God Bless the Child

Billie

Them that’s got shall have,
Them that’s not shall lose,
So the Bible said and it still is news.
Mama may have, Papa may have,
But God bless the child that’s got his own,
That’s got his own.

            – Billie Holiday, God Bless the Child

See post: Why Ownership Matters

Why Ownership Matters

TheOwnershipSociety

A little over a decade ago, in 2004 to be exact, the subject of ownership in democratic capitalist society was raised as a national political issue. Attribution goes to President George W. Bush, as he was campaigning for a second term, when he stated, “…if you own something, you have a vital stake in the future of our country. The more ownership there is in America, the more vitality there is in America, and the more people have a vital stake in the future of this country.” He called his vision The Ownership Society and it became the theme of his campaign. Naturally, his political opponents pounced on the idea, deriding it as the You’re-On-Your-Own Society, with the catchy acronym of “YO-YO.”

At the time I found the original statement to be more profound than was probably intended by its conservative proponents. My doubts were confirmed when the focus soon narrowed to the Holy Grail of residential home ownership, which was experiencing a boom due to policies favored by both parties that powered a historic bubble based on cheap credit and lowered lending standards. In the final capitulation to politics, the ownership agenda was reduced to, and attacked as, a naked partisan strategy to privatize entitlements, primarily to carve away support for liberal Democratic proponents of the social welfare state.

However, I don’t see ownership as a partisan issue, or even an ideological one, despite the fact that our political class certainly does. Instead, I see it as a theoretical and empirical issue that goes far beyond policy or politics to encompass economics, psychology, moral philosophy, and evolution.

For reasons that will become apparent, I will define this discussion to the ownership of financial capital. The ownership and control of capital assets is essential in the age of capital for two main reasons: first, it enables people to diversify against the risks of change; and two, the establishment of ownership rights is how the market and our legal system determine the distribution of returns to those aforementioned risks. Thus, ownership rights serve to determine the distribution of both a priori risks of, and a posteriori returns to, uncertain change.

Managing Risk

The best way to illustrate these two assertions is with the analogy of a roulette game. Imagine that several players with equal stakes gather around the roulette table. They wager their ownership stakes according to different risk preferences, some playing single numbers (highly risky) down to those who play black or red, odd or even (less risky). After each turn of the wheel the winners receive pay-offs or absorb losses in proportion to the odds ratios, or risks, of their strategies. In other words, if one played a single number or a row of numbers that hit while another played a red or black, the first would receive a much larger pay-off because she would have taken a much higher risk of loss. What we see if we examine the odds ratios of all the different plays on the roulette table is that the risk-adjusted rates of return of all strategies are essentially equal (and favor the casino ever so slightly). If the return/risk ratios are all the same, the only way to increase one’s return is to increase one’s risks and manage them successfully. This risk-return trade-off is the foundation of finance theory.

Behavioral studies show that we are uniformly loss averse. Since we cannot know the future, uncertainty and the risk of loss is inherent to our existence (although every tomorrow also offers hope for new opportunities). The best way to insure against losses due to unpredictable risks is through diversified pooling. We do this when we buy auto or homeowners insurance. These insurance pools are in fact diversified portfolios of capital assets. Likewise, ‘saving for a rainy day’ is a form of self-insurance. Due to the asymmetric information of insurance, certain problems arise that we call moral hazard and adverse selection. Moral hazard is when the beneficiary of the insurance changes risk-taking behavior because they are insured. This is like someone who drives recklessly because they have insurance to cover the cost of an accident. However, if the insurance issuer knew the person was going to change their risk behavior it would demand higher premiums. Adverse selection is when good risks opt out of an insurance pool with bad risks, causing the risk pool to become more risky and require ever higher premiums until the pool breaks down. Because we know our own risk-taking behavior better than anyone else, both of these insurance problems result from asymmetric information.

We can see that self-insurance doesn’t not suffer from asymmetric information because we are essentially insuring ourselves, so the incentive to drive recklessly is irrational. For this reason, self-insurance incurs no agency costs and is by far more efficient than insurance pooling. But to self-insure, i.e. save for a rainy day, we must accumulate assets to diversify in a portfolio. Thus, asset ownership is essential.

A second analogy—the scientific principle of natural selection and species adaptation—reinforces the importance of risk diversification. Nature constantly adapts to unpredictable change and the imperatives for survival by promoting diversification. Biodiversity is nature’s way of achieving a sustainable ecological balance and we can imagine human societies are certainly subject to the same survival imperatives.

Sharing the Rewards

If we not only want to protect ourselves from unpredictable risks of loss but also want to share in the returns to capitalist success, we must accumulate capital assets through ownership, put them at risk, and manage those risks successfully. Establishing the policies and complementary institutions, both private and public, to facilitate this process is actually the primary policy challenge of a free democratic society. In this sense, George Bush and his critics were both right: One must take an ownership stake in America to reap her benefits, and in so doing, one assumes the risk of loss and the obligation to manage that risk successfully.

Critics of this view might ask why capitalist profits are not more justly distributed through the payment of input costs, such as labor. The problem is exactly that: labor is an input cost that must be minimized under the profit incentive in order for the enterprise to succeed in a competitive environment. With access to a world supply of labor, the dynamics of capitalism exert constant downward pressure on wages. Laborists have long sought to use countervailing political power to constrain capital, but this strategy conflicts with the globalization of free trade among sovereign nations. In an open global economy with mobile capital and immobile labor, capital has strategic dominance over labor in simple game theoretic terms. Capital can move instantaneously, withdraw, or lie dormant indefinitely.

Labor’s argument is also undermined by the fact that if workers take no explicit residual risk in the enterprise, they have no defensible ownership claim to a share in the residual profits of success. Fixed labor contracts, in effect, assign risk and thus profits to owners in return for lower, and, hopefully, more secure and stable compensation. But under fixed labor contracts, firm losses are largely, and unjustly, borne by the unemployed, who are not fairly compensated for these hidden risks in good times.

For these reasons, I believe it is a misguided political strategy to pit labor against capital in an adversarial relationship. The solution is for labor to participate in capitalist enterprise as owners as well as workers. Risk then is more broadly shared across all stakeholders rather than borne by the weakest members of the labor force.

Equally important is the policy demand to share the returns of capitalism more broadly. There has been growing public criticism of market capitalism due to cronyism and widening economic inequality. A quick analysis of the distribution of wealth and income will confirm that much of this inequality can be attributed to the benefits accruing to those who own and control financial capital. Corporate elites get rich off stock options as part of their compensation packages. Employees of successful tech start-ups become fabulously wealthy due to their equity participation, not salaries. More important, financial markets concentrate the rewards to success, especially through the use of debt leverage. Federal Reserve financial repression that keeps interest rates near zero has rewarded borrowers and asset holders while penalizing savers and workers. Enhancing labor skills through education can only mitigate these trends to a point. In capitalism today, it is essential to own and control financial capital.

Financing Adaptation and Innovation

The analogy to nature’s biodiversity suggested above is more consequential than may appear. Diversification helps species survive, but it does this by enhancing the ability to adapt successfully. Natural adaptation is synonymous with human discovery and innovation. There is a branch of social psychology that focuses on the science of human creativity and innovation and draws from the lessons of natural adaptation. In a seminal article in 1960, the psychologist Donald Campbell argued that creative thought depends on a two-fold procedure he called blind variation and selective retention (BVSR). Blind variation refers to undirected change, much like unpredictable mutation in genetics. Selective retention refers to the replication of successful change. His argument suggests that creative innovation frequently relies on novelty and surprise, as well as utility.

What does this mean in the context of technological innovation and discovery? It means that many creative discoveries in the sciences and the humanities result from unintended consequences and not deliberate, intentional efforts. In other words, discoveries often come out of the blue; creativity is magical in that it cannot be so much cajoled by deliberate effort as just being allowed to happen under the right conditions. A creative artist knows this well from experience. This research has implications for how we can stimulate economic innovation by sowing the seeds of risk-taking capital far and wide in order to reap the benefits of creativity and discovery. It also suggests the limits of directed risk-taking through the public sector or through the bottlenecks of private venture capital. The next new big thing (or just very successful small thing) is more likely to come out of a garage or kitchen and not be financed by either the state or the financial sector. More likely it will be financed by personal relationships referred to as angel financing. Broadening the accumulation and ownership of financial capital helps to broaden the reach of angel investment to fund unorthodox risk-taking.

Agency

There is an ubiquitous weakness inherent to economic systems of specialization and exchange, alluded to above in the insurance case, that is referred to as the “agency problem.” When a principal hires an agent, such as a sales agent or a manager, there is always a potential conflict of interest between the principal and the agent, which can end up being quite costly to the principal. This agency problem was recognized by Adam Smith and more recently by those who study industrial organization and the public corporation. Managers often have material interests that diverge from the principal owners, i.e., shareholders and other stakeholders of the corporation.

This agency problem can never be perfectly eliminated (except through small sole proprietorships), but economic efficiency demands that the costs be minimized by aligning the interests of all stakeholders. This has been at the root of the use of stock options and profit participation in compensation. It’s called having “skin in the game, ” but too frequently the game is played with somebody else’s skin. The abuse of stock options merely points out the pitfalls of misunderstanding the nature of ownership and control. Equity financed with other peoples’ money is not a good way to eliminate conflicts of interest and minimize risk behavior. A recent article in The Economist points to the relative success of family-owned private firms that minimize agency costs. But for the large corporation to grow through needed access to outside capital, minimizing agency costs requires transparency and close monitoring of owners’ interests. This will require the checks and balances of competing agents, such as an independent board that represents various stakeholders’ interests to management. I would suggest that this offers a positive role for organized labor—to represent their worker/shareholders so that their interests align with public shareholders in ownership and control.

Property Rights, Morality, and the Law

Because English common law was established to protect property, ownership is the linchpin of our contracts legal system: we assign losses or gains in transactions according to the legal ownership of tangible assets. We even have a maxim that says, “ownership is nine-tenths of the law.” The relevant principle is equity, in every meaningful legal, moral, and accounting sense of the word. The moral implication of the finance law of risk and reward should be apparent: those who bear the equity risk of the enterprise assume the losses of failure or reap the gains of success. The importance of equity claims can also be illustrated through accounting principles: on the income statement, input costs such as labor reduce profits that accrue to equity; on the balance sheet, labor contracts are a liability that reduce residual equity of the firm. A labor union that seeks excessive wage rents by controlling the supply of labor is actually using politics to exploit rents from the owners of capital. But if workers participate in equity, they merely shift claims from the cost to the profit side of the income statement and from the liability to the asset side of the balance sheet, all the while aligning their interests with the overall success of the enterprise. As implied, with their own “skin in the game,” they also share more of the risk.

Lastly, the legal statutes for business equity are consistent with the criminal code that states that the innocent shall not pay for the crimes of the guilty. In this light we can see that political cronyism that privatizes gains but shifts losses to taxpayers is not only an abrogation of ownership rights, it is a violation of the moral spirit of the law.

In summation, I have argued that capitalist ownership matters for the following reasons:
1. Accumulation of capital assets for self-insurance, minimizing risk through asset diversification, and reducing the need for after-tax entitlement transfers;
2. Sharing the benefits of capitalist success by broadening participation in the market economy. These benefits feed back into future consumption and investment demand while reducing the inequality generated by finance;
3. Broadening the sources of finance capital, helping to fund adaptation and innovation;
4. Reducing agency costs by aligning interests of stakeholders in capitalist risk-taking enterprise;
5. Reaffirming the moral and legal basis of equity and the law of risk and return through transparency and accountability.

These five reasons illustrate why ownership and control is an essential component of a free society. The ultimate challenge to an organic entity, whether a species or a civilization, is to adapt successfully to constant change. In economic terms, we need to harness the forces of change and adaptation for the long-run sustainability of the economy and security of society. There certainly are other social systems that attempt the same by eschewing private ownership and imposing top-down control, such as authoritarianism, national socialism or fascism, and communism. But none of these systems are able to assert the primacy of individual freedom and security that we hold inextricably entwined. To empower ownership is to advance freedom, to facilitate risk management under uncertainty, to spur adaptation and innovation, to affirm equity and justice, and ultimately, to foster peace and prosperity.

On the other hand, without ownership, we get feudalism:

feudalism-1percent

People’s Capitalism

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Finally. The WSJ finds somebody who thinks outside the box of economic obsolescence. The constraints on capitalism have been evident for almost 200 years, but the socialists just get it completely backwards: we don’t need state capitalism, we need democratic capitalism. Marx thought nobody should be a capitalist, but the more obvious solution is that if capitalism works, then it must work for everybody. Everybody should be a worker AND a capitalist. How else to survive in a capitalist world?

What’s more, capital accumulation works on the upside and the downside: It empowers people to produce and create wealth while capital assets as savings also protect us from the vicissitudes of a risky, uncertain world, obviating the need for expanding inefficient state entitlement programs.

Capital ownership is not a new idea, but it gets buried under the morass of the neoclassical debate over government vs. business. And in the 21st century the constraints on tax and redistribution and its negative effects on wealth creation should be obvious to all.

From the WSJ:

Capital for the Masses

Thomas Pikettey’s new book from the left provides unwitting support for private retirement accounts.

‘Capital in the 21st Century,” by French economist Thomas Piketty —its title inviting comparison with Karl Marx’s “Das Kapital”—has electrified the intellectual left in the U.S. since its English publication in March. The book is bold, brilliant and perfectly aligned to the current obsession with economic inequality.

Mr. Piketty argues that, in modern market economies, private returns on capital investment are systematically higher than the rate of growth of income and output, and that the difference explains the increase in inequality. A fortunate few derive their income from capital: Some are celebrity capitalists like Warren Buffett or Bill Gates but most are mere business executives who extract enormous salaries from corporate earnings. Capital returns enable them to accumulate wealth at far higher rates than the mass of men whose wages grow no faster than the economy or their own productivity.

Mr. Piketty believes that capital divergence is natural and inexorable and that the only effective corrective is highly progressive taxes on investment income and wealth, preferably on a global basis to forestall capital flight to low-tax jurisdictions.

“Capital” is a serious work that merits careful consideration and vigorous debate. Indeed the book’s rhapsodic reception is already instructive in an unintended way. For the left that is now extolling “Capital” long ago lost interest in capital ownership, and in recent years ferociously opposed policies for democratizing capital advanced by the right.

That story begins with the 1976 essay of Peter Drucker in the Public Interest (later expanded to a book) on “pension fund socialism.” Drucker observed that the growth of invested pension funds—corporate, union, public employee, professional and individual—had made wage earners the owners of one-third, soon to be one-half, of the equity capital of American industry.

“The U.S., without consciously trying, has ‘socialized’ the economy without ‘nationalizing’ it,” Drucker wrote. Capital investment was better for workers than owning just their own firms because it offered higher returns through trading and diversification—advantages that, Drucker suggested, could be improved with earlier vesting and portability. The corporate income tax, he added, had become exceedingly regressive, because its rate was much higher than that on low-income pensioners—eliminating it, at least for pension holdings, would be a great stroke for income equality.

The left was contemptuous. Writing in the New York Review of Books, Jason Epstein pronounced Drucker’s book “the sort of torpid whimsy that high-price business consultants concoct to amuse their clients.” Hadn’t Drucker noticed that the stock market was flat while the consumer-price index was soaring (this was 1970s stagflation)? Corporations, Mr. Epstein opined, were ripping off poor pensioners just as effectively as the then-notorious New York City politicians who had diverted city pension funds.

In the ensuing decades, academic and think-tank economists, most of them right of center, put forth a succession of proposals for transforming Social Security from a wage-transfer program (from workers to retirees) to one of real capital investment and heritable personal ownership. The aims were to anticipate the retirement of baby boomers, improve on Social Security’s already poor returns on payroll taxes, increase national savings, and promote widespread ownership of productive capital.

President George W. Bush campaigned for personally owned and invested Social Security accounts in 2005. He was crushed by an avalanche of objections from progressive intellectuals, AARP lobbyists and Democratic politicians. The objections ran the gamut from high brokerage fees to consumer confusion to corporate self-dealing. But the central, ultimately decisive argument was that exposing average folks to the vicissitudes of stocks and bonds would be tantamount to shredding the social contract.

“Capital” is a comprehensive refutation of that argument. If returns on capital are as superior to the growth of GDP and wages as Mr. Piketty has found, then short- and medium-term fluctuations are a detail. They can be managed through classic diversification, as practiced by many progressive professors in their own TIAA-CREF accounts. Social Security can be divided into a minimum tax-financed guarantee augmented with personally owned, professionally managed investments like TIAA-CREF’s. Nations such as Chile with capitalized pension systems have employed these and other approaches with little fuss and much success.

Nor do Mr. Piketty’s other concerns help the opponents of capitalized pensions. He believes that corporate insiders often reap large windfalls while outside investors stand helplessly (or ignorantly) by. Yet outsiders have earned much more from corporate investments than from their own wages or Social Security benefits, and pension funds have fueled many efforts to de-feather executive nests. He shows that the earned fortunes of great entrepreneurs become dramatically large over time—but that is due to the value of time and the arithmetic of compounding, which are equally available to the most diminutive capitalist.

Yet Mr. Piketty has no interest in expanding capital ownership: It doesn’t even make his list of inferior alternatives, and he dismisses capitalized pensions with a few uncharacteristic rhetorical slights. Like others on the left, he seems to have concluded that the only way to promote economic equality is confiscatory taxation—redistribution of capital returns rather than wider distribution of capital ownership. After Marx’s idea of comprehensive state ownership of the means of production proved to be hellacious and tyrannical, progressive attentions turned in a different direction. They would leave ownership—with all of its risks and tribulations—alone, and control its rewards through taxation and regulation.

But redistribution of capital returns is easier to describe in a book than to accomplish in practice, even if one sets aside, as Mr. Piketty largely does, the incentive and growth effects of high tax rates. Taxation and regulation are shaped by powerful, conflicting pressures that may democratize capital returns—or, just as easily, may protect and amplify them more than corporate managers could possibly do on their own. The statist intellectual imagines redistributing capital profits while leaving owners with the losses, but the opposite—profits for owners and managers, losses for taxpayers—has been frequently observed in the wild.

That is not Mr. Piketty’s teaching but it shouts from his pages. “Capital” begins with luminous excursions into intellectual history and economic theory, building to a monumental empirical demonstration employing original data laboriously assembled over many years. It then culminates in a proposal for global surveillance and taxation of individual wealth that would astonish a World Federalist. The only hope for social justice in the modern world is utopia: “political integration . . . not within the reach of the nation-states in which earlier social compromises were hammered out.”

Mr. Piketty is a prodigious scholar and likable writer. Here’s hoping that his labors will promote an end that was no part of his intention: to stimulate the progressive left to rethink its hostility to broadening the ownership of capital.

The GOP FLOP

As the emotionalism of the election results fades, our curiosity demands an objective analysis of the state of our national politics. In most general terms, 2012 appears to have been a status quo election, with both candidates achieving fewer votes than in 2008, and the Senate and House being returned to the same party control. The only real defeat was at the top of the Republican ticket for Romney/Ryan. The other uncontestable conclusion is that there were also far fewer enthused voters going to the polls for either candidate.

Besides the rationalization of déjà vu all over again, this must be considered a defeat for the Republican party in light of the weak performance of Obama’s first term. So, what went wrong? Early voting analysis confirms that the loss can be mostly attributed to traditional, white, Republican voters who stayed home. There were 7 million fewer voters in this cohort of voters compared to 2008. One would have thought that the voters disappointed with Obama would have been motivated to turn out for Romney. One can point to the dismal economic performance, the high unemployment that must be laid on Obama’s economic policies, and the antipathy for Obamacare as the motivating factors. Apparently not.

There was obviously a lukewarm feeling about Mitt Romney and one wonders where it was lodged. Both bases turned out fairly strongly for their parties, the difference was with the middle, the independents and party moderates. These voters were primarily focused on the economy as the primary factor in the election and it appears that Romney’s ineffective economic message, and Obama’s interpretation of that message, can largely explain the marginal difference in the outcome.

The Obama campaign’s negative attacks started early and were expected. But for many months they were largely ignored as Romney was forced to consolidate his general election campaign. This also was expected. The problem is that little was done about it and thus the residual negative impression of the candidate lasted through the summer and the conventions, deep into the election season. Only the first debate seemed to dispel this caricature of the “Bain capitalist vulture,” but it was not enough. I believe we can attribute this to the fact the most effective propaganda holds an element of truth and this applies to both sides. Obama was very vulnerable on the economy, healthcare, and entitlement reform, so he steered clear of these issues. Romney and Ryan both attacked his positions and record. However, the American public has endured almost 25 years of growing crony capitalism enabled by both political classes as well as the monetary institutions of the Federal Reserve and the Treasury. As a turnaround, private equity specialist, Romney was incredibly successful in exploiting the economic policies of the past three decades. Many ideological Democrats met or exceeded this level of success as well, but the constant harping on the Bush years and the traditional Republican support of business elites allowed the Obama campaign to pin all transgressions on the Republican poster boy for success. Want somebody to blame? Blame Greenspan and Bernanke.

Now comes the crucial point: I see little evidence that the Republican establishment understands or credits these failures within its own policy agenda or campaign message. When voters hear Republican candidates extol economic growth, they foresee more winner-take-all success leaving them relatively worse off. They see bankers and financiers with fat bonuses and golden parachutes, leaving the true stakeholders in American capitalism—workers, entrepreneurs, and small shareholders—with the crumbs and the pink slips. This has all been enabled by cheap debt that leverages ownership and control into few hands—the very hands in fact of private equity and leveraged buyout principals. The irony is that the Obama administration has been the architect of these policies as much as any other administration. Goldman Sachs alumni populate the administration’s financial appointments and reap the tax benefits for their investment banking winnings. Apparently what’s good for Goldman Sachs is now good for America.

Wait, stop. This is not an anti-capitalist screed. On the contrary, the argument is pro-capitalist and pro-free market. A clear understanding of the 1980’s buyout era recognizes it was a necessary response to the corporate cronyism of the 1970s. The growth of private equity is also a response to world-wide competitive pressures to avoid the growing costs of regulation. But it also reflects poor policy design from Washington that is primarily motivated by politics. Cronyism doesn’t start and end in the board room, in extends all through the elected political class, the legislature, and the regulatory bureaucracies.

The Obama agenda does not address this cronyism, and therein lies the Democrats’ true weakness. Their only policy prescription is to “sock it to the fatcats,” and “redistribute the wealth,” even though most of the fatcats are paying for the re-elections of the politicians and redistribution is mostly redistributing the pain to taxpayers. It’s a charade. But the GOP’s failure can be traced to its ignorance of what drives democratic politics in this age of winner-take-all economics. A large section of American voters are being left out of the winner’s circle, they no longer buy into “trickle-down” economics, if they ever did, and they have witnessed an unfair and unequal playing field. The GOP must champion free capitalism in a free society, not just successful capitalists. And every member of a free capitalist society should participate at some level as risk-takers and residual claimants. There are many policies that can be applied to reinforce the basic principle of capital accumulation and the rights of ownership. It’s not a giveaway, ownership participation is always earned.

We might ask, what’s fair? Fair is receiving the rewards of successful risk-taking and suffering the consequences of failure. Nobody asks for more than a fair shake. One of the cardinal sins of the rich, powerful, and connected is to rig the system where every gamble is “heads we win, tails you lose.” This is the definition of immorality in a capitalist society, and the political party that puts a stop to it will have no problem gaining the votes of a grateful citizenry.