Saturday, January 24, 2015

Taming The Big Squeeze

To the victor belongs the spoils.

Capitalism itself is in trouble.  It no longer produces outcomes that benefit enough of the population.  The problem is captured by the phrase, "the hollowing out of the middle class."  President Obama's State of the Union address mainly concerned itself with this issue.  The President cast the Federal Government in the role of leveler, to fix what the market has wrought.

The President did not ask why the market is doing this now where it didn't do so in the past.  Let us review the factors.  To begin, we are still coming out of the horrible recession, seven years after the financial markets froze up.  Yesterday's Dealbook column is all about the European Central Bank finally pursuing an aggressive monetary policy.  The financial markets were pleased with this move.  Let's see if real economic activity improves as a consequence.  But nobody doubts that Europe has been in the doldrums for years and this current move suggests recognition that past policy was in error.  Yet I should also note that in my view this is a second best approach.  First best would be an aggressive fiscal policy, not rooted in tax cuts for the wealthy, those have little if any benefit to stimulate the economy, but rather in direct government spending, which increases aggregate demand.  However, our national politics and the politics in Europe as well have rendered the first best approach infeasible.

Next, there are the so-called structural changes in the economy that are a consequence of globalization.  Jobs can much more readily be moved off shore.  Workers overseas have a lower reservation wage.  While there has been a recent trend to bring some of those jobs back home, the question is: at what wage?  There is no doubt that increased competition in the labor market has had a depressing effect on wages for the ordinary Joe in America.  There is also no doubt that this change is permanent.   Even if the world economy rebounds from its sluggishness, this factor will serve to retard wage growth nationally.

Yet I don't believe the above gives the full story.  There is still one more factor to consider, one that has gotten far less attention in its consequences on the earnings of ordinary working people.  The economy has gotten far more concentrated.  One explanation for why is "network externalities."  The rise of the Internet and eCommerce has made network externalities that much more important for the economy overall.  The consequence is first and foremost on Internet companies.  Think of Apple, Google, Facebook, etc.  Network externalities are also obviously present in retail.  Think of Walmart and Amazon.  Indeed, the retail companies have been entering the Internet business and the Internet companies have been entering the retail business.  This is news to nobody.  But the increased concentration is happening elsewhere too, where the network externalities are less obvious or perhaps even nonexistent.  It is happening in banking and finance.  It is happening in air travel.  And in some sectors, high concentration has been a factor for some time, such as in pharmaceuticals, but other factors that are more recent have expanded the power of the providers.  Obamacare, for example, has boosted aggregate demand for the products pharmaceutical companies provide.

In the 1990s when the economics of network externalities was being articulated, for example see this piece in the Harvard Business Review by W. Brian Arthur, it was observed that competition in this arena tended to produce a winner-takes-all outcome, but sometimes the winner was selected by serendipity rather than by having a better product.  Arthur's prime example was DOS, a poorly designed operating system.  Yet Microsoft won the competition over Apple, because the business users who predominated the market had first cut their teeth on IBM mainframe products, and were therefore disposed to IBM PCs.  Paul David showed us that the example given by DOS was no fluke.  His paper on the Economics of Qwerty shows this is the norm with such competition, which is based on consumer lock-in to whatever the market happens to glom onto.  (As an owner of a Betamax in the mid 1980s, I should also note how VHS vanquished Beta.)  Over time, the business world has come to better understand this economics.  Now the initial goal of aspiring enterprises is to capture the market and lock in the customers. 

It may be instructive to look back at The Microsoft Case.  Indeed, Arthur's views at the time are interesting to ponder, given how quaint they may seem in present circumstances.

His work attracted the attention of the Justice Department as it was considering the Microsoft case. He has influenced the case with his writings and, although not directly involved, has been in contact with the Department of Justice. While he does not think a monopoly in high tech is necessarily a "bad thing" Dr. Arthur points out that such a monopoly is short-lived, a temporary monopoly. These "lock-ins" survive only until something better is developed. Interviewed by Dominic Gates for PreText Magazine last May, (text at Arthur says that the important thing for the consumer in high technology is that innovation continues at a reasonable pace. What he sees as a problem, and what is behind the Microsoft case, is if someone achieves a lock-in and then uses that unfairly in another market.

Nowadays, of course, the big guys leverage their current advantage to help them win in the next competition and that has become ordinary business practice.  Nobody seems too bent out of shape about it, though it clearly encourages industry to become even more concentrated.  And some may argue that the innovating activity itself is subject to increasing returns, so such leverage is actually efficient.  In other words, society gets more innovation that way than if most of the innovative activity was done by young whippersnappers while doing their skunkworks in their parents' garage.  I'm agnostic on this one.  It may be true in certain sectors of the economy, while implausible in other areas.

But what seems evident, and what I think we should be bothered about, is that a company which is large in its input and product markets has power to set the terms in those markets.  Further, the firm gets increased leverage in setting the terms as these markets become more and more concentrated.  With market concentration, the firm can squeeze input suppliers and consumers alike, getting terms that are more favorable to itself.

Unlike developing new product or making current product better, however, there is no way to construe squeezing stakeholders as improving the economy.  At best it is a neutral activity, a form of transfer payment from others to the company.  But often these transfers are pernicious.  On a microeconomic level there is the possibility of deadweight loss that emerges when marginal benefit exceeds marginal cost, something that market power encourages.  On a macroeconomic level there are Keynesian "multiplier effects" to consider.  President Obama argued in the State of the Union address that what he called middle class economics is good for the economy, by boosting aggregate demand.  Suppose that is true.  It is said now that corporate America is sitting on $2 trillion of assets.  How can it make sense for the economy overall to add to this war chest, through even more squeezing?

The agenda that President laid out in the State of the Union is likely to go nowhere with the current Congress.  But even if this agenda were to be implemented eventually, say after the elections in 2016, there are economic reasons to believe it will only have modest success in achieving its goals. And when I say this I do so from a position of sympathy for those goals.  The issues I refer to are not right wing zeitgeist about the President's agenda being anti-growth.  Rather it is because the Federal Government acting as Robin Hood, primarily through its policy on taxation, does not itself change the fundamentals of the labor market. In this manner government policy may have modest impact on the equilibrium in the market.  But the market will have a tendency to undo what the Federal policy is trying to do, if the fundamentals are not otherwise altered.  As an economist unwed to the President's policy ahead of time the obvious question to me is this?  What might be done to change those fundamentals in a way that promotes the goals that the President would like to advance?

* * * * *

The now traditional solution to excessive market power is regulation and/or antitrust.  Yet there are reasons to not advocate for them here.  These include an inability or an unwillingness of government to regulate in an effective way even when given the authority to do so, a desire not to punish winners for their success, and a fear that such punishment will only result in out migration of the capital these companies hold to destinations overseas.  So, as ridiculous as this may seem to some, one wonders whether market innovation itself might provide a cure.  In what follows I will suggest how that could possibly happen.

But first, one must confront the specter of Milton Friedman and his essay from 45 years ago in the New York Times Magazine, The Social Responsibility of Business is to Increase its Profits.  If Friedman is right then it's game over for expecting the market to address The Big Squeeze.  Indeed, in that case firms should squeeze their suppliers and their customers to the full extent possible, because that would be the socially responsible thing to do.

Friedman's argument goes something like this.  Managers of big corporations are agents of their shareholders.  The shareholders' goal is to make money off their investments.  So as good and faithful agents, the managers should pursue maximal profit.  This logic seems air tight, but I believe there to be a flaw to it. 

The error lies in presuming what shareholders want.  In a society where capitalism otherwise seems to be working, maybe Friedman is mainly correct that shareholders want only to make money on their investments.  But we have well known cases where shareholders act otherwise in the cause of social justice.  For example, there were shareholder resolutions as part of the disinvestment campaign from South Africa in the 1980s.  If it is painfully clear to shareholders that capitalism is not working well, as I claimed in my opening paragraph, there is some reason to believe that shareholders might moderate their views of what they'd like the company to do in favor of moving in a more socially responsible direction, even if this means a lower return on the stock they own.

Whether shareholders will moderate their views in this way, it seems to me, is not something that can be determined a priori by theoretical analysis itself.  It is an empirical matter that must be tested by trying it out and seeing what happens.  It is what I'm encouraging here.

Now let us consider the same issue from the perspective of CEOs and other high level executives of these big and powerful companies.  To the extent that these people live up to the Veblenesque and megalomaniacal vision that flows from a populist vision of corporate excess, Friedman's view should be confirmed, for the pursuit of profit regardless of the the consequences is just what a robber baron would do.

But a different conception is possible, one where such CEOs feel trapped, in spite of their privilege and power.  They play the game of maximizing profit because that is the only game in town to play.  They need some game to play, one where it is clear how the score is kept and thus determines who is winning the game.  But they fully understand that further accumulation of wealth for themselves is senseless, they are actually sympathetic to the goals that President Obama articulated about middle class economics, and they really dislike being cast as the heavy in that drama.  If there were a different game to play, one that was more benign on this front, they would willingly switch to that instead.  Further, they would willingly embrace the leadership role needed to get their shareholders to think likewise about this alternative game. 

With that in mind, let's consider what this alternative game might look like.  In its simplest possible conception, measures of squeezing (or lack thereof) would have to be aggregated in with profits to produce an index of performance that is more balanced.  For example, regarding employee compensation, now that Piketty and others have popularized thinking about income distribution, why not consider income distribution within the company measured by mean earnings, median earnings, and the Gini coefficient on earnings?  Good outcomes from the employee's view, which is what should be included in the aggregate performance index,  would value high mean and median earnings and a low Gini coefficient.  This itself would mean that excessive CEO compensation enters as a negative in the index in that it would raise the Gini coefficient on compensation, though it enters as a positive in raising mean earnings.  A well constructed index would have the first effect trump the second, at least for sufficiently high CEO compensation.

Customer satisfaction might be a harder nut to crack.  At present eCommerce attempts to solicit customer reviews of their recent experiences are fraught with the following problem.  The customer doesn't really understand how offering up an opinion will impact future performance by the company.  Absent this connection, there is little incentive for the customer to respond to such queries, which now appear as annoying messages in the customer's inbox.  The company asking for this information must be able to prove to the customer ahead of time that the customer's opinion will be valued and that service changes will be implemented when customers as a group complain about the same thing.   Further, these service changes have to be seen as addressing the problems that were articulated by the consumers.

For both the compensation and customer satisfaction data, naive schemes for eliciting the information are likely manipulable by the provider.  Such naive schemes should therefore not be trusted to produce a reliable picture of how much (or how little) the firm is squeezing its stakeholders.

But these problems are not insurmountable.  Their resolution can then be considered as challenges for compensation specialists and accounting firms that would undoubtedly find the building of a reliable performance index of company performance a boon to their own businesses.  One might then envision the production of such a performance index like any innovation.  The product itself will go through many iterations of development and the diffusion of the innovation will follow the typical s-curve pattern.

Might it then be possible for the result to be a kinder and gentler capitalism that is more inclusive?  And in this way might the fundamentals of the labor market change in a way that embraces the ideals of middle class economics that President Obama articulated, thereby relieving government tax policy from having to do the heavy lifting?

* * * * *

Here is one further thought.  For readers who found the above hard to believe it can be possible, they will likely be completely incredulous at this next suggestion.  But it seems possible to me that it is sensible, if the above ideas work in some fashion.

With a well functioning company performance index in place, where profit is but one component of that index and where good performers according to the index are those companies who don't squeeze their suppliers or their customers, it might be sensible to develop a different form of currency specifically to reward good performers.  The reasoning for this is as follows.  Currently a major motivation for CEOs and other high level executives is their ability to influence outcomes - in their industry, with the public, and with government oversight.  In this sense power is as important as personal income generation. Perhaps, it is even more important.  But the way the world works now, power and income generation are virtually perfect complements.  Money talks.  With enough of it, power flows.  (The image of Republican hopefuls preening themselves in front of Sheldon Alderson comes to mind, as one example to signify the current situation.)

Suppose this linkage could be severed.  The demand for influence would not go away, but it would have to be earned in a different way.  Mere money wouldn't do.  There would be a special currency to be used for influence only, and it would be earned by producing good scores with the company performance index.  In other words, benevolent capitalism would be rewarded with influence.  The old style of capitalism, based on opportunism and holdup, would lose out in this dimension.

The old style is entrenched now and unless this new sort of currency were credible in how it would be used, it would not overturn the entrenched practices.  So there is good reason to be skeptical about the idea.  But we live in an era where disruption of entrenched practices is an ordinary happening.  Doesn't it behoove us to envision the sort of disruption of the status quo that would make things better?

That's been my goal in writing this piece.

1 comment:

Lanny Arvan said...

This piece from the NYT gave me some hope that my ideas here might actually be realized. I wonder if it will produce some imitators.