk, Fried, and Walker. They point out that options which are indexed to overall stock market movements are (a) better tied to executive performance and (b) treated properly as an expense by accountants. What this suggests is that from the perspective of managers trying to gain at the expense of their shareholders, the absence of transparency in stock option accounting is a feature, not a bug, of the current system.
Discussion Question. Why don't investors sell shares in companies that use stock options heavily and buy shares in companies that use them less?
Zimran Ahmed comments on the purchase of PayPal by eBay.
PayPal's large number of established accounts gave it some pricing power through charging higher service rates, just as eBay's market power for unique items lets it charge higher auction rates, and summing the two markups lead to higher prices than was optimal for the system as a whole. eBay corrected this by buying PayPal and (I'm guessing) will lower the (combined) transaction prices.
Ahmed points out that when two monopolies sell complementary products or services, consumers actually can be better off if the monopolists combine forces. He links to a math-and-jargon exposition of the theory. For a clear explanation in English, see Peanut Butter, Jelly, and the Antitrust Knife.
Discussion Question. In my essay, I say that separating the monopolists increases their incentives to be compatible with competitors. Is that an issue in the eBay/PayPal case?
The Minneapolis Fed has a must-read interview with Gary Becker, winner of the Nobel Prize in 1992. In addition to talking about topics he pioneered, such as the economics of crime and the economics of discrimination, Becker talks about economic literacy among non-economists.
Economics is an easy subject and a difficult subject at the same time. It is easy in the sense there are only a few principles that really guide most economic analysis. It is simple and yet it's obviously very difficult. I have dealt a lot with Nobel laureates in physics, chemistry and other fields who have very strong opinions on economic issues and usually they are terrible. These are obviously first-class minds, but they have not given economic issues much attention. They believe that they can casually talk about an economic issue and come up with the right answer, that one just has to be intelligent. This is obviously not the case. There are economic principles. If you do not use these principles, you are likely to come to the wrong answers.
Discussion Question. Why would a physicist be confident in his or her opinions about economics, while an economist would be reticent about voicing an opinion about physics?
Traffic congestion is a classic example of market failure. By taking a shopping trip at 5 PM, I add to the cost of other people's traveling. Jerry Taylor and Peter Van Doren argue that the best solution would be a toll road where the toll varies based on time of day.
Advances in technology make this a viable strategy, allowing us to collect tolls without the burden of toll plazas and gates that can bottleneck traffic. The tolls would vary according to the time of day to ensure that the lanes remain uncongested at all times. Such a system is in use on State Route 91 in Orange County, Calif.
In economics, charging a high price when capacity is under stress is known as "peak load pricing." What Taylro and Van Doren are arguing is that peak load pricing is feasible for roads, and that it would help alleviate traffic congestion.
Discussion Question. Even if people were aware that peak load pricing is technically feasible for roads, what political objections would they raise?
Brad DeLong has a paper about an interesting question. As the economy moves from the industrial age to the information age, what happens to the nature of macroeconomic vulnerabilities?
He claims that the 20th century vulnerabilities were:
I cannot think of any examples of (4). Also, I think that the "oil shock" of the 1970's is another type of macroeconomic disturbance worth mentioning.
Along the way, DeLong says that
There is reason to fear that the runup in asset prices in the 1990s may have reduced American asset markets' effectiveness as part of a rational social capital allocation mechanism.
I think there may be a deeper issue here, which is that the stock market emerged during the age when allocating physical capital was important. Today, it is human talent--particularly research and development--that has to be allocated correctly for optimal economic performance. I have talked about that issue in several essays, including
Finally, DeLong concludes by talking about factors that will make macroeconomic policy easier and harder. He says that in the future the policy environment will be made easier by: reduced inventory cycles, as firms do a better job of controlling inventories; and faster productivity growth, which reduces the likelihood that workers will have unrealistically high expectations for wage growth relative to productivity growth.
To these, I would add that as the economy grows more complex with greater varieties of goods, elasticities of substitution should rise. This should make it easier to adjust to shocks in a single sector. Also, workers are increasingly relying on generic skills rather than firm-specific learning. That means that when someone loses a job, it is easier for them to find another one. In the old days, a shock to General Motors caused many layoffs at GM and its suppliers, and the laid-off workers stayed unemployed. Today, when people lose their jobs at Arthur Andersen or WorldCom, they are more likely to find other positions in the economy than to remain in limbo for many months.
DeLong says that the information economy increases macroeconomic vulnerability by: making it more difficult for the stock market to value assets, increasing the opportunity for large price fluctuations; the government may lose focus on macroeconomic issues, particularly during a boom; financial arrangements will become more complex, making it harder for regulators to spot vulnerable institutions before they collapse.
Discussion Question. If it is the nature of financial institutions to become more complex and harder to regulate, is the current outcry for "reform" in the wake of corporate accounting scandals likely to achieve successful long-range results?
I predict that newspapers will have a hard time dealing with demographics and Internet competition.
The newspaper business is going to die within the next twenty years. Newspaper publishing will continue, but only as a philanthropic venture.
Discussion Question. It is argued that everyone benefits from having a local paper, even those who rarely buy it. What does this say about the way newspapers ought to be funded?
Brad DeLong describes an interesting article on growth, but his link to it does not work. DeLong writes,
We look sequentially at the three broad factors that have driven modern American economic growth: human capital, the formal knowledge and the skills acquired through practice and experience of our labor force; physical capital, the machines, buildings, and infrastructure that amplify worker productivity and embody much of our collective technological knowledge; and the ideas that make up our modern industrial technology and that are in the end the crucial factor making our society so rich in historical and comparative perspective. Of these, ideas—technology—must take first place when ultimate causes are discussed. But it is human capital—education and skills—that must take first place when we think about policy.
Discussion Question. One of the ideas that has contributed to economic growth has been the idea of market competition. How might this idea be applied to education?
Why is the number of Americans not covered by health insurance on the rise? David Cutler writes
insurance coverage declined primarily because fewer workers took up coverage when offered it, not because fewer workers were offered insurance or were eligible for it. The reduction in take-up is associated with the increase in employee costs for health insurance. Estimates suggest that increased costs to employees can explain the entire decline in take-up rates in the 1990s.
In other words, when people are faced with more of the cost of health insurance, they decline it.
Discussion Question. Should people be forced to have health insurance?
Brad DeLong expresses his discontent with Joseph Stiglitz's new book.
As I understand it, two types of countries come to the IMF for help. The first group are countries that have long been running unsustainable fiscal policies....The second group are countries whose fiscal policies may or may not be in intertemporal balance, but which are in trouble because of a large currency or maturity mismatch somewhere in their economy...
Here the issues are harder. IMF money gets you a better set of short-term options, and you have to hope to god that the IMF money will open up the sweet spot at which interest rates can be high enough to avoid the large-scale devaluations that in combination with mismatch trigger the collapse of the financial system, and yet low enough not to derange domestic investment through the pure cost-of-capital channel. Whether such a sweet spot exists is an empirical matter.
...It's not that Joe believes that bankruptcy across national borders is quickly resolved. What is it that causes him to believe that financial market failures--adverse selection and moral hazard--are not to be feared when the home-currency value of foreign debt rises rapidly?
DeLong's two types of countries correspond to what I call insolvency (his first type) and illiquidity (his second type). You should not lend money when a country is insolvent--although outright gifts may be appropriate if they will not be wasted. You might want to lend to an illiquid country.
Discussion Question. Stiglitz argues that the IMF faces conflicts between the interests of banks and the interests of countries that are in difficulty, and that the IMF is too friendly to the banks. What could the IMF do differently to help the countries?
One cynical view of economic regulators is that eventually they are "captured" by the interests that they are supposed to regulate. Bruce Baugh explains
All of this leads to the point where the regulatory agency may bristle and grr for the popular press, but its day-to-day business is strongly congruent with the interests of its subjects. At this point the regulatory agency has been captured, and once it happens, it's proved nearly impossible to fix. Any effort to abolish the agency and start over will be met with cries that someone wants to do away with any government oversight of the issue. Even mild efforts at changing the agency's composition or mission will get the same treatment,
The problem with industries governed by captured regulators is that they can resist competition. For example, imagine trying to start an automobile company today. You would need to hire more lawyers than engineers.
Discussion Question. How can we balance the desire to use regulation to protect consumers with the challenge of keeping regulatory agencies from being captured by industry cartels?