The major deregulation movement of the past 100 years started with the Ford and Carter administrations in the 1970s, and continued through the Reagan years. This movement came to an end with the passage of the Americans with Disabilities Act of 1990 under the administration of George W. Bush. Since then some sectors, such as labor markets and product safety, have been regulated much more extensively, while others, including commercial and investment banking, have had no further declines in the extent of regulation. Despite the considerable and tangible successes of this deregulation movement, the pressure is intense to significantly increase the regulations affecting consumer safety, the introduction of new drugs, and especially financial markets.
The 1970s saw a bipartisan reduction in the regulation of airline travel, trucking, security exchanges, and commercial banking. Measures of the success of this deregulation include sharp declines in the cost of air travel and of shipping goods by truck, huge reductions in commissions on stock transactions, and higher interest rates on bank deposits. Not only has no serious attempt been made to re-regulate these activities, but also European and many other nations on all continents have copied the American deregulation of airlines and securities.
The impetus to tighter regulations varies from sector to sector, although there is a growing belief that many activities are insufficiently regulated. Obviously, the current turmoil in the financial sector is stimulating many proposals to regulate extensively various types of financial transactions. Yet it is not obvious that the problems in the financial sector resulted mainly because of insufficient regulation. For example, commercial banks are probably the most heavily regulated group in the financial sector, yet they are in much greater difficulties than say the hedge fund industry, which is one of the least regulated industries in the financial sector. Banks participated very extensively in originating mortgages, including subprime mortgages, and in buying mortgage-backed securities, and so they are suffering from the high foreclosure rates, and the sharp decline in the market value of these securities.
One reason why extensive regulation of commercial banks did not prevent many banks from getting into trouble is that bank examiners became optimistic along with banks about the risks associated with mortgages and other bank assets because the market priced these assets as if they carried little risk. It would run counter to human nature for regulators to take a skeptical attitude toward the riskiness of various assets when the market is indicating that these assets are not so risky, and when originating and holding these assets has been quite profitable. One can expect regulators to mainly follow rather than lead the market in assessing riskiness and other asset characteristics.
To some extent that was also true of the Fed's behavior during the past few years. I believe that Alan Greenspan is right in claiming that the main cause of the housing boom was not the Fed's actions but the worldwide low interest rates due to an abundant world supply of savings. The demand for very durable assets like housing is greatly increased by low interest rates. Still, the Fed seems to have contributed to the booming demand for housing and other assets by keeping the federal funds rate artificially low during the boom years of 2003-05.
In evaluating the need for greater financial regulation, one should also not forget that the American economy greatly outperformed the European and Japanese economies during the past 25 years. Might that not be related in part to the fact that the United States led the way with major financial innovations like investment banks, hedge funds, futures and derivative markets, and private equity funds that were only lightly regulated? An infrequent period of financial turmoil may be the price that has to be paid for more rapid growth in income and low unemployment. Rapid income and employment growth might be worth an occasional period of turmoil especially if they do not lead to prolonged slowdowns in the real part of the economy. So far the effects on GDP and employment have not been severe, although the financial distress is not yet completely over.
Nevertheless, a few important regulatory changes are probably warranted. For the first time the Fed allowed investment banks access to its federal funds window, and the Fed guaranteed $29 billion worth of mortgage-backed assets to induce J.P. Morgan to take over that investment company. Since these types of Fed actions would likely be repeated in the event of future financial turmoil, investment banks would have an incentive to take on additional risk since they can reasonably expect to be helped out by the Fed in the future. For this reason it might be desirable for the government to impose upper bounds on the permissible ratios of assets to equity held by investment banks. The ratio of assets to the equity of the five leading investment banks did increase greatly from about 23 in 2004 to the highly leveraged level of 30 in 2007.
Other regulations of financial institutions may also be merited, but elaborate new regulations of the financial sector would be counterproductive. For example, the Fed has proposed limits on how much mortgage interest rates can exceed the prime rate for low-income borrowers with poor credit ratings. This would be a foolish intervention into the details of credit contracts that have all the defects of usury laws.
The financial sector has served the economy well by managing, dividing, and pricing different types of risks in the economy. It would be a mistake if Congress and the President allow the present financial turmoil to panic them into inefficient new financial regulations.
I no longer believe that deregulation has been a complete, an unqualified, success. As I indicated in my posting of last week, deregulation of the airline industry appears to be a factor in the serious deterioration of service, which I believe has imposed substantial costs on travelers, particularly but not only business travelers; and the partial deregulation of electricity supply may have been a factor in the western energy crisis of 2000 to 2001 and the ensuing Enron debacle. The deregulation of trucking, natural gas, and pipelines has, in contrast, probably been an unqualified success, and likewise the deregulation of the long-distance telecommunications and telecommunications terminal equipment markets, achieved by a combination of deregulatory moves by the Federal Communications Commission beginning in 1968 and the government antitrust suit that culminated in the breakup of AT&T in 1983.
Although one must be tentative in evaluating current events, I suspect that the deregulation (though again partial) of banking has been a factor in the current credit crisis. The reason is related to Becker's very sensible suggestion that, given the moral hazard created by government bailouts of failing financial institutions, a tighter ceiling should be placed on the risks that banks are permitted to take. Because of federal deposit insurance, banks are able to borrow at low rates and depositors (the lenders) have no incentive to monitor what the banks do with their money. This encourages risk taking that is excessive from an overall social standpoint and was the major factor in the savings and loan collapse of the 1980s. Deregulation, by removing a variety of restrictions on permitted banking activities, has allowed commercial banks to engage in riskier activities than they previously had been allowed to engage in, such as investing in derivatives and in subprime mortgages, and thus deregulation helped to bring on the current credit crunch. At the same time, investment banks such as Bear Sterns have been allowed to engage in what is functionally commercial banking; their lenders do not have deposit insurance--but their lenders are banks that for the reason stated above are happy to make risky loans.
The Federal Deposit Insurance Reform Act of 2005 required the FDIC to base deposit insurance premiums on an assessment of the riskiness of each banking institution, and last year the Commission issued regulations implementing the statutory directive. But, as far as I can judge, the risk-assessed premiums vary within a very narrow band and are not based on an in-depth assessment of the individual bank‚Äôs riskiness.
Now it is tempting to think that deregulation has nothing to do with this, that the problem is that the banks mistakenly believed that their lending was not risky. I am skeptical. I do not think that bubbles are primarily due to avoidable error. I think they are due to inherent uncertainty about when the bubble will burst. You don't want to sell (or lend, in the case of banks) when the bubble is still growing, because then you may be leaving a lot of money on the table. There were warnings about an impending collapse of housing prices years ago, but anyone who heeded them lost a great deal of money before his ship came in. (Remember how Warren Buffett was criticized in the late 1990s for missing out on the high-tech stock boom.) I suspect that the commercial and investment banks and hedge funds were engaged in rational risk taking, but that (except in the case of the smaller hedge funds--the largest, judging from the bailout of Long-Term Capital Management in 1998, are also considered by federal regulators too large to be permitted to go broke) they took excessive risks because of the moral hazard created by deposit insurance and bailout prospects.
Perhaps what the savings and loan and now the broader financial-industry crises reveal is the danger of partial deregulation. Full deregulation would entail eliminating both government deposit insurance (especially insurance that is not experience-rated or otherwise proportioned to risk) and bailouts. Partial deregulation can create the worst of all possible worlds, as the western energy crisis may also illustrate, by encouraging firms to take risks secure in the knowledge that the downside risk is truncated.
There has I think been a tendency of recent Administrations, both Republican and Democratic but especially the former, not to take regulation very seriously. This tendency expresses itself in deep cuts in staff and in the appointment of regulatory administrators who are either political hacks or are ideologically opposed to regulation. (I have long thought it troublesome that Alan Greenspan was a follower of Ayn Rand.) This would be fine if zero regulation were the social desideratum, but it is not. The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith. Judging by the number of scandals in recent years involving the regulation of health, safety, and the environment, this is not being done. And to these examples should probably be added the weak regulation of questionable mortgage practices and of rating agencies' conflicts of interest and, more basically, a failure to appreciate the gravity of the moral hazard problem in the financial industry.
Airline delay has increased in the last five years, and the statistics understate the amount of delay because airlines have increased scheduled flight times--the flight from Chicago to Washington used to be scheduled for an hour and a half; now it is scheduled for two hours. Flights are horribly crowded, food and beverage service has deteriorated in first class and virtually disappeared in coach, and the incidence of mislaid baggage has increased.
Delay is the main problem, and the one that I shall focus on. Many culprits have been named--high fuel costs that have contributed to deferred maintenance that results in cancellations, the failure of the Federal Aviation Administration to upgrade the air traffic control system so that it can handle more traffic with less spacing between aircraft, more turbulent weather perhaps due to global warming, and crowded aircraft that result in delays in boarding and hence in departure. But all these seem to me to miss the point. Persistent delay is usually the result of a failure to use price to equate demand and supply. When demand increases in advance of an increase in supply, failure to raise price results in buyers' incurring cost in the form of delay rather than in the form of a higher price. The cost of delay is a deadweight loss, whereas a higher price would be merely a wealth transfer to the sellers and would finance an increase in supply.
Some delay in the provision of services is unavoidable because of fluctuations in demand; it usually is wasteful to increase supply to the point at which every spike in demand can be accommodated without rationing (i.e., queuing, delay). But the persistent delays that airline passengers have been encountering for many years now cannot be explained by demand uncertainty. The delays impose enormous costs, particularly but not only on business travelers. The value of Americans' time is high.
So why are airline prices so low? The answer may lie in the lumpiness of airline service. (This was pointed out many years ago by the Chicago economist Lester Telser, and was repeated last week by Holman Jenkins in the Wall Street Journal.) The fixed costs of modern passenger aircraft are very high, but the marginal costs--the costs of carrying one more passenger if the plane is not full--are very low. At any price above marginal cost, the airline is better off selling a ticket than flying with the seat empty. Competition between airlines will therefore exert strong downward pressure on price. Prices tend to be pushed down to a level at which the airlines find it difficult to finance the purchase of new planes. As the existing planes age, equipment failures become more frequent, contributing to delays and cancellations. Airlines prefer delays to cancellations, because they get to keep the fares, and they resist raising prices to reduce congestion because that will make it more difficult to fill the planes, and an empty seat is, as explained, very costly in revenue forgone. Furthermore, airline service is quite uniform across airlines, which makes travelers more sensitive to airline prices than, say, to hotel prices, since hotels compete in many other dimensions besides price.
Another aspect of lumpiness that should be noted is the difficulty of adjusting prices to different passenger time costs. Business travelers have higher time costs than leisure travelers, but there are not enough business travelers to fill a plane of efficient size, and even if there were, no one airline could significantly reduce the problem of delay, just as no one driver can affect traffic congestion by reducing the number of his trips.
I am not aware that the delay costs of airline service, and the costs of the other disamenities (the very crowded airplanes and slow boarding and deplaning in coach) in the current market, have been quantified, but assuming that they are, as I suspect, very substantial, the question arises what if anything should be done to alleviate the problem.
One possibility would be to allow the airlines to agree on minimum prices: in other words, to exempt the airlines from section 1 of the Sherman Act, which forbids competitors to agree on prices. The problem is that the airlines would fix a profit-maximizing minimum price, and it probably would exceed the price necessary to reduce congestion to the optimal level. Moreover, any increase in the price level would attract inefficient entry.
Another possibility would be to return to the regulatory system administered by the Civil Aeronautics Board before the deregulation of the airline industry in 1978. The CAB did not regulate rates, but it controlled entry into city pairs and used that control to limit entry to the point that flights were frequent and uncrowded. If a flight was canceled or delayed, it was usually easy to get a seat on another flight leaving soon. But with entry tightly limited, prices were above the competitive level; planes were not just uncrowded, they flew nearly empty. Prices have fallen sharply since deregulation. Competition has also led the airlines to adopt a variety of cost-saving measures. Pilots' wages are now much lower. Before deregulation, the powerful pilots' union (powerful because of the enormous costs of a work stoppage to a company that cannot produce for inventory and thus make up some of the revenue that it loses from a strike) was able to extract some of the airlines' regulation-enabled cartel profits, in the form of supracompetitive wages for pilots.
Another option would be to encourage, or at least place no antitrust or other obstacles in the way of, mergers between airlines. If there were only two airlines on every route, tacit collusion between them would probably keep prices high but not so high as if there were a single airline or an explicit price-fixing agreement. But any increase in prices would attract entry, pushing prices back down. Moreover, mergers often result in higher rather than lower costs.
A better alternative than any I have discussed thus far would be a heavy tax on airline transportation, with the tax rate varying according to the contribution of a particular route, time, or type of plane to congestion (for example, in general large planes would be taxed less heavily per passenger than small ones, because for a given number of passengers there are fewer big planes to clog the airways and runways than there would be small ones). To the extent effective, the tax would eliminate the deadweight cost of congestion.
The increase in flight delays is just one aspect of a general decline in airline service. A few prominent examples of this decline are the elimination of meals in economy on domestic flights, more lost baggage, and dirtier seats and toilets. Posner gives several reasons why service has declined, with concentration on flight delays. I will add one reason to those he mentions that has been very important but is usually overlooked; namely, that the decline in service is an integral part of the substantial fall in the cost of airline travel after the airline industry was deregulated.
The crucial point is that the lower income and leisure flyers, and families with children that now make up the vast majority of customers on domestic routes, and a substantial fraction on international flights, prefer lower prices to better quality service and higher prices. On this interpretation it is no surprise that Southwest Airlines achieved remarkable success by offering low prices with no meals, and only non-reserved economy seats. The revealed preference of the majority of flyers has been that they prefer lower prices to meals and many other amenities that were once standard on flights in the United States. American Airlines and other more traditional airlines have been forced to react to the competition from the no frills airlines by, for example, eliminating meals, and sometimes eliminating first class seats and even reserved seats, so that they too can offer lower prices.
The same considerations explain the greater crowding on flights since airlines can offer much cheaper seats with average loads of 80 percent rather than say 50 percent. The reason is that the cost of handling the additional 30 percent of passengers is very low compared to the high cost of owning and operating planes, and compared even to the reduced revenue they receive from these passengers. Most persons who now fly prefer lower prices with more crowded planes and greater delays in boarding to the high prices and low occupancy rates that prevailed prior to deregulation.
The same trade off between price and service applies to the flight delays discussed by Posner. These delays are stochastic in that they vary from day to day according to different probability distributions of delay times. When delays persist, airlines are forced by the regulatory authorities to increase their scheduled flight times to recognize that typical travel times are longer. Airlines can cut down their delays by having greater amounts of deicing equipment during winter in the event of unexpected icing of planes, greater reserves of crews in case some crew members call in sick or get stranded, a larger number of backup aircraft in case some aircraft develop mechanical problems, and so on for other determinants of delays.
I am arguing that many passengers prefer the combination of low fares and greater delays on average to higher fares and fewer delays because it is cheaper to operate planes when inventories of people and equipment are smaller. Consider as an analogy a clothing store that has a large inventory of merchandise. It charges customers a lot for the suits and dresses it sells partly to help finance the convenience to customers of having many types of clothing to choose from. More generally, sellers often offer customers goods that have at least two dimensions: price and size of inventories. Prices generally are higher when inventories are greater so that delays in buying particular merchandise due to unexpected surges in demand are shorter because of the greater inventory of goods.
Of course, not all passengers are identical, and some of them prefer shorter delays and higher prices to the present situation. A number of airlines have been started in order to cater to these customers by providing exclusively first class or business class seats. These airlines have generally not been successful, probably because there are not enough of these customers to support commercial airlines that only offer first class service. Instead more affluent flyers have opted to buy shares in or outright ownership of private planes where service is far better and delays are much shorter. Private planes even have shorter delays from air traffic congestion because they frequently use less crowded airports.
Air traffic delays at major airports can be reduced through varying pricing of take offs and landings with time of day and the density of traffic, as discussed by Posner. Implementation of such sophisticated pricing is always difficult with publicly owned resources like airports and roads. So the privatization of airports could make possible greater flexibility in pricing the use of airports to take account of congestion.
The high fixed cost and low variable cost of airlines do not imply that airlines must be unprofitable in a competitive environment. Southwest and Jet Blue are two examples of airlines that have done quite well by offering low prices and limited service. Airlines made considerable profits in the latter part of the 1990s, but then the industry was hit first by 9/11, and then by the sharp run up in the cost of their fuel. Fuel costs have become more important to airlines than labor costs.
The hotel industry offers insights into the airline industry. This industry is more competitive than the airline industry since entry into the hotel industry is even easier than into the airline industry, and hotels also have high fixed costs of operations and relatively low variable cost of servicing individuals who occupy their rooms. Hotel prices adjust in the short run to the level of demand, but there are times when it is hard to get rooms, and people with reservations are denied rooms because of overbooking. Yet hotels have on average been quite profitable, which has stimulated various booms in the building of new hotels. To be sure, airlines have been exposed to major shocks, such as deregulation, terrorism attacks, and expensive fuel, but there is no intrinsic structural reason why the airline industry should be less profitable than the hotel industry.
Addendum on Rising Food Prices-Becker
It was an oversight that I did not discuss explicitly long term prospects for food price increases. The brief discussion below corrects this.
A major concern about the rapid rise in food prices is that these high prices will persist into the indefinite future, and perhaps food prices will rise much further. An analogy is often drawn with oil prices since both have risen rapidly during past couple of years, and there is much fear by oil importing countries that oil prices will continue to go up during the next few years.
However, the analogy to oil is seriously flawed. Whatever happens to oil prices, there are grounds for much greater optimism about food prices. Any increase in the production of oil is limited by its fixed availability at different locations on earth. The supply responses to higher prices of agricultural production will be much greater than that of oil production for two fundamental reasons. The first is that only a small fraction of potential arable land is used for farming because the growth of cities and suburbia has led to mass conversions to other purposes of land formerly used to grow foods. Persistent high and climbing prices of grains and other foods will induce conversion of some of this land back to farming.
The second reason for optimism relates to the lower productivity of food production in the poorer parts of the world relative to the United States and other developed countries. Higher food prices will induce an increase in productivity in developing nations by encouraging greater use of machinery, fertilizers, and other forms of capital. It will also encourage consolidation of some agricultural holdings into the hands of more efficient farmers. Efficiency in oil production is more uniform in different parts of the world than is food production since the major energy international conglomerates produce all over the globe, including many poorer nations.
The World Bank's index of food prices increases by 140 percent from January 2002 to the beginning of 2008, and a full 75 percent just since September 2006. This highly unusual explosion of food prices has been seized upon by neo-Malthusians as the beginning of a day of reckoning due to the collision between he limited capacity of the earth to produce foods and the growing demand for food and other commodities induced by rapid world population and income growth. Malthusians have turned out to be wrong in the past when they extrapolated from events like food price inflation to prophesies about world catastrophe-witness the embarrassingly wrong predictions in Paul Ehrlich's The Population Bomb about the impending mass world starvation in the 1970's due to what he considered vastly excessive world population growth. They are also wrong about this current food price rise because it has nothing to do with population growth, and is only a little related to the rapid expansion in world incomes in recent years.
Rather, the boom in petroleum prices and subsidies to ethanol and other biofuels are the most important forces explaining the recent increase in food prices. Both the sharp run up in oil prices, and the continuing subsides to ethanol production in the United States, and to a lesser extent Europe, induced an increasing diversion of corn from feed and human consumption to the production of biofuels. The main goal of the diversion has been to produce more ethanol as a substitute for gasoline. During the past year, one quarter of American corn production, and 11 percent of global production, was devoted to biofuels, and the US contributes a lot to the world corn market. The growth in demand for biofuels explains why acreage was shifted from other grains to corn-the acreage devoted to corn in the United States increased by over twenty percent in 2007-8, while that devoted to soybean production declined by more than fifteen percent. The reallocation of production away from other grains explains the rapid price increases for wheat, soybeans, and rice as well as for corn.
The huge increase in petroleum prices also pushed up the cost of producing foods, and hence food prices, since energy is an important input in the production of fertilizers and agricultural chemicals. Other factors affecting the rise in food prices include the drought in Australia in 2006-07 that cut world grain production during those years, and the fall in the value of the dollar that may have increased the dollar value of foods and other commodities.
The Malthusian forces of population and income growth ontributed only a little to explaining the big increase in grain prices since 2002. The large rise of world food prices came after food prices had been either stable or declined for many years.
Although incomes in China and India, countries that account for almost 40 percent of the world's population, did grow rapidly during this decade as well as during the 1990's, global consumption of corn, wheat, and rice grew more slowly since 2000 than during the five years earlier. To be sure, the slower growth in consumption is partly the result of the rapid increase in grain prices. However, if an unusually large increase in world wide demand for grains to use as feed for animals and for human consumption explained the rapid increase in these prices, consumption should have grown more rapidly during the later period, even after adjusting for any induced increase in grain prices.
Some countries, including Argentina, India, Russia, and Vietnam, have responded to the sizable run up in food prices by severely restricting, or heavily taxing, food exports. By reducing exports of rice and other grains, these policies lowered the supply of these grains to importing countries, and helped bid up world prices. At the same time, however, these restrictions kept a lid on domestic prices of rice and other grains by diverting some supplies to domestic markets.
Governments in countries that restricted food exports usually responded to urban riots and other domestic disturbances, such as those in Egypt, Haiti, and Vietnam, that were protests against food price increases. The restrictions on food exports reflect the general tendency of governments in poorer countries to favor urban consumers over farmers. Since food accounts for a large fraction of household spending in poorer countries-over 70 percent in poor households- sharp food price increases would cut by a lot the purchasing power of poorer urban consumers. On the other hand, farmers are hurt by restrictions on their food exports since they get lower domestic prices than they could get on the world market. Restrictions of food exports also lower the efficiency and overall incomes of the countries imposing them since a lid on domestic food prices discourage farmers from increasing their food production at a time when world food prices have been rising at a fast pace.
Some analysts have justified these export restrictions as a way to combat the effect of rising food prices on poverty. However, poverty is much more prevalent among rural than urban families in developing countries like China, Egypt, India and Vietnam. So restrictions on food exports in developing nations not only lower the efficiency of their food production, but also usually raise inequality and overall poverty. The greater political clout of urban households in developing nations is the pressure behind the support for these inefficient and inequitable export restrictions, just as the greater political clout of farmers in developed nations maintains the inefficient, and probably energy-wasteful, ethanol subsidies in the United States and other rich countries.
Becker is right of course that a growing demand for food, resulting from world population growth, relative to supply cannot explain the very steep food-price increases that have occurred since 2006; world food prices are 75 percent higher than they were that year and obviously world population has not grown by that percentage, But I do not take this to be a refutation of Malthus, whose insights have relevance to the modern world.
Malthus argued that if a population is living at the subsistence level, if population increases geometrically (for example, a couple has three children, each of the three children eventually marries and produces three children, and so on) but food production only arithmetically, there will be more people than can be fed, and so population will decline through starvation, disease, or war until a new equilibrium is reached. (Because the population is assumed to be living at the subsistence level, the equilibrium cannot be achieved through higher food prices.) Malthus did not foresee the technological advances that have resulted in a faster rate of increase in the food supply than in the population, or increases in wealth that enable food prices to rise to prevent shortages should demand outrun supply. Nor did he foresee modern contraception technology, or China‚Äôs one-child policy. But given his assumptions, his analysis is sound and it gave Darwin the clue he needed to develop the theory of natural selection. In Malthus's model people kill each other to avoid starvation, and those who do best in the desperate struggle survive--hence survival of the fittest as determined by a competitive process.
As Becker points out, Paul Ehrlich and others predicted in the 1970s (beginning with the first "Earth Day," in 1970) mass starvation as a result of continuing population growth. They were wrong, in part by failing to predict the Green Revolution, which greatly reduced the cost of food production. The situation today is different.
The demand for agricultural products has grown, though not as a result of population growth; instead as a result of increased demand for ethanol and other biofuels, and for food that requires more agricultural acreage to produce. Today, besides people and pigs eating corn, our motor vehicles "eat" corn that has been converted into ethanol. And in China and India, which together contain a third of the world's population, increased wealth has led to an increased demand for meat, in China for beef. Cattle eat corn and other crops and are in turn eaten, but the amount of crops consumed in this process is several times greater than the amount that would be consumed if people ate the crops directly, rather than indirectly by eating vegetarian farm animals. China's consumption of beef, which has been growing rapidly for a number of years, is expected to grow 4 percent this year--yet it will still be only about 15 percent of U.S. beef consumption per capita.
Increased demand for agricultural products should lead to increased supply, but the supply response is limited because of the higher price of gasoline, an important input into food production, and because of scarcity of good agricultural land (in part a result of population growth), which implies an upward-sloping supply curve for food..
The fact that increased demand for agricultural products, and resulting high prices, are due to factors other than growth of population does not make a demand-supply imbalance any the less serious. We may be seeing the beginnings of an attenuated Malthusian response in Egypt, where there have been riots recently over food prices. Egypt is a poor country, and to avoid violence the government has had to increase its food subsidies--making the country poorer and hence more vulnerable to political instability, which could result in an Islamic insurrection. In poor countries today, as in ancient Rome, keeping the urban population happy is the foremost political imperative, because urban riots, especially in a nation's capital, can bring the government down. Urban residents are not farmers, so rising food prices only hurt, and do not help, them. But urban food subsidies immiserate the rural population, and limits on food exports, designed to control domestic food prices, disrupt the international agriculture market.
Our ethanol subsidies, and equivalent policies, such as the European Union's rejection of genetically modified foods, and the wealthy nations' (including the United States') tariffs on agricultural imports, could in principle be abandoned in order to increase the supply of food. But domestic interest-group pressures (which in the United States include the disproportionate influence that Iowa exerts in presidential politics) make reform unlikely.
It used to be thought more widely than it is now that in a competitive market, the compensation of workers, on the assumption that it is left to the market, will be efficient. That of course is a major assumption, given unions, minimum wage laws, laws against employment discrimination, and other regulations of employment. But such regulations do not bear significantly on the employment of executives and professionals, and it is they with whose compensation I shall be concerned. Shouldn't we expect that they at least--corporate executives, lawyers, and other elite workers--are efficiently compensated, provided their employers are operating in a vigorously competitive market, as most markets nowadays, other than those that are natural monopolies (that is, markets in which economies of scale are obtainable over the entire range of feasible output), but fewer and fewer markets are naturally monopolistic?
The answer should be yes, but increasingly it seems, as a matter both of theory and of evidence, that to implement efficient methods of compensating executives and professionals is extremely difficult, and maybe as a practical matter impossible for a free-market system to accomplish.
There is a long-standing concern that corporate executives are more risk averse than a corporation's shareholders, because the latter can eliminate firm-specific risk by holding a diversified portfolio, while the former cannot, because they have firm-specific human capital that they will lose if the firm tanks. The solution to this problem was thought to consist in making stock options a large part of the executive's compensation, so that his incentives would be closely aligned with those of the shareholders. True, because he would bear more risk, he would have to be paid more in total compensation than if he did not receive a large part of his compensation in the form of stock options. But the cost to the corporation of the additional pay would presumably be offset by the gain to the shareholders from the executives' enhanced incentives to maximize shareholder wealth.
But we are beginning to realize that the grant of stock options may make corporate executives take more risks than the shareholders desire. Suppose that instead of being compensated for bearing risk just by being paid a higher salary or given even more stock options, the executive is guaranteed generous retirement and severance benefits that are unaffected by the price of the corporation‚Äôs stock. Now he has a hedge against risk, and can take more risks in operating the corporation because his personal downside risk has been truncated. Perhaps this was a factor in the recent stock market bubbles--the one that burst in 2000 with the crash of the high-tech stocks and the one that burst this year as a result of the collapse of the subprime mortgage market and the resulting credit crunch. A bubble is both a repellent and a lure. It is a lure because during the bubble values are rising steeply, so an investor who exits before the bubble has peaked may be leaving a good deal of money on the table. He will be especially loath to do that if he is hedged against the consequences of the bubble's eventual bursting.
Boards of directors could devise compensation schemes that limited the attractiveness of risky undertakings, but they have little incentive to do so. The boards tend to be dominated by CEOs and other high corporate executives of other firms, who have an interest in keeping executive compensation high and who are abetted by compensation consultants who naturally recommend generous compensation packages to directors who are recipients of generous compensation and therefore believe that the CEOs of the companies on whose boards they sit should be paid top dollar.
It is not clear what the free-market antidote to this tendency to ratchet up executive compensation is. The compensation of the CEO and other high officials of a large corporation is usually only a small part of the corporation's costs, so shaving such compensation is unlikely to be a powerful competitive weapon. But more important, what rival corporation would have the governance structure that would enable such shaving to be accomplished by overcoming the obstacles that I have discussed? The private-equity firm is a partial answer, because it has only a few shareholders and so need not delegate compensation to a board of directors that has other interests besides the welfare of the shareholders at heart. The reason it is only a partial answer is that there are too few owners of capital who want or have the ability or experience to participate as actively in management as the private-equity entrepreneurs and there are too many efficiently large corporations for all of them to have the good fortune of being owned by a handful of entrepreneurial investors. There is a vast pool of passive equity capital that can be put to work only in companies that are organized in the traditional board-governed corporate form.
Here is another though related example of a stubborn efficiency-in-compensation problem, also in a highly competitive sector of the economy: law-firm billing practices. Major law firms, with few exceptions, base their bills to their clients on the number of hours that the firm's lawyers work on the client's case or other project. In other words, they bill on the basis of inputs rather than outputs. This is rational when output is difficult to evaluate, as is often the case with a law firm's output because of the uncertainty of litigation (in nonlitigation practice, because of legal and factual uncertainties). The fact that a firm loses a case doesn't mean that it did a bad job; both the winner's firm and the loser's firm may have done equally good jobs--the lawyers don't control the outcome. A law firm can give the client a pretty good idea of the quality of the lawyers it assigns to the client's case, because there are observable proxies for a lawyer's unobservable quality, proxies such as his educational and employment history. What the client cannot readily judge is whether the law firm put in excessive hours on the case, and the result, according to persistent and cumulatively persuasive anecdotage, is a tendency for law firms to invest hours in a case beyond the point at which the marginal value of the additional hour is just equal to the marginal cost to the client. Young lawyers often feel that they are being assigned work to do that has little value to the client but that will increase the firm's income because the firm bills its lawyers' time at a considerably higher rate than the cost of that time to the firm. The very high turnover at many law firms is attributed in part to dissatisfaction of young lawyers with the amount of busywork that they are assigned, work that bores them and does not contribute to the development of their professional skills, yet may be very time-consuming.
The problem is compounded by the distorted incentives of corporate general counsels. A general counsel wants to show his boss, the corporate CEO, that he monitors expenses carefully, and, since he knows that he is likely to lose at least some of his cases, he also wants to be able to avoid if possible being blamed by his boss for the loss. Hourly billing serves both of these ends. The law firm and the general counsel play a little game, in which the law firm prices its hours on the assumption that it will not be able to collect its billing rates on all of them, and the general counsel reduces the number of hours that he is willing to pay for. He can then show his CEO that he squeezed the water out of the law firm's bills. At the same time, by paying a prominent law firm by the hour, he can assure his CEO, in the event a case is lost, that he had told the firm to do as much work as was needed to maximize the likelihood of a favorable outcome, rather than paying a fixed rate agreed to at the outset that might have induced the law firm to skimp on the amount of work it put into the case.
One can imagine a law firm's adopting a different method of pricing, in which it would charge at the outset a fixed fee, subject to adjustments up or down at the end of the case based on outcome, amount of work, or some other performance measure or combination of such measures. The conventional law firm billing system is a form of cost-plus pricing, which is considered wasteful. But litigation is risky, and cost-plus pricing diminishes risk by eliminating a contractor's incentive to cut corners. If the disutility of risk to a general counsel is great, he will prefer to "overpay" law firms rather than trying to explain to the CEO that the novel compensation deal that he worked out with the law firm that lost the case was not a factor in the loss; that he had not been penny wise and pound foolish.
Although the compensation practices that I have described seem inefficient, it does not follow that corrective measures would be appropriate. They would be costly and the net benefits might well be negative. It is efficient to live with a good deal of inefficiency. Stated otherwise, the fact that competitive markets contain large pockets of inefficiency is not in itself inefficient. For example, while cartel pricing is inefficient, if the cost of preventing cartelization exceeded the benefits one wouldn't want to prevent it. Yet cartel pricing would still be inefficient in the sense of misallocating resources, relative to the allocation under competition. We must live with a good deal of inefficiency, but it is still inefficiency.
Executive compensation has been criticized both for being too generous, and for encouraging excessive risk-taking relative to the desires of stockholders. Yet while there are links between the level of pay and the amount of risk chosen, these are mainly distinct issues. Executives may be paid little, but the pay can be structured to have a much better payoff when profits are high than when profits are low. In this case, the average level of pay over both good and bad times would not be particularly generous, but its structure would tend to encourage risk-taking behavior. On the other hand, a CEO's pay might be excessively high on average, but not appreciable better when his company does well than when it does badly. He would be overpaid, but he would not have a financial incentive to take much risks.
Does the pay structure in American corporations, with the growing emphasis during the past several decades on stock options, bonuses, and severance and retirement pay, encourage excessive risk-taking, where "excessive" is defined relative to the desires of stockholders? It may look that way now with the sizable number of major financial companies that have taken huge write downs in their mortgage-backed and other assets, while top executives of some of these companies have only had modest declines in their pay (although others, such as the head of Bears Sterns, have taken huge hits). However, these financial difficulties do not necessarily imply that heads of most financial companies knowingly engaged in more speculative activities than desired by stockholders because of the incentives CEOs had. A more compelling explanation is that heads of companies have undervalued the risks involved in holding derivatives and other exotic securities, particularly securities that were rather new and not well understood. Let me stress, however, that I am not trying to excuse the many CEOs in the financial sector and in other sectors who got off much too easily for terrible investment decisions.
Bubbles are prolonged periods of excessive optimism where the true longer-term risk to holding particular assets is generally underestimated. The housing boom of the past few years now appears to have been a serious bubble where pervasive optimism about housing price movements raised the rate of increase in housing prices far beyond sustainable levels. Sophisticated lenders as well as low-income borrowers underestimated the risks involved in the residential housing market, as they appeared to have assumed that housing prices would continue to rise for a number of years in excess of ten percent per year.
Evidence suggesting that the risk taken by companies during the recent boom was not mainly due to a principal-agent problem between executives and stockholders is that the major private equity firms also experienced serious loses on their investments, especially on their housing investments. Private equity companies have much less of a principal-agent problem than do Citicorp, Bears Sterns and other publicly traded companies because private equity companies have a concentrated ownership. Also borrowers in the residential housing market have basically no principal-agent problems since they buy for themselves; yet many of them too took on excessive risk because of undo optimism about the housing market.
The private equity example provides a more general way to test whether CEOs take greater risks than their stockholders desire. One can analyze the relation between the degree of concentration of stock ownership in different companies and various measures of risk, such as their year-to-year variance earnings, adjusted for industry and other relevant determinants of this variance. The excessive risk argument would suggest that the more concentrated the ownership, the smaller would be the actual exposure to earnings and asset risk.
Another test of the excessive risk argument is whether the trend toward greater compensation in the form of stock options and other performance contingent compensation increased the risk taking of companies. Some have attributed much of the dot-com bubble to increased performance based compensation. However, most dot-com companies that went under were quite small and rather closely held by venture capitalists and similar investors. Hence these companies did not have a sharp conflict between stockholders and managers. Moreover, during the dot-com bubble, assets of minor Internet companies were raised in market value to more than 100 times earnings, even when they had no sales, let alone earnings. Such huge earnings-profits ratios suggest excessive risk taking by stockholders more than by managers.
Economic theory does imply that the increasing trend toward performance-based compensation would increase the degree of risk-taking by top executives. It is much less clear whether this effect is large- doubts are expressed by Canice Prendergast in his study "The Tenuous Trade-Off Between Risk And Incentives", Journal of Political Economy, 2002, (Oct), 1071-1102. It is also unclear if CEOs have been induced to take more risks than the level of risk desired by stockholders. Furthermore, and most important, there is no persuasive evidence that the structure of CEO compensation played an important roll in either the dot-com or housing bubbles.