Danny ChaiSome more areas in which I think markets today fail.
Actually, a lot of this is related to Michael Lewis’ Vanity Fair feature on the failure of Iceland. It’s fascinating. He links the fishing industry to it’s massively overleveraged banking industry that destroyed the country.
Fishermen, in other words, are a lot like American investment bankers. Their overconfidence leads them to impoverish not just themselves but also their fishing grounds. Simply limiting the number of fish caught won’t solve the problem; it will just heighten the competition for the fish and drive down profits. The goal isn’t to get fishermen to overspend on more nets or bigger boats. The goal is to catch the maximum number of fish with minimum effort. To attain it, you need government intervention.
You’ll have to read the article to understand what they did.
Anyway, fishing is one area where free markets fail and require intervention. I dunno if you’ve ever visited Monterey, but there’s this nice restaurant called the Sardine Factory. It’s a reference to decades ago when fishermen brought sardines in to Monterey by the tons (250,000 tons annually at its peak), the basis of Cannery Row. Now its name is slightly ironic, because there is no sardine industry in Monterey – they got fished out.
Free markets simply don’t work in this situation. Completely losing a resource – killing the golden goose – is bad for everyone. But the market can’t self-regulate in this situation. Demand isn’t lowered enough by higher prices (reflecting lower supply) until it’s too late. It’s a market failure.
That’s why I like the Bay Area’s crabbing policy. There’s a big section of the Bay where crabbing is completely unallowed (and thus serves as a crab nursery for the rest of the Bay). Additionally, crabbing season is limited to a few months. Together, these artificial market rules ensure that there will be a steady crab supply forever.
(Actually, after reading Lewis’ article, I think an Iceland-type approach might work better: issue permits to catch a certain number of crabs a season. Initially, they can be issued based on how many crabs fishermen caught the year prior. Crabbers keep those permits in perpetuity, and are free to buy/sell/trade them with each other. Each year, reduce the number allowed for each permit slightly, and auction off new permits that match the net reductions. This accomplishes the same thing the current policies do, but also solves the problem we have now in the Bay Area – when crabbing season opens, there’s a glut of crab as all the boats try to catch the available crab before everyone else does. So for about 2 weeks, there’s a massive supply of crab, so local crab is fresh and super cheap. Then the available crab is basically fished out, so the rest of the year, crab is less fresh, less local, and less cheap. It sucks.)
Executive pay is another example of market failure. I don’t believe in artificial executive pay caps. They just won’t work. But I don’t believe their crazy pay is merited by the market either.
Everyone knows that over the last few decades, executive pay has increased exponentially, orders of magnitude more than the average worker. The thing is, corporate profitability has not increased at the same rate as executive pay, so it’s not that executives are making more because the companies they head are making more. Furthermore, if you map the executives of Fortune 500 companies and compare their company earnings to their compensation, there’s no correlation. In short, there’s no evidence that the increase in executive pay is a result of better executives, as (properly) measured by corporate profits.
So the increase in executive pay may have be driven by two things – a reduction in the available supply of good executives, or a market failure. I can’t rule out the first for sure, but I sincerely doubt it. In my opinion, it’s almost certainly the second.
My thoughts on this are almost entirely guided by John Bogle, my financial discipler. He recently wrote a book, The Battle For The Soul Of Capitalism that talks about this. And this speech outlines the main ideas. His primary point is that capitalism is broken today because it’s moved from owners capitalism, where companies are controlled by and served to benefit shareholders, to managers capitalism. It’s resulted because of the rise of mutual funds and pensions, which are now the primary corporate shareholders (in the old days, 92 percent of all stocks were owned by individuals – today, individuals only own 24 percent of stocks; 76 percent is held by institutions). The problem is that these intermediaries have abdicated their ownership responsibility, leading to a separation between ownership and control. Therefore, ridiculous CEO pay is not a natural market consequence, but a result of broken, managers capitalism. As Bogle writes:
The system [capitalism] worked. Or at least it did work. And then, late in the twentieth century, something went wrong, a “pathological mutation in capitalism,” in the words of journalist William Pfaff. The classic system—owners’ capitalism—had been based on a dedication to serving the interests of the corporation’s owners in maximizing the return on their capital investment. But a new system developed—managers’ capitalism—in which, Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” And so it is.
I cannot recommend reading that speech enough. You’ll learn something, it’s absolutely spot-on, and I totally agree with him.
Anyway, that’s the sea change that’s enabled absurd executive pay. When individuals are the primary owners, they’re hands on and active in insuring that costs (including compensation) are kept down, because it directly affects their profit. Modern intermediaries like mutual funds and pension plans have abdicated their ownership duties, largely leaving monkeys in control of the zoo. It’s no wonder that executive pay is absurd. The boards who approve them are largely executives themselves, and the true owners aren’t there to rein anyone in.
The most lucrative position to have in today’s capitalism is the manager. The manager has control over the company (that ultimately is supposed to belong to the owners) and reaps the greatest slice of the reward. That’s not good. It’s the worst sort of capitalism. One could even argue that it’s socialism. The owners (stockholders) assume all the risk. Managers assume no real personal risk but reap the greatest reward. It’s screwed up.
How to fix it? I’m not sure. Like I said, I don’t think artificial caps work. Honestly, I’m most intrigued by Eliot Spitzer’s proposals. (As I’ve said before, I think he’s kind of a jerk, but find myself agreeing with almost everything he writes about the economy.) His take is to enact some common sense rules: compensation consultants should be chosen by shareholder committees, these consultants must have no dealings with the CEO, and executive compensation must be subject to a binding shareholder yes-no vote. These rules aren’t interfering with markets, they’re helping them, as the “market” for CEO pay is broken. As Spitzer writes, “We must create a genuine market for CEO services, generating meaningful competition and socially acceptable results.” We must demand pay for performance, instead of the broken system we have now.
Anyway, yeah, there are many examples in which markets fail, and we should acknowledge that instead of clinging to the empirically discredited idea that markets can regulate themselves. And we should also realize that good regulations don’t harm markets – they protect, even define and create them. There are certainly tons of bad regulations out there. But the goal should be good regulations, not no regulations.