Archives For Sykuta

An interesting story in the WSJ Online today about American International Group (AIG)’s use of a standard tax write-off and the political firestorm it is creating…all because the Washington establishment thought it could hide behind semantics during the bailout era.

The benefits at issue were accrued by AIG as it amassed record losses amid the financial crisis; the U.S. tax code allows businesses to “carry forward” such net operating losses to offset future tax obligations, in effect saving on future tax bills. But those carry-forwards can vanish if a company is taken over or sold, an exception that prevents healthy companies from avoiding taxes by buying firms with significant losses.

The criticism from the former members of the congressional panel stems from a series of Treasury determinations beginning in late 2008 that said the federal government’s bailout of AIG, General Motors Co. and other firms didn’t constitute a sale.

The US government acquired as much as 90% ownership in AIG during the bailout era. Under most any definition, such a shift would be considered a change in corporate control. However, because the Treasury Dept. wanted to maintain the illusion that government was not taking over large swaths of the US economy, it pronounced that these bailouts were not what any student of financial markets understood them to be: an exchange of equity control and strings on management for access to cash. In short, a sale of control.

Now the Treasury Department’s ruling is coming back to bite. Under the US tax code, AIG and its investors have a legal right to carry forward losses from the financial crisis to offset taxable earnings now. But now legal-scholar-turned-bureaucrat-turned-politician Elizabeth Warren, and others, want to change the rules after the fact. Warren is calling on Congress to “end this special tax break”. I’m not sure what exactly is so “special” about this tax break, since it applies to any business, not just those bailed out by the Feds. So is Warren suggesting all businesses should be prohibited from carrying forward losses? Or only businesses whose losses the Federal government wasn’t willing to tolerate in the first place? After all, if the Treasury had let nature take its course, AIG (and many other bailout recipients who are now wondering about their own ability to carry forward losses) would have been bought–albeit likely in pieces–and this whole issue would be moot.

What’s really interesting about this whole argument is that Treasury still holds 70%–a controlling interest–of AIG’s stock. AIG reported their beneficial tax breaks weeks ago. Presumably Treasury is paying attention to their investments and knew about that decision, possibly even before it was publicly released. So why didn’t they exercise their controlling interest and stop management from electing to use the carry forward? More importantly, Treasury is the “owner” that stands to gain the most from this tax benefit. So what exactly is Ms. Warren and others complaining about?

Either way, this is a mess of Treasury’s own making with its semantic gamesmanship on whether the bailout should be named for the government take-over that it was. Seems like we have a bit of non-buyer’s remorse.

Last week’s business news highlighted two tremendous subsidy programs. In one case, the company received no direct payment for product development. None of its suppliers received targeted subsidies to produce parts. But consumers were subsidized to encourage them to buy the product.

In the other case, the company received direct payments to underwrite the cost of product development, one of the company’s suppliers received an even larger subsidy to create critical components, and consumers were given subsidies to encourage them to buy the product.

One of those products is among the best selling products in the world. The other just halted production. The successful one was subsidized through private market transactions. The other was subsidized by the US government using taxpayer dollars.

If you haven’t guessed by now, I refer to the Apple iPhone and the Chevy Volt, respectively.

The irony of these twin tales is that they highlight the problems of subsidies in general, but particularly when the subsidy is used as a tool for the government to pick winners and losers in the market (i.e., industrial policy).

In the case of the iPhone, cellular phone companies subsidize the phone in the hope of being able to recoup those costs in the price of the service contracts that are bundled with the subsidized phones. Basically, the subsidy really amounts to nothing more than a marketing expense for the cell phone companies to expand their market share of (particularly data) service contracts. Cell phone carriers recognize that consumers value the features of the phone and are willing to take a loss on the phone to get the consumers locked into a service contract. The subsidy creates value all the way around, since the cellular companies would not offer the subsidy if they did not believe they could more than recoup the cost on the service contracts.

In the case of the Volt, the government had no concern for being able to break even. The motive was to unlevel the playing field by giving GM an (unfair?) advantage in developing an electric vehicle, whether compared to other electric vehicle manufacturers or to traditional combustion engines and recent hybrids. (Actually, according to the WSJ report, the Feds also subsidized Fisker Automotive’s Nina plug-in, which is also no longer in active production.) The problem is, consumers don’t want the product—even at the whoppingly-low, subsidized price of $40,000 per car. GM sold barely half of its originally target of 15,000 cars in 2011. The company has built up so much excess inventory that it shut down production and laid off 1,300 workers for a couple months, with the hope that consumers will eventually buy up the excess.

This doesn’t mean that private market “subsidies” are necessarily good either. As the WSJ reported, Apple is facing an uphill battle. As the market for contract cell service begins to get saturated, Apple finds itself unable to effectively compete in the non-contract market because it doesn’t have affordably-priced phones for that segment and cellular companies cannot (or simply will not) subsidize the iPhone if they can’t recoup the cost. Some investment fund managers have even grown leery of Apple because they see a rough road ahead as Apple tries to expand into LDC’s where non-contract phone plans dominate and consumers cannot afford the pricy iPhone.

As the WSJ headline indicates, subsidies provide a crutch for producers. In every case, over-reliance on the crutch will inhibit long-term growth and economic viability. The difference between privately-provided crutches and government-provided crutches is that the private sector market has a much stronger incentive to make sure the patient has a realistically good prognosis to begin with, rather than Washington’s knack for picking losers.

It seems President Obama has discovered a magical cure for his contraception controversy: simply force insurance companies to provide free coverage for contraceptive services, but only for women who work for organizations that qualify for exemption from the original mandate that requires contraceptive coverage be part of any respectable (i.e., Obama-approved) health plan. Never mind the whole religious liberty issue. I think that pales in comparison to the economic liberty argument against the mandates to begin with. But the President’s proposed solution should strike fear into the hearts of any person who likes to be paid for what they do.

The underlying premise of the Administration’s decision is that the federal government has the right to force people to give away the products and services they produce. If the government can force insurance companies to “give away” health care coverage to avoid a political embarrassment, what is to prevent the government from requiring other companies or industries to give away their products if such a mandate would be politically expedient? And more importantly, does Mr Obama really believe any company is going to simply write-off the cost of the “free” service and not cover it by raising the cost of other services? In essence, insurance companies will have incentive simply to raise the price of the health plans they offer to exemption-qualifying employers. Either way, the employer will pay for it. It just might not be listed on the receipt.

Or perhaps Mr. Obama plans to make the cost of the “free” contraceptive care a qualifying charitable contribution for health insurers, since it will only apply to non-profits.

What makes the proposed solution even more ludicrous is that health insurance companies neither manufacture nor deliver, in most cases, contraceptive pills. So why should insurance companies even be involved in this great giveaway? A more direct solution would be to require pharmaceutical manufacturers to give the pills away to begin with. Or to require pharmacies to distribute them for free to qualifying individuals.

Regardless of where one stands on women’s reproductive rights, women’s health or religious liberty, we all make our living by getting paid for what we do. The President’s mandate attempts to create something from nothing by forcing insurers to provide services without getting paid for them. That should violate the sensibilities of anyone who works for their pay.

That’s the title of an interesting article by Emmanuel Farhi and Jean Tirole in the current issue of the  American Economic Review. Here’s the abstract (emphasis added):

The article shows that time-consistent, imperfectly targeted support to distressed institutions makes private leverage choices strategic complements. When everyone engages in maturity mismatch, authorities have little choice but intervening, creating both current and deferred (sowing the seeds of the next crisis) social costs. In turn, it is profitable to adopt a risky balance sheet. These insights have important consequences, from banks choosing to correlate their risk exposures to the need for macro-prudential supervision.

Last week Thom posted about the government’s attempt to hide the cost of taxes and regulatory fees in commercial airfares. Apparently Spirit Airlines is highlighting another government-imposed cost of doing business by advertising a new $2/ticket fee that the airline has imposed. According a CNN report yesterday:

Spirit Airlines says a new federal regulation aimed at protecting consumers is forcing it to charge passengers an additional $2 for a ticket.

The fee, which Spirit calls the “Department of Transportation Unintended Consequences Fee,” has been added to each ticket effective immediately, according to Misty Pinson, a Spirit spokeswoman.

The new DOT regulation allows passengers to change flights within 24 hours of booking without paying a penalty. The airline says the regulation forces them to hold the seat for someone who may or may not want to fly. As a consequence, someone who really does want to fly wouldn’t be able to buy that seat because the airline is holding it for someone who might or might not end up taking it.

In short, DOT is requiring airlines to give consumers a real option to change their flight plans at zero cost within a 24 hour window. Spirit rightly recognizes that options have value. Not only is there a value to consumers in ‘buying’ such an option, there is a cost associated with providing the option; in this case, the opportunity cost of selling seats that may be held for someone that will exercise the option to cancel without a fee.

Obviously, DOT head Ray LaHood is unimpressed.

“This is just another example of the disrespect with which too many airlines treat their passengers,” Department of Transportation Secretary Ray LaHood said in an e-mailed statement. “Rather than coming up with new and unnecessary fees to charge their customers, airlines should focus on providing fair and transparent service — that’s what our common sense rules are designed to ensure.”

Perhaps Mr. LaHood doesn’t understand the concept of options and option value. The right, but not the obligation, to undertake an activity (particularly under pre-specified terms) is clearly an economic good.  The very notion that DOT’s new regulation is touted as “consumer friendly” recognizes that it creates additional value for consumers. That is, it’s giving something away that is of value…a property right to change one’s mind at zero cost. However, it is disingenuous of Mr. LaHood to object to the idea that giving away value imposes a cost on the one providing the value (and I don’t mean the DOT, but the airlines who must honor the consumer’s exercise of the option).

A better solution might be to require airlines to explicitly offer the option of a no-penalty change within a 24-hour window. Then consumers could choose whether to pay the fee and airlines might discover the true market value of that option. Spirits’ $2 may be too high. More likely, it’s too low. Many airlines already do offer the option of a no-fee cancellation and the fare differential is much higher than $2, but that option typically has a much longer maturity…any time after booking up until departure. A shorter maturity window should command a lower option value.

Spirit Airlines may be the epitome of nickle-and-diming air travel consumers, something many consumers (myself included in some cases) don’t appreciate. However, there is no denying that Spirit understands the nature of options and their value. And there’s also no denying that, based on its stock price over the past year, Spirit is doing at least as well as industry leaders in providing consumers value for the options they choose. Perhaps instead of casting aspersions, Mr LaHood and his staff should invite Spirit to teach them about this fairly fundamental concept of options and option value rather than imposing regulations with so little regard for their true costs.

Consider this a venting, especially as one of the few non-lawyers in our blogging group.

Recently one of my lawyer friends posted a Facebook status as “Amending moving violations and saving clients on their insurance” at the local municipal court. This post reminded me of one of my less-than-enjoyable encounters with the Missouri traffic court system, which got me thinking more generally about this issue and it’s negative social effects. I’m led to believe this may be relatively unique to Missouri, so I welcome comments on to what extent this is the ‘norm’ in other states.

But in Missouri, it is common that municipal prosecutors will regularly “amend” moving traffic violations, which incur points against one’s driver’s license and potentially raise car insurance rates, to non-moving violations which do not incur said points and insurance rate hikes. Of course, the prosecutor only does so under two conditions: Continue Reading…

Larry makes a strong argument below for why the proposed SEC rules changes reported today in the WSJ should not be heralded as some great opening up of US securities markets, but that the changes are little more than political posturing to prevent addressing the real problem of the costs imposed by securities regulation more generally. I don’t disagree that the proposed rules changes Larry targets are, at best, window dressing to release some (well-justified) pressure created by innovative market-based solutions to circumvent the rules that lie more at the root of the securities market problem.  So long as the costs associated with “public” placements are so high, investors and issuers will continue to look for ways to expand their access to capital within the “private” placement market, which by definition excludes many (especially smaller) investors.

That said, I will point out that one of the quotes in the article bemoaning this proposal comes from an institutional investor–one of the groups that is more likely to benefit from the current 500 entity cap. If raising the cap would not open up the market meaningfully to new potential investors, I wouldn’t expect to see such negative comments from one of the groups who will face this greater competition in the supply of private equity. So while the proposed changes certainly don’t address the real problem, it seems they may make the market a bit more open (and less subject to contrived and costly work-arounds like special purpose vehicles) than it currently is.

However, among the rules changes being proposed is one that should open up the market to greater access even to smaller investors (up to whatever new cap might replace the current 500 entity rule). And it’s a rule  change that appears a direct response to something Larry blogged about here just earlier this year.

According to the WSJ report, the SEC “is considering relaxing a strict ban on private companies publicizing share issues, known as the ‘general solicitation’ ban.” The current regulations are currently under Constitutional scrutiny as a potential violation of 1st Amendment speech rights, as a result of a case by Bulldog Investors that Larry discussed in his earlier post.  Again, how far will the ‘relaxing’ go and will it be a substantive change in the underlying problem, or just another hanging of curtains? But there should be no doubt that more open communication about private equity investment opportunities should further open the market to smaller investors.

All this to say, I believe Larry is on point for the big picture, but the proposed regulation changes don’t seem to be all bad. Of course, the devil is in the details–so we’ll have to reserve judgment until the specifics are revealed before having more confidence in that conclusion.

Tomorrow I will be attending a symposium on small business financing sponsored by the Entrepreneurial Business Law Journal‘s at the Moritz College of Law at the Ohio State University. I’m on a panel entitled “Recessionary Impacts on Equity Capital,” which is a bit misleading–or at least a bit different that the topic I offered to speak on, which is the effect of the recession and recent financial crisis on small business financing more generally. The rest of the day includes presentations governmental and policy responses to the crisis and practical implications of constricted capital. A copy of the schedule and list of speakers is available. I’m not very familiar with any of the other panelists, but the luncheon address will be given by Al Martinez-Fonts, Executive Vice President, U.S. Chamber of Commerce.

I’m going to focus on a few basic points and highlight some of the myths around small businesses and small business financing that drives poor policy. My first objective is to lay out a simple framework for thinking about financing deals, or any deal for that matter. Namely, the idea that every transaction involves allocations of value, uncertainty and decision rights; and the deal itself provides structure on those allocations by specifying the incentive systems, performance measures and decision rights that address both parties’ interests. How those structures are designed determine the nature of risk exposure and incentive conflicts that may affect the ex post value and performance of the deal.

In a sense, there is nothing new in small business financing post-crisis.  The fundamentals are the same. There is a multitude of contractual terms to address the various kinds of incentive issues and uncertainties that exist in the current market environment. To the extent there is anything truly unique about the current context, they are less about the financial market itself than about broader regulatory and economic issues. For example, much of the uncertainty affecting credit-worthiness have to do with economic and cash flow uncertainties stemming from upheavals in the regulatory landscape for small businesses, including health care. Uncertainty concerning implementation of financial market reforms passed in July 2010 create uncertainties for lenders. These uncertainties exacerbate the usual economic uncertainties of new and small businesses during an economic recovery period.

During the recession itself, “stimulus” spending distorted the credit-worthiness of small businesses in industries that were more directly benefited by government handouts and by the security provided small businesses that supply large, publicly-administered and guaranteed businesses (such as in the auto industry).  Thus, federal and state economic policy to “create jobs” in some sectors distorted the incentives to lend to different groups of small businesses, likely reducing employment in other sectors.

Finally, I’m going to suggest that talking about “small business” financing is a misnomer if we are truly motivated by a care of job creation. A recent paper by John Haltiwanger, Ron Jarmin, and Javier Miranda illustrates that business size is not the key determinant of job creation in the US, as is often argued in the media and policy circles. (HT: Peter Klein at O&M) They find that it is young firms, which happen to be small, not small firms in general that provide the job creation. Ironically, these young firms are also the ones for whom financing is most difficult due to the nascent stage of development and uncertainty. Thus, policies directed to firms based on size alone further distort capital availability from other (larger) companies that are equally likely to create jobs. Since this distortion is not costless, the policies are not welfare-neutral by simply switching where jobs are created, but likely to reduce welfare overall.

So now you don’t need to rush to Columbus, Ohio, to hear what I’ll have to say–unless you want to see the fireworks in person. But now you’ll know what’s going on in case there is news of more upset around the horse shoe in Columbus.

I was waiting to write something about today’s announcement of the Nobel Memorial Prize in Economics being awarded to Diamond, Mortensen, and Pissarides. Josh has already provided his thoughts and provided links to comments by Ed Glaeser and Steve Levitt, respectively. As they describe it, the honorees’ research provides a theory of unemployment, explaining why we see willing buyers and willing sellers of labor go without finding trading partners, thus resulting in persistent unemployment. The Nobel committee paints it a bit more broadly, explaining:

Since the search process requires time and resources, it creates frictions in the market. On such search markets, the demands of some buyers will not be met, while some sellers cannot sell as much as they would wish.

This basic lesson certainly has broader implications for the workings of markets and the build-ups or mismatches of production capacity, inventories, and consumer demand more generally. In that sense, I believe the honorees provided much more than simply a theory of unemployment, though that is certainly where their particular applications have focused.

My colleague, Peter Klein, over at O&M has offered a little more crude assessment of the economics Nobel Prize in general, and this year’s award in particular. In short, Peter suggests the Nobel Prize in economics has become an award for those who most elegantly state (or prove) the obvious. That there are information and search costs that keep buyers and sellers from finding one another and efficiently taking advantage of all possible gains from trade is one of those things you don’t really need a PhD in economics to figure out. (Perhaps that’s why it isn’t taught much in Econ 101…overestimating students’ grasp of the obvious.)

Indeed, this idea (of search costs) was already awarded the Nobel Prize at least once, in 1991 when Ronald Coase received the prize “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy” (see here). The work of this year’s recipients is simply one specific application of Coase’s theory, which identified the cost of searching out trading parties and determining relevant prices as part of the set of costs that affect behavior (and boundaries) in the market.

So, I am very delighted that Messrs. Diamond, Mortensen and Pissarides have received this honor, further illustrating the importance of understanding transaction costs (or more specifically, search costs in this case) and their implications for the workings of the economic system.

That said, I am appalled at the New York Times report today that suggests the action of the Nobel Prize committee somehow qualifies Peter Diamond to serve on the Federal Reserve Board. While Republicans may be making too little of Mr. Diamond’s experience, I don’t believe they have suggested his academic research is sub-par. The Nobel Prize committee may have added weight to the idea that Mr. Diamond’s (and his fellow honorees’) research has made significant contribution to the field, it bears nothing on the relevance of that research–or on Mr. Diamond’s personal experience–for setting federal monetary policy, the role of the Federal Reserve Board.

It is a shame that, for the second year in a row, Alfred Nobel’s memory is being abused as a battering ram for partisan politics in the US. We may expect that more of the Peace Prize. And while I would like to think that was not the intent of the selection committee for the 2010 Economics prize, its use to that effect by the NYT and others detracts from whatever significance the Prize imbues to the research contribution of its recipients.

Peter Klein (over at Organizations and Markets) and I recently edited a volume for the Elgar Companion series titled The Elgar Companion to Transaction Cost Economics. At long last, the volume will be available in the US in November, 2010; in plenty of time for spring semester classes that might want to incorporate some or all of the readings in the book.

Transaction cost economics (TCE)  has become a dominant, if not mainstream, theoretical approach for understanding a variety of applied topics such as vertical integration, the structure of networks and alliances, franchise contracting, the multinational firm, parts of antitrust analysis, marketing channels, and more. The influence TCE has come to have in law, economics and organization theory was recognized last year when the Nobel  Prize in Economic Sciences was awarded, in part, to Oliver Williamson “for his analysis of economic governance, especially the boundaries of the firm”, which has come to be known as TCE.

Our objective in editing this volume was to create a thorough, if not exhaustive, resource for individuals interested in better understanding TCE, its intellectual origins, the fundamental concepts underlying the theory, TCE’s application in a broad array of specific fields, and some critiques of the theory. The volume includes articles from a range of leading scholars in their respective fields, including my fellow blogger, Josh Wright.

Scott Masten, one of the early scholars to apply and promulgate TCE, offered these comments in his review of the book:

‘Not too long ago it was possible to be familiar with all of the important works and latest developments in transaction cost economics. That that is no longer the case is a testament to the intellectual appeal and empirical success of the transaction cost approach. For newcomers, the entries in this volume, by some of TCE’s most knowledgeable and eloquent contributors, offer an excellent introduction to the issues, methods, discoveries, and debates in the field; for veterans, the volume provides a highly valuable resource for catching up on the newest research.’

Following is a copy of the table of contents, for those interested.

Continue Reading…

That’s the title of Steve Horwitz’s blog post reflecting on a recent celebration honoring the lifetime contributions of 1986 economics Nobel Prize winner James Buchanan. (HT: Art Cardin for pointing it out on FB) Horwitz describes Bachanan’s comments about how “the most basic insight of economics is fairly simple: the spontaneous order of  the market.” He goes on:

At the core of the economic way of thinking is the idea that economic coordination requires no coordinator and that an order which serves the interests of all can emerge from the interaction of self-interested choices. Although simple, it is also highly counterintuitive when first encountered.

This fundamental insight underlies much of the spirit that unites the collection of bloggers called Truth On The Market (at least as I see it…Geoff and Josh can delete me if I’m wrong). Horwitz then goes on to describe Buchanan’s remarks on a subject that relates even more closely to TOTM. To wit:

Buchanan’s final point, however, was one that is perhaps the most important in our own time and place. He reminded the audience that not all spontaneous orders are equally good. The quality of the outcomes depends crucially on the rules that frame the economic processes and behavior which produce that order.

In short, the rules matter. Or, as one of my professors, 1993 economics Nobel Prize winner Douglass North might say, “institutions matter.”  Spontaneous order will emerge from the interaction of individual decision makers as they work to maximize (or satisfice) their own well-beings, regardless the nature of the rules. However, the rules themselves create incentives and constraints that shape the nature of the spontaneous order itself.  Often, the rules result in spontaneous orders which are neither intended nor desirable…largely because those responsible for creating the rules have such little grasp of and/or appreciation for that most basic insight of economics: the spontaneous order of the market.

When I was in grad school I had the pleasure of attending a talk by Buchanan and picked up an anecdote that I still use with my students. Buchanan told a story of a trip to Russia just shortly after the reforms of the early 90s. He learned that there had been (or was at the time) a thriving market for burned out light bulbs. It was a great tale of how spontaneous market order can emerge, even in a society that had been taught for generations to eschew the market.

So,while not so presumptuous as to write on behalf of all my colleagues, I will simply suggest that TOTM readers may better understand the philosophy behind much of what is posted here by coming to an understanding of the complexity of simple economics; remembering the spontaneous order of the market and the importance of the rules by which it is shaped.

Alan Greenspan has been revered in political and media circles since his benevolent reign over times of fortune as the Chair of the US Federal Reserve. Now Mr. Greenspan has acknowledged what many of us have been saying for a long time: fiscal stimulus didn’t work. (insert gasps of surprise here)

Now, to his credit, Mr Greenspan was not an avid proponent of the fiscal stimulus plan (that I have seen) and more often pointed to concerns about the financial markets and the debt (and politics) associated with fiscal spending (for instance, see here).  However, Mr. Greenspan’s newly restated appreciation for normal market forces is welcome, especially given the reverence with which he is typically held by the political masses.  From today’s Wall Street Journal “Real Time Economics” blog (see the full post here):

“We have to find a way to simmer down the extent of activism that is going on” with government stimulus spending “and allow the economy to heal” itself, former Fed Chairman Alan Greenspan told a gathering held at the Council on Foreign Relations in New York on Wednesday.

At this point, “we’d probably be better off doing less than more” because “you’d be far better off to allow the normal market forces to operate here,” Greenspan said.

(Again, gasps of surprise, indeed shock: You mean, we should just let the markets work?!)

According to the article, Greenspan claims that “fiscal stimulus efforts have fallen far short of expectations and the government now needs to get out of the way and allow businesses and markets to power the recover.”

I would suggest a different interpretation.  The fiscal stimulus efforts have had no less effect than expected…at least by the expectations of reasonable economic thinkers. For example, see the posts here and here from my pre-TOTM days.  But as to his conclusion that government needs to get out of the way? Preach it, Brother Greenspan!