Married to the Market: How We Got There in Five Easy Steps

The stock market has a much bigger presence in the life of the average American now than it did a couple of decades ago.  As a result, the pain inflicted by the current economic crisis has been more widely felt than ever before. 

How did we come to be married to the market?  Others could no doubt add to this list, but here, in roughly chronological order, are five changes that have helped to tie the knot.[1]

No more planning for the unforeseen

In the nineteenth and early twentieth centuries, many public companies regarded it as prudent to set aside a portion of their earnings as reserves against a rainy day.  The idea was that the reserves would enable them to continue paying dividends – and thereby safeguard the market value of their shares – in years when their current earnings were inadequate. 

In 1975, this practice was ruled unacceptable by the Financial Accounting Standards Board.  Its FAS Statement No. 5 required reserves to be accrued for losses that were “probable” and could be estimated; it explicitly prohibited “reserves for general contingencies” (§14).    The board was fully aware of the arguments in favor of a general reserve fund.  In its words, “The Board recognizes that some investors may have a preference for investments in enterprises having a stable pattern of earnings, because that indicates lesser certainty or risk than fluctuating earnings.  That preference, in turn, is perceived by many as having a favorable effect on the market prices of those enterprises’ securities” (§65).  But the alternative to setting aside reserves – purchasing insurance or reinsurance – was preferable, the Board concluded, and it overruled prudence:  “Earnings fluctuations are inherent in risk retention, and they should be reported as they occur” (§65). 

FAS Statement No. 5 thus tied public firms more closely to the ups and downs of the market (and surely stimulated the insurance/derivatives market as well), with pro-cyclical consequences, as others have noted.[2]  When the market speaks (that’s an allusion to my childhood memories of “The Shadow”), it now speaks louder for public firms.

The shrinkage of regulation

A confluence of factors that has shrunk the scope and coverage of regulation has also – inevitably – given market forces a stronger presence in American life than at any time since the 1930s.  One is the drive to deregulate American industries that began with the de jure deregulation of airlines in the 1970s, followed by the banking and trucking industries, and continued through repeal of (what was left of) the Glass-Stegall Act in 1999 and beyond.  De facto deregulation has also occurred through the de-funding and understaffing of regulatory agencies.

Alongside domestic deregulation, the globalization of financial markets since the 1980s, as many commentators have noted, has also produced an international “race to the bottom,” that is, towards ever laxer regulation.  The international competition that drives this race looks very much like the competition among the American states that first gave rise to a “competition in laxity” in the late nineteenth century.[3]  In arguing (successfully) against the regulation of derivatives in 2000, Federal Reserve Chairman Alan Greenspan summed up the competitive pressures wrought by globalization in these inimitable words:  “I see a real risk that, if we fail to rationalize our centralized trading mechanisms for financial instruments, these markets and the related profits and employment opportunities will be lost to foreign jurisdictions that maintain the confidence of foreign investors without imposing so many regulatory restraints.”[4] 

With large holes torn in the American regulatory net, trading not only of exotic securities but also of commodities such as oil has shifted increasingly to “dark markets,” whose byways are unlighted by regulation.  In this sense, we live with the market in ways that we did not before the 1980s.

Incorporation of investment banks

Until the 1980s, the large private investment banks, whose business itself is highly dependent on the state of securities markets, were organized as partnerships.  This gave them a measure of insulation from short-term market pressures.  Beginning in the 1980s, however, one after the other, they converted themselves into public companies.  The last to go over to the short-term-pressured fast lane was Goldman Sachs, which went public in 1999 with Henry Paulson as its chairman and CEO.  As a result, large investment banks – like the new investment houses of the 1920s – are now doubly vulnerable to the power of the stock market.  For the banks’ clients, this means that not only their stock investments but now the brokerage firms that handle them are subject to short-term market pressures.

“Forced capitalists”

And more Americans are now in the market, whether they like it or not.  Leo E. Strine, Jr., Vice Chancellor of the Delaware Court of Chancery, coined the nifty term “forced capitalists” to capture the consequences of the widespread shift from defined-benefit to defined-contribution pension plans in recent years.

Traditional defined-benefit pension plans, which have all but disappeared, once guaranteed employees fixed retirement benefits tied to their wages and length of service.  These have now been largely supplanted by defined-contribution pension plans, which carry no guarantee of retirement benefits.  Instead, and at best, employers make contributions to employees’ 401(k) plans, which the employees invest in the market.  “As a result of these changing dynamics,” observes Vice Chancellor Strine, “most ordinary Americans have little choice but to invest in the market.  They are in essence ‘forced capitalists,’ even though they continue to depend for their economic security on their ability to sell their labor and to have access to quality jobs” (p. 7).  Millions of Americans, in other words, find themselves in forced marriages with the market.

“Mark to market” rules

Last but not least, a recent FASB accounting rule change has, like the prohibition on  general-contingency reserves, tied firms more tightly than ever to the fluctuation of markets – with disastrous results, it turns out, when those markets freeze up.  The culprit here is FAS 157 – the Financial Accounting Standard Board’s Statement No. 157, Fair Value Measurements – issued in 2006.  This requires that assets and liabilities be carried on a company’s balance sheet at their present market price, rather than at a reasonable estimate of their long-term value.  Like the prohibition on general-contingency reserves, this rule was intended to increase “market transparency,” and market transparency translates into greater exposure to short-term market forces.  I won’t belabor this point, since it’s gotten a lot of attention in the last year.  Try a Google search of “mark to market” and wade through some of its 1,160,000 hits.

This is by no means an exhaustive review of the changes that have brought Americans into more intimate relations with markets.  One could add others such as the decline of unions (part of the deregulation, in effect, of labor markets) and the rise of computerized trading (even computerized trading based on computerized reading of the news).  But they would merely reinforce my main point:  Americans today find themselves on more intimate terms with the market than ever before.

[typos corrected 5/26/09, 7:05 p.m.]

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[1] Thanks are due to my students in History 247, who got a preview of this blog in my last lecture this semester.

[2] Cheyenne Hopkins, “Dugan:  Turmoil Shows Need for Reserve Leeway,” American Banker, March 3, 2009, on Lexis-Nexis Academic.

[3] Colleen A. Dunlavy, “Bursting Through State Limits:  Lessons from American Railroad History,” in The State, Regulation, and the Economy:  An Historical Perspective, eds. Lars Magnusson and Jan Ottosson (Cheltenham, UK and Northampton, MA:  Edward Elgar, 2002), 44-60.

[4] Joseph Rebello and Dawn Kopecki, “Greenspan Urges Congress to Exempt OTC Derivatives From U.S. Regulation," Wall Street Journal, February 11, 2000, C11.

Cuomo and AIG - a history lesson

Doesn't anyone know the (peculiar) history of insurance regulation in the U.S.?  

Based on the tv coverage of President Obama's news conference this evening, it seems safe to assume that the tv pundits aren't aware of it.  In his press conference, President Obama was asked why Attorney General Andrew Cuomo of New York was able to make more headway (regarding bonuses) with AIG than the federal government.  What Pres. Obama could easily have said (had he not focused on the questioner's second question) was that the insurance business is one of the few industries (the only industry?) in the U.S. that is still regulated principally by the state governments (click here for a brief synposis).  This is despite the fact that the insurance industry -- one of the first businesses (after the slave trade) to expand across state lines -- lobbied Congress for federal regulation after the Civil War.  It is precisely because insurance companies have taken on much broader financial activities in the last couple of decades that the Obama administration is (finally) proposing to broaden federal regulation of financial institutions so that it encompasses entities such as AIG. 

For details on the post-Civil War efforts on behalf of federal regulation, see Philip L. Merkel, "Going National:  The Life Insurance Industry's Campaign for Federal Regulation after the Civil War," Business History Review 65:3 (Autumn 1991): 528-553 (on JSTOR).

[edited to correct typ0]

Govt. intervention? A venerable American tradition

As debates about how the federal government should respond to the credit crisis have shifted over the last week towards equity stakes in financial firms and initiatives to boost economic growth and create jobs, one thing is clear:  Americans need a crash course on the history of their government’s role in the United States’ economic growth.  Why we (including reporters and most historians) know so little about that history is a question for another day.  The point here is that most Americans have little idea that we have a long and venerable tradition of government action to encourage and support economic growth.

I am not talking about the basic legal framework that has supported the rights of private property throughout our history.  We can take knowledge of that for granted, I think.  But few Americans realize just how deeply, continuously, and thoroughly the American government has actively supported and encouraged economic growth.  A richer sense of our own history—of the impressive support the American government has provided for economic growth throughout our history, and of the multifaceted ways in which it has done so—will help to put current debates in a broader perspective.  Knowing what we, as a nation, have done in the past makes it easier to think anew about what we might do today and tomorrow.

Equity Holdings

Take the question of equity holdings by the federal government, which was finally incorporated as an option into the bill that passed Congress last week and now is being actively considered (under competitive pressure from Europe).  The idea is that financial aid should be extended in a form that gives taxpayers an ownership stake in companies that receive financial aid.  One frequently-heard argument against the proposal was that “we don’t do that” in the United States.  Unlike, say, the French or the Germans, we supposedly do not have a long tradition of state ownership of shares in private companies. 

But, in fact, we do, and our tradition dates back to the founding.  In 1791, two years after the U.S. Constitution took effect, Congress chartered the first Bank of the United States with an authorized capital of $10,000,000—a behemoth institution at the time.  The bank was created, amidst raging controversy, to aid the new federal government in managing its finances (federal government securities had to be used in partial payment for stock in the bank).  As an equivalent percentage of U.S. GDP in 2007, the Bank of the United States’ share capital would amount to about $671 billion. The bank’s charter limited individual shareholdings to 1,000 shares, but authorized the federal government to buy up to 5,000 shares—which it did.  The nominal value of the federal government’s shares—$2,000,000—would be about $134 billion in today’s terms (as a comparable proportion of 2007 GDP).

The first Bank of the United States was allowed to die in 1811, when its twenty-year charter expired, but five years later, in the aftermath of the War of 1812, Congress created the second Bank of the United States for similar reasons.  Chartered with a twenty-year life, its authorized capital was $35 million or, as a comparable share of 2007 GDP, about $596 billion dollars.  Again, the federal government bought 20% of its shares, giving it a nominal stake in the bank of $7 million, or $119 billion in 2007 GDP dollars.

In our own history, in other words, equity holdings by the federal government were a valuable tool for shoring up the American financial system during its first half-century.

Collective Action Problems

Or consider what the federal government has done in the past to help businesses solve collective-action problems.  If the core problem in the credit crisis is uncertainties about the value of exotic, mortgage-backed assets, this is a classic collective-action problem:  Individual firms, under intense competitive pressure to attract capital, are unable to do what would be best for the industry as a whole—fully disclose their risks.  By tackling this problem, the federal government is building on its own long  history of helping businesses solve collective-action problems. 

In the 1920s, for example, the Department of Commerce launched an initiative to solve a collective-action problem that was limiting American industry’s ability to mass produce.  The problem manufacturers faced was that multiplying their product offerings was an effective way to attract consumers, especially during the post-WWI recession.  The result was an “over-diversity” of products that was incompatible with high-volume production.  “Mass production” only makes economic sense (as Henry Ford well knew) if the number of products can be limited, but manufacturers were unable to take this critical step towards mass production on their own.  

During World War One, the War Industries Board had made important strides in shifting critical industries from craft-based to mass-production methods, but back-sliding set in when the war ended.  As manufacturers competed intensely for consumer dollars, the variety of products began to swell again.  So Secretary of Commerce Herbert Hoover set up an administrative mechanism for industries to co-operate in reducing the number of products they offered consumers so that they could reap the economies of mass production.  Among notable successes achieved by introducing what was called “Simplified Practice” was a reduction in the types of paving bricks from 66 to 4; in types of sheet steel from 1,819 to 263; in types of milk bottle caps from 29 to 1; in types of hospital beds from 67 to 4; and in types of brass lavatory and sink traps, from 1,114 to 72.

Had the federal government acted earlier in the current crisis, it might have done something similar, setting up a mechanism to enable financial firms to act co-operatively—under careful government oversight and with full transparency, of course—so that they could tackle the challenging task of figuring out how to value mortgage-based assets themselves.  Instead, with urgent action apparently needed to unfreeze credit markets, the federal government will evidently be taking more direct action, buying up “toxic assets” and recapitalizing banks in hopes that this will get credit flowing again.  Once this crisis is over, however, the way that Herbert Hoover facilitated co-operative action among manufacturers in the 1920s might provide a model for the financial industry in the future.

In the meantime, as the government’s mammoth undertaking gets underway, another worthy tradition in American history, now all but forgotten, suggests that the financial industry should be furnishing  the needed technical expertise on a pro-bono basis, not as outside contractors working on the taxpayers' dollar to solve problems of their own making.  In the emergency mobilization of the American economy during both world wars, leading figures from the business world stepped forward and headed wartime agencies for a token salary.  Known as “dollar-a-year men,” they included executives, for example, from AT&T, General Motors, U.S. Steel, and Sears, Roebuck, enlisted for their expertise in communications, manufacturing, and distribution.  In the current emergency, financial executives would stand on long tradition if they stepped forward as the twenty-first century’s “dollar-a-year men.”

Investment in the “real” economy

In the coming months (perhaps years), we are likely to endure a sharp contraction of the financial industry, if not the economy as a whole.  To ease or prevent an economic contraction, a number of proposals to have the government invest in the “real” economy are in play.  Here, too, we have a venerable tradition in American history.  It, too, extends back to the early years of the Republic, when the American states funded the construction of thousands of miles of canals, providing some 70 percent of all investment.  The tradition continued when railroad construction began in earnest around 1830.  American states and cities contributed nearly 45 percent of the capital invested in railroads during the 1830s.  Of the $1 billion invested in railroads up to 1860, some 25-30 percent was government funded—in 2007 GDP terms, equivalent to about $800 billion.

This was just the beginning.  In the last half of the nineteenth century, the federal government provided millions of acres in land grants to railroads, along with various other subsidies.  In the early twentieth century, it subsidized electrification and the extension of telephone service into rural areas.  In 1956, Congress passed legislation to build 41,000 miles of interstate highways in what President Dwight Eisenhower proudly lauded as “the greatest public works program in the history of the world.”  As a share of 2007 GDP, the cost of the interstate system (some $32 billion at the time) would be equivalent to about $1 trillion. On a smaller scale, there are countless other examples of government investment in the “real” economy—from the War Department's decades-long initiatve in the antebellum years to develop interchangeable parts in gun manufacturing to the decades-long work of the Defense Advanced Research Projects Agency, which gave birth to the inventions underlying the Internet as well as nanotechnolgy.

To offset what seems to be an inevitable contraction of the financial industry, why not build on this venerable tradition?  These days we may not be able to afford a project the size of the interstate highway system, but even half of the $700 billion at play in the bailout plan would go a long way towards rebuilding our crumbling infrastructure, reorienting our energy use, making education and health care more affordable, creating jobs, and stimulating consumption (not to mention mortgage payments).

Realigning regulation

The United States will also have to face—once again—the task of realigning the spatial dimensions of business regulation.  The mantel of financial regulation seems likely to be expanded within the U.S. to cover financial instruments and entities not currently regulated, but the jurisdiction of U.S. law ends at our borders and the operations of the largest financial firms do not.  We faced a very similar situation in the nineteenth century, when railroads became the first businesses (after the slave trade) to cross state lines, challenging and undermining the American states’ traditional powers to regulate transportation.

In a complicated political process spanning the years from the 1850s to the 1880s, punctuated by disastrous rate wars, railroad regulation was realigned to accommodate this new reality.  With the passage of the Interstate Commerce Act in 1887, regulation of interstate railroad rates shifted from the state to the national level.  In subsequent decades, as other American businesses became increasingly national in scope, so did other aspects of business regulation—always amidst great controversy and never completely so.  (Antitrust policy was effectively nationalized after 1890, as was securities regulation during the New Deal, for example, but incorporation policy has remained largely in the hands of the states.)

The financial industry has undergone a similar spatial realignment in the last two decades.  Where giant railroad systems spanned the American continent by the late nineteenth century, financial companies now span the globe.  As a result, nations today, much like the American states in the nineteenth century, are facing a competitive “race to the bottom” in business regulation.  International regulatory competition was one of the factors Alan Greenspan cited in arguing (successfully) against federal regulation of over-the-counter derivatives in 2000: if the U.S. regulated derivatives more stringently than other nations, the derivatives market — and its associated revenues and jobs — would migrate to more favorable jurisdictions.

In the coming years, the force of competition among nations to attract capital is likely to intensify.  We can stay the course, dealing as best we can with the periodic crises engendered by the laxity of national regulation that intense international competition promotes, or we can begin the hard work of doing what Americans did in an earlier era—realigning business regulation in light of the new spatial realities of business.  In the present environment, fortunately, we would find eager allies abroad if we chose realignment.

As we debate what to do next, let us at least agree on this:  the American government has a long and rich history of initiatives, large and small, to support economic growth.  “Laissez-faire” is a myth.  Our history of government action, in times of crisis as well as in normal times, extends back to the founding.  The question today is not whether the government should do something, but what it should do this time.  In view of our history, very little is off the table.

The ineffable resilience of capitalism?

My lecture course is off and running again this week, and as I said to my students on Tuesday, I can't imagine a more exciting time to study the history of American capitalism. For a historian (not to mention those with more intimate connections), the fascinations are endless.

This morning's financial pages have me mulling over two dimensions of the current economic mess:

• Risk

This is a core attribute of capitalist activity, as everyone knows. Read the letters of Manhattan merchant Gerard R. Beekman from the 1760s (as my students are doing) and you will get a very concrete sense of the array of risks that traders faced in his time. Over the long haul, business people have continually sought, as he did, to minimize risk, the methods changing as the nature of risks changed. If they ever achieved complete success, of course, not much would be left of capitalism.

What is fascinating about the current crisis in the money/housing markets is that financial people by the 1990s thought they had mastered risk -- for example, by slicing and dicing it into collaterized debt obligations and the like -- only to discover that they had done their work too well. They spread risks so broadly that no one knows for sure where they are anymore and now everyone is potentially at risk. So what's that about? The ineffable resilience of capitalism?

• Competition

Another of those core attributes of a capitalist economy. And, like risk, competition is something that business people have spent extraordinary energy trying to reduce -- in the informal ways famously noted by Adam Smith, by means of cartels in the 1870s and 1880s, via mergers during the Great Merger Movement at the turn of the twentieth century, and so on into the early twenty-first century. The resulting oligopolies are so common in so many lines of business that they have become naturalized and thus go largely unnoticed today.

Occasionally, however, events force us to notice them and to confront the reality that oligopoly-building to reduce competition has generated a variety of new risks. Consider the recent financial turmoils: suddenly everybody knows that there are only a handful of big auditing firms, or that only two bond insurance companies carry on most of the business (the big new concern in the financial pages). Success in reducing competition to a handful firms in these lines of business has made large segments of American business dependent on their health, in effect increasing risk for everyone else. The ineffable resilience of capitalism?

Giving shareholders an equal say

The big news in EU/corporate governance circles in recent days is EU internal market commissioner Charlie McCreevy's decision not to pressure EU companies to adopt one-vote-per-share voting rules. As has been the widespread practice in its pages and elsewhere, the Financial Times characterizes one-vote-per-shares rules as giving "shareholders an equal say." The same thinking underlies the concept of "shareholder democracy" as it is used today. But this is hardly what such rules do.

Here's the text of a letter on this point that I emailed to the Financial Times today. Hope to see it in print!

In your report ("Brussels drops shareholder plan," October 4) and your editorial ("Beating the Retreat," October 5) on EU commissioner Charlie McCreevy's decision to abandon his push for EU companies to adopt one-vote-per-share voting rules, you characterize such rules as giving "all shareholders an equal say." This reflects a fundamental--and unfortunately widespread--misunderstanding of the ways in which shareholder voting rules distribute power.

The only voting rule that gives shareholders an equal say is the Anglo-American common-law practice of giving shareholders only one vote each. One-vote-per-share rules, in contrast, give each share an equal say but concentrate power in the hands of large shareholders. If shareholdings are dispersed, as in the U.S., then power under one-vote, one-share rules tends to end up in the hands of management, especially when shareholders' procedural rights are as severely limited as they are in the U.S.

In practice today, voting rules fall into two broad categories: those that concentrate power in the hands of a minority of shareholders, including not only one-vote-per-share rules but also priority rights and multiple voting rights; and those that, like the spirit of the common-law default, tend to disperse power, such as voting rights ceilings. Portraying the debate as a stark choice between one vote per share rules, on the one hand, and "control enhancing mechanisms," on the other, misses this very important distinction. Multiple voting rights and voting rights ceilings distribute power among shareholders in opposite ways.

Giving "all shareholders an equal say" may be a laudable goal, but that is not what one-share, one-vote rules do.

Management votes by default

Brokerage firms hold roughly 80% of listed company shares (NYSE only?) and if the owners do not instruct their brokers how to vote their shares, the brokerages vote in favor of management proposals. As a result, reports Gretchen Morgenson, "brokers control an estimated 25 percent of the shareholder vote at the typical annual meeting." (The estimate comes from the London-based organization Governance for Owners.)

The NYSE had proposed to prohibit the practice before next spring's annual meetings but has now decided to postpone the change until 2008 to give companies, especially those that now require directors to receive a majority of votes cast, more time to prepare. Some observers, including at least one member of the working group that formulated the proposed rule change, expressed concern that the rule change had been postponed because of pressure from opponents, which include the Business Roundtable and the Society of Corporate Secretaries. The Roundtable opposes the change "because it would require educating their shareholders on proxy voting issues, yet corporations cannot communicate directly with those who hold their shares at brokerage firms, for example."

Gretchen Morgenson, "Big Board Delays Plan On Voting," New York Times (natl. ed.), 3 October 2006, C1, C6.

Safeguards

Time for my quarterly blog update (I'll spare you my grumbles about why I can't seem to find time to do this more often).

Why is it that the U.S. seems so persistently to pay less attention to safeguards than its European peers? Of course, as soon as I write those words, I have to ask myself, "Who is this 'U.S.' that you are talking about?" Fair enough--there is no monolith that holds singular values. All we perceive is the de facto outcome of political battles, which doesn't necessarily tell us anything about the specific values that informed individuals' actions. So better to ask: What is it about the U.S. that its policymaking so often slights safeguards?

Three reports in today's New York Times prompt this question. One is on the National Research Council's review for Congress of the National Nanotechnology Initiative established in the 1990s. In the Times reporter's words, "the report cautioned that too little money was being invested in understanding the potential health and environmental risks of manipulating matter on such a small scale [billionths of a meter]."

Barnaby J. Feder, "Study Says U.S. Has Lead in Nanotechnology: A Hopeful Report Also Warns That Risks Deserve More Study," New York Times, 26 September 2006, C6.

The second concerns the U.S. program that permits intelligence agencies to monitor international financial transactions for traces of terrorist activity. The European Union's Article 29 data protection working party reports that the program lacks the safeguard--independent supervision--needed to make it consistent with European law. "That's a crucial point for us," says the German who heads the panel. "There must be independent supervision."

Eric Lichtblau, "Europe Panel Faults Sifting Of Bank Data," New York Times, 26 September 2006, A1, A19. See also Tom Zeller, Jr., "93,754,333 Examples of Data Nonchalance," New York Times, 25 September 2006, C5

The third report is on proposals in Congress to have the Department of Homeland Security build a wall (of fence, vehicle barriers, and electronic surveillance) along portions of the U.S. border with Mexico. In the wrong hands, walls can keep people in as well as out, so some kind of safeguard--e.g., independent supervision--might be appropriate here, too.

Eric Lipton, "Lawmakers Agree to Spend $1 Billion on Tightening Border," New York Times, 26 September 2006, A21.

The overall pattern seems pretty clear, but the reasons for it puzzle this observer.