What The Great Recession Has Taught Us About Macroeconomics

A number of articles have been written about the failure of macroeconomic models to predict the Great Recession.  Nobody is more familiar with those models than Olivier Blanchard who has been a top economist at the IMF.  He provides an understandable description of the assumptions in those models, and he explains why the Great Moderation had deluded economists into believing that the models were able to deal with economic shocks.  There were "dark corners" in the models but most economists believed that they could be ignored.  In this article he argues that: " We were much closer to the dark corners, and that they were darker than we had thought".  He describes the dark corners as well as some of the efforts that are being made to deal with them.  In particular, finance is being incorporated into the models but we may still have to deal with dark corners.  We are a long way from the days of the Great Moderation.

The Capitalist's Dilemma

The Harvard Business Review published this study on how corporations make investment decisions.  It shows that corporate investments are primarily directed towards cost reduction.  Presumably, it is easier to satisfy investors by meeting quarterly financial targets such as return on assets, discounted cash flow etc., than it is to sell them on investments that will have a longer term payout.  Its also job insurance for the CEO, and less job security for those on corporate payrolls.  Economists use all kinds of aggregate data in efforts to explain high levels of unemployment and stagnant growth in median household wages.  The basic decisions that effect these measures are made at the institution level by corporate executives.  It is important to understand how these decisions are made.

Some CEO's take a longer term perspective when they make investment decisions.  This article, published in the McKinsey Quarterly, was written by the CEO of Unilever.  He explains what Unilever did to shift its focus to a 10 year plan that was designed to build a more sustainable and profitable enterprise.  Part of the solution was to target shareholders who have a longer term investment horizon.  This was not easy because 75% of the capital on US stock exchanges is held by pension funds.  The mangers of these funds are measured on quarterly performance.  Unilever sought out longer term investors just like they target customer groups in their consumer marketing.  These investors want proof of progress against the 10 year plan, but the progress is not measured simply by standard accounting metrics.

The Decay Of American Politics

Economists often get involved in politics because many of the decisions that need to be made are about the economy.  They realize that our political system has become polarized and dysfunctional, but they are not well schooled in political science.   This article was written by a political scientist.  It provides an excellent description of the origins and the evolution of the US political system.  It was designed to counter the abuse of authority that was characteristic of monarchies in Europe.  Checks and balances were built into the system that limited the power of the executive to manage the system.  Moreover,  there is not a clear delineation of authority between state, local and federal government agencies on numerous matters.  To make matters worse, disagreements within the legislature are often transformed into legal issues that delegate political matters to the judicial system.  In a polarized society, such as we have today,  almost any political decision is subject to judicial review. 

We would be in a better position to fix our dysfunctional political system if more of us had a detailed understanding of how the system has broken down.  Public contempt for government has never been higher but it is incapable of fixing itself.  The many actors in the system have adapted to the ways in which the system has evolved.  It works just fine for those who have the understanding and the means to engineer the system on their behalf.  It does a poor job of representing the interests and  concerns of the public at large.

Predatory Capitalism

Predators usually focus their attention on the most vulnerable prey to which they have access.  Predatory capitalism is the name given to businesses which earn profits by taking advantage of vulnerable human prey.  Our recent financial crisis was partially the result of predatory capitalism.  Lenders provided mortgages to vulnerable households who did not have the income to service their debt.  The sold the mortgages to bankers who packaged them into securities which they sold to poorly informed investors.  This article describes another form of predatory capitalism.  The public sector has found a way to shift the cost of government services to the poor.  It is a form of privatization in which the private sector performs the services that were once performed by government, and the cost of those services is shifted to the poor.  For example, some of the costs of monitoring citizens on probation are shifted to those on probation.  The are required to pay fees for some of those services and the penalties for non-payment are very high.  The services providers then act like bill collectors who have a powerful weapon.  They can send those who can't make the payments to jail.  Similarly, many judicial services are provided by private firms and the costs are shifted to the poor.  For example, some courts require the poor to pay for public defenders.  Furthermore, in many states private firms run some of the prisons.  They receive funding from the government for those services but they charge prisoners for some of the services that are not funded by government.

This article only touches on the extent of the privatization of government services that are essentially predatory.  The growth of for-profit colleges and trade schools is perhaps the major form of predation.  The poor take out education loans that are subsidized by government in the hope of getting jobs that are promised.  Most of them either fail to graduate or fail to get the promised jobs upon graduation.

What Is The Purpose Of The Publicly Held Corporation?

This article provides an answer to the question raised in the title of this post.  It argues that the major purpose of the publicly held corporation is to reward investors. That includes top corporate executives who are also major shareholders.  It supports that conclusion by showing how corporations have been using their profits.  Between 2003 and 2012 the 449 corporations in S&P 500 during that period used 54% of their profits to buyback their own stock.  That reduces the number of shares outstanding which increases the price to earnings ratio.  That, in turn, boosts share prices.  They also returned 37% of their profits to shareholders in the form of dividends.  That leaves only 9% of profits for other purposes such as R&D, capital expansion and employee wage increases. It is no wonder that unemployment remains high and median wage growth has been stagnant.  The system operates to redistribute income from workers to investors.

These changes in corporate behavior were not accidental.  They have occurred in response to government policies and corporate governance.  They also contribute to the financialization of our economy.  Corporate America and Wall Street are joined at the hip.  Corporations are managed as financial assets and Wall Street plays a role in determining the value of those assets.

In 1981 Ronald Regan's SEC removed a rule that limited corporate share buybacks.  That eliminated a legal barrier to what we observe today.  Tax policies also contributed to these changes.  Capital gains on stocks and corporate dividends used to be taxed as ordinary income.   Now they are taxed at rates well below income from wages.  It is not surprising that corporate executives and other investors prefer to receive their incomes from capital gains and dividends instead of from wages.

Exxon provides one example of how this story plays out.  Exxon used 83% of its net income for stock buybacks and dividend payouts. 73% of CEO compensation at Exxon is stock based.  Corporate governance at Exxon reflects the financialization of the corporation.  The incentive system is consistent with that purpose.  Managing the stock price aligns top management with its largest shareholders.  It also aligns the corporation with Wall Street analysts and investment bankers.  They are primarily concerned with earnings per share and quarterly performance against that target.

Why Do So Many Graduates From Elite Colleges End Up on Wall Street Or In Consulting?

Wall Street banks and top consulting firms restrict their recruiting efforts to America's elite colleges.  There are many bright and competent candidates at less prestigious colleges but the banks and consulting firms burnish their brands by capturing the brand value of our elite colleges.  This article (via Manan Shukla) describes the process used by the banks and consulting firms to dominate the recruiting systems at elite colleges.  It also describes the process by which students from our elite colleges end up competing for jobs that were unfamiliar to them as freshman.  Its part of the socialization process at our elite colleges.

Central Bankers Have Reached A New Consensus: Weak Labor Markets Are A Greater Problem Than Risk Of Inflation

The annual Federal Reserve meeting at Jackson Hole included central bankers from the UK, Japan and the EU.  They all agreed that weak labor markets were a problem despite declining unemployment rates.  They used to believe that falling unemployment rates led to a greater risk of inflation.  That is no longer true.  That is because wages should be rising as labor markets tighten.  Wage growth has been stagnant.  The unemployment rate is no longer an useful measure of inflation risk.  The Fed, for example, has developed a multi-factor measure of labor market strength that is more useful than the headline unemployment rate.  Central bankers are looking for more ways to improve the labor market.  Inflation risk has been put on the back burner.