Radio Interview with WRUW, Cleveland, Ohio

I was on Cleveland People's Radio this week. I'm about 17 minutes in or so.

http://wruw-stream.wruw.org/archives/56/457.mp3

External Damnation--Companies are designed for destruction

3.6 million jobs into this recession,[i] insult has been added to injury. The Peanut Corporation of America, nut supplier to Kellogg and the lower-rent peanut butters, deliberately sold peanuts contaminated with the salmonella bacterium. Twelve times in the last two years. The current headline-grabbing salmonella outbreak is the most recent result of these knowingly–tainted shipments.[ii] Now, the FDA could have been on top of this, but companies aren’t obliged to inform the food regulator of the results of their own tests. And then, even after the contaminated plant was found by the FDA, the full recall couldn’t be announced for almost three more weeks because the FDA has to obtain corporate approval of the wording of product recall announcements.[iii] While a few hundred more people enjoy nausea, vomiting, and diarrhea.

Pretty cold, I know, but this is just another example of what economists call “externalities.” An externality is an impact of an economic transaction that falls on someone outside the transaction. The nice smell of your neighbor’s barbecue is an example of a positive externality, and your insomnia when he buys new sub-woofers would be a negative one. These externalities are treated as rare occurrences in economic theory, but the reality is that external effects of our actions are everywhere. As the Harvard Business Review puts it, “Virtually every activity in a company’s value chain touches on the communities in which the firm operates, creating either positive or negative social consequences.”[iv] And for the business world, negative social consequences can mean big corporate savings.

Take the energy industry, where gas prices increased in recent years as demand grew. BusinessWeek reports “Even though it seems like the market is working in this regard, it really isn’t. There’s widespread agreement that the current price of oil doesn’t reflect its true cost to the economy,” such as “the more than $100 billion cost of having troops and fighting wars in the Persian Gulf.”[v] It turns out that the market can’t make a price for everything: “The tricky part is pricing these externalities...More dollars come from adding in numbers for the costs of air pollution, oil spills, and global warming.” The magazine also invites us to “imagine” that “in an ideal world, we could settle on the size of the externalities.” This is one reason why economists prefer to sweep externalities under the rug—they make the economy much more complicated.

And speaking of complicated things, externalities are also a crucial element of the credit crisis. The immediate cause of the banks’ dire straights is their overinvestment in risky credit derivatives—financial products representing pieces of loans, often “subprime” ones. Banks spend millions on executives and staff who are expert at risk-management, yet clearly the risk of these assets was underestimated by the banks, as our billions or trillions of bailout dollars prove.

The Financial Times says the paradox “echoes a fundamental problem about banking…the social cost of a systemic disaster is greater than the private cost to the individual bank. In the end, it is the task of regulators, not investors, to address this externality.”[vi] So a bank will view its assets as representing a certain risk to the company, and cannot afford to think of the broader “external” risk created for the system if the bank collapses from holding excessively risky assets. In other words, the stability of the system is someone else’s problem, and while investors may not want to see the system collapse, “their fiduciary obligations prevent them from taking a broader, systemic view.” The result is that risk is chronically underpriced in the financial markets.

Beside external costs, other related developments lie behind the crisis, like the bipartisan consensus to bail out big companies. As the business press reports, “Private-sector companies and individual bankers have been making huge profits in the bubble. Their risk appetite has been enhanced by previous bailouts and…by the government’s implicit guarantee. Yet their market pricing does not reflect the potential cost to the system of their own collapse.”[vii] The business world recognizes that “This inability to handle externalities” has worsened the financial crisis at every stage, such as when hedge funds further weakened the banks and insurers by short-selling their stock.

In fact, the market’s failure to value external costs and benefits helped lead the banks to hold so much subprime debt in the first place. Law professor and corporate governance expert Janis Sarra explains that before debt was packaged into derivatives, the banks created a “positive externality” for investors: “corporate stakeholders…could be confident that the bank was engaged in a measure of monitoring and oversight of the firm’s solvency,” so bank loans created a standard of trust for investors[viii]. But since banks now package and sell off loans, “The exponential growth in use of credit derivatives has shifted the externalities in a way that may contribute to market destabilization…originating lenders may be less willing to expend the time and resources to undertake due diligence in undertaking credit arrangements, as risk is laid off through derivatives under the originate and distribute model…previous positive externalities are lost and new negative externalities are created, creating more systemic risks across the market.”

The foreclosure crisis also owes something to externalies: “credit derivatives impede the normal negotiations between creditors and debtors in that borrowers can less easily renegotiate terms and conditions with lenders…Spread across the economy, the freezing of such relationships may increase systemic financial risk.” Again, bad for everyone, but highly profitable in the short term.

So it comes out that corporations don’t pollute because they’re evil villains, but because the very real costs of pollution can be made to fall on others, or “externalized.” Likewise banks load up on unregulated, risky assets because they don’t consider the risks to the whole financial system, beyond themselves. In general, companies have compelling reason to externalize any costs they can—lowered costs improve profitability. So global climate change, air pollution, contaminated food, an unstable financial system—all are external impacts that firms are obliged to ignore.

Regulation has been the traditional way of limiting the external impacts of corporate activity, as the business press recognizes. But firms will always resist regulatory restraints on their income, and historically companies have worked together to cajole the government to relax regulations. Besides, in the end it’s not good enough to just put a leash on institutions that can’t sustain their own financial system, let alone value long-term ecological health. As long as our economy is run by companies that see the world as an externality, then your health, the environment, and the overall economy will be things the market has an “inability to handle.”

True, more regulation would lower profitability, so America’s executives and equity holders may have to cut back on the caviar and foie gras. Let them eat peanuts.

Rob Larson is sharing the external benefits of his cigar smoke with everyone else on the elevator. He’s Assistant Professor of Economics at Ivy Tech Community College in Bloomington, Indiana, and blogs at http://theprofitmargin.blogspot.com.

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[i] Wall Street Journal, Soaring Job Losses Drive Stimulus Deal, February 7, 2009.

[ii] Washington Post, Peanut Processor Knowingly Sold Tainted Products, January 28, 2009.

[iii] New York Times, Peanut Product Recall Took Company Approval, February 3, 2009.

[iv] Harvard Business Review, Strategy & Society: The Link Between Competitive Advantage and Corporate Social Responsibility, December 2006.

[v] BusinessWeek, Taming the Oil Beast, February 24, 2003.

[vi] Financial Times, Watchdogs Must Not Kick Banks When They Are Down, February 4, 2009.

[vii] Financial Times, Capitalism In Convulsion, September 20, 2008.

[viii] Sarra, Janis. “Credit Derivatives, Market Design, Creating Fairness and Stability,” Network for Sustainable Financial Markets, January 2009.

The Least They Could Do--The Clinton Foundation's donors cause the problems it aims to solve

When president-elect Obama nominated Hillary Clinton for State Secretary, the Clintons agreed to release the donor lists of the Clinton Foundation, the huge charity created by Bill Clinton. The Clintons agreed to air their dirty laundry in a deal with the new Obama Administration, to help avoid conflicts of interest as the former Senator tries to undo the smoldering diplomatic wreckage of the Bush years. The donor list is extremely revealing, and not only for being “a who’s who of some of the world’s wealthiest people,” as the Wall Street Journal called it.[i] The donor list also shows that the Foundation is funded by the people, governments, and companies that help create the problems that the charity seeks to address.

Take development. The Clinton Global Initiative places charitable giving and development high on its list of priorities, and in fact recently began an initiative to encourage philanthropy in the Mideast and Africa.[ii] But one of the Foundation’s biggest donors, giving in excess of ten million dollars, is the Kingdom of Saudi Arabia. In addition to the Kingdom itself, rich Saudi citizens and Friends of Saudi Arabia gave several million more.[iii] The Royal Family of Saudi Arabia is reaching out to the struggling masses of the middle east.

But with a blindfold. BusinessWeek recently reported that “Saudi censorship is considered among the most restrictive in the world” as “the country blocks broad swaths of the Internet, from pornographic Web sites to calls for the overthrow of the government.”[iv] And Saudi subjects may have some solid reasons to throw out their Royal Family, such as the 2007 ruling by the Justice Ministry that sentenced a gang-rape victim to 200 lashes and six months in prison. The woman had been in a car with an unrelated man prior to the rape, and had appealed her original 90 lash sentence, leading the court to increase it and add a jail term “because of her attempt to aggravate and influence the judiciary through the media.”[v]

But conditions can’t be that bad—King Fahd finally approved a Saudi human rights “watchdog,” but with members chosen only by the government, after having withheld approval for a citizen group to organize one. The business press thinks it’s “unlikely” that the rights group would “openly embarrass” the monarchy.[vi]

So the Royal Family, having a guilty conscience, relaxes by plowing a few ten million bucks from its oil fortune into the Clinton Foundation, which accepts it in part to fund programs to increase charitable giving in the region. If the Saudis really felt generous they could give their subjects the vote.

Or consider Lakshmi Mittal, the Indian steel magnate whose global conglomerate Arcelor-Mittal produces 10% of the world’s steel. Mittal built his steel empire buying old plants or government sell-offs, with the explicit goal of becoming big and powerful, believing that the key to “heavyweight profits” was growing “big enough to negotiate on an equal footing with suppliers of iron ore and coal and with customers such as automakers…In the long run Lakshmi’s vision is an industry dominated by a handful of powerful companies, strong enough to cut output rather than prices in a downturn.”[vii] This is what economists call an “oligopoly,” and it doesn’t have much to do with the central Foundation goal of expanding economic opportunity. Once companies become large, they gain advantages against competitors, as Mittal describes: “as we are becoming more global…we are able to reduce our costs on a global basis. Like purchasing… [we] aggregate our demand. We are able to have stronger muscle power to negotiate with our suppliers.”[viii]

The scale of Mittal’s steel empire stacks the deck against smaller competitors. But a nice seven-digit check to Clinton’s global charity sufficiently levels the playing field. The Open Hand giveth, and the Invisible Hand taketh away.

Or take AIDS, often seen to be the Foundation’s core issue. The Foundation recently negotiated heavy price reductions for certain AIDS drugs sold in the developing world, and has come to partially support moves by Brazil and Thailand to break the patents on AIDS therapy drugs held by U.S. companies.[ix] This position has been pushed for by AIDS activists and groups like Doctors Without Borders for years, but only recently has the hand of the Foundation been forced by Brazil’s and Thailand’s patent-breaking, which is seen by even conservative observers like the Economist as successful in fighting the disease.[x]

The business press describes the position of the most prominent AIDS activist in South Africa, Zackie Achmat: “Like many activists, he believes drug companies have been goaded into their recent donations…only by terrible publicity,” and that “contrary to what the industry said, patents were indeed an obstacle to affordable medicines.”[xi] The Financial Times elsewhere describes the limited giveaways or price reductions of AIDS drugs by the pharmaceutical industry as “part of public relations efforts by western companies to deal with an onslaught over the prices they charge for their drugs.”[xii]

So while the Clinton Foundation has gradually come to support production of some far-cheaper generics in the developing world, it has only been public and activist pressure, and the growing independence of developing countries, that brought them and Big Pharma around.[xiii] And some of the medicine can even be paid for with the hundreds of thousands of dollars donated to the Foundation by AIDS drug patent-mongers Pfizer and Ranbaxy.[xiv]

While the Foundation’s work is clearly valuable to the people and communities served, the point is that its money comes directly from parties contributing heavily to the problems in question, from the brutal Saudi tyrants paying to encourage human dvelopment, to the global steel tycoon kicking in for classes on entrepreneurship, to the drug patent-owner grudgingly granting licenses for generic production.

The Foundation would probably defend itself by saying that its thousands of small-scale donors gave a median amount of $45, that doesn’t get you to the $492 million total the Foundation manages.[xv] That comes from Clinton’s big-ticket donors, which also include Victor Pinchuk, the Ukrainian steel “oligarch” who built his empire from the Soviet Union’s asset sell-off;[xvi] and Blackwater, the U.S. mercenary company under legal sanction for its killings in Iraq.[xvii] Blood money still spends.

In the end, the Clinton Foundation’s big-ticket donors are a ruling-class rogue’s gallery with a guilty conscience. But in a world of tyrannical regimes, deepening economic crisis, and spreading disease, you can count on more ego-stroking from the guilty parties that keep the lights on at Big Charity.

Rob Larson is charitably donating free crutches to everyone he runs over. He’s Assistant Professor of Economics at Ivy Tech Community College in Bloomington, Indiana, and blogs at http://theprofitmargin.blogspot.com.

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[i] Wall Street Journal, Clinton Reveals Donors—Charity Got $140 Million Abroad; Questions For Sen. Clinton, December 19, 2008.

[ii] New York Times, Clinton Foundation’s Success Was Buoyed by Donors’ Boom Years, December 20, 2008.

[iii] BusinessWeek, Saudis, Indians Among Clinton Foundation Donors, December 18, 2008

[iv] BusinessWeek, Internet Censorship, Saudi Style, November 13, 2008.

[v] Financial Times, Saudis Reject Rape Case Protests, November 22, 2007.

[vi] Financial Times, Saudi Arabian King Approves Selected Human Rights Group, March 2004.

[vii] BusinessWeek, Mittal & Son, April 16, 2007.

[viii] BusinessWeek, Ispat International’s Lakshmi N. Mittal: The Man Who Would Be JP Morgan, August 28, 2000.

[ix] New York Times, Clinton Foundation Announces A Bargain On Generic AIDS Drugs, May 9, 2007.

[x] Financial Times, Third World and Drugs Groups Remain Wary Of Each Other, July 10, 2000. The Economist, A Portrait In Red, May 13, 2008.

[xi] Financial Times, South Africa’s Positive Force, April 21, 2001.

[xii] Financial Times, Pfizer Extends Medicines Giveaway In Africa, July 7, 2001.

[xiii] See for example Wall Street Journal, Pfizer Makes Aid Pledge, Breaks Pact On AIDS Drug, November 12, 2003.

[xiv] Wall Street Journal, Clinton Foundation Donors Include Drug Makers, December 18, 2008.

[xv] Wall Street Journal, Clinton Reveals Donors—Charity Got $140 Million Abroad; Questions For Sen. Clinton, December 19, 2008.

[xvi] New York Times, Clinton Foundation’s Success Was Buoyed by Donors’ Boom Years, December 20, 2008.

[xvii] BusinessWeek, Saudis, Indians Among Clinton Foundation Donors, December 18, 2008

WFHB Radio interview

I was interviewed by our local community radio station here in Bloomington, WFHB, about the bank bailout. Here's the link to their news program, the interview was on the January 8th, it's about nine minutes or so in.

http://news.wfhb.org/rss/dln.xml

Not Too Big Enough--The Banks Laugh All the Way To the Bank

The country’s financial markets have collapsed, as they tend to do when left without adult supervision, and they’re taking our economy with them. With the large banks refusing to make loans after losing billions on worthless subprime derivatives, the government stepped in and agreed to October’s financial bailout package. The $700 billion legislation was meant to buy banks’ “troubled assets” for cash, and thus improve banks’ balance sheets to the point that they would lend again. This would mean credit for struggling businesses and households, and could encourage expansion and hiring, thus pulling us out of recession.

But it turns out the banks haven’t held up their end of the bargain. All they’re holding up is a glass to a government that would rather shovel cash into the largest banks than take the edge off the recession.

The bailout was highly unpopular, despite a heavy push by the U.S. political leadership.[i] Most citizens apparently couldn’t figure why we should give money to the banks that caused this crisis by investing in complicated and risky securities to the point that they lost their shirts when the housing bubble exploded. Especially when foreclosures and bankruptcies among regular homeowners are out of control—the Mortgage Bankers Association reports that “a record one in 10 American homeowners with a mortgage was either at least one month behind on their payments or in foreclosure at the end of September.”[ii] But the plan has not been carried out as advertised—rather than buying the subprime securities from the banks, the government has instead decided to “recapitalize” them.[iii] Meaning, invest money in the big banks for some equity, money which the banks could then loan to the staggering economy. Well, at least the part where we give them money went well.

The fact is that the banks are not making loans—the “credit crunch” goes on, and the economy is the worse for it. After so many of Wall Street’s great investment banks went bankrupt, or were bailed out by the government, or were bought by competitors, the banks want to “hoard cash” to avoid a similar fate.[iv] But besides shoring up their own finances, the banks are putting our public bailout money to another purpose—buying up their smaller competitors.

Mergers and acquisitions have been a major part of the government’s strategy to deal with the crisis since its beginning. Bear Stearns, the first respectable Wall Street powerhouse to approach bankruptcy, was sold to the larger bank Chase in a shotgun marriage, arranged by the Federal Reserve. Since then, the government has arranged for a tanking Merrill Lynch to be sold to Bank of America, a heavily leveraged Wachovia to Wells Fargo, and a failing Washington Mutual to Chase, again. The Treasury Department would say that the damage to the economy can be limited if larger, more stable banks buy their struggling rivals.

Of course, some of these largest banks, such as Citigroup, are not so secure themselves.[v] But more than that, the money used by the larger banks to acquire the others is capital that could have been used to make the loans our economy is desperate for—and of course, that’s what they were supposed to do with the public money in the first place. But most importantly, remember that the reason we’re paying to bail out these banks at all is that they are “too big to fail,” in the language of the business press—in other words, if these huge banks go under, the loss of employment, lending, and tax revenue could do profound damage to the greater economy. So if these banks were too enormous to allow to die in the first place, why in God’s name would we be paying them to get even larger?

The mergers are large-scale—the Financial Times calls them a “wave of consolidation as banks scramble to use the cash on takeovers and bolt-on acquisitions.”[vi] BusinessWeek reports “what could emerge is a barbell-shaped system with megabanks, small banks, and little in between.”[vii] The business reporters for the New York Times describe the Treasury Department as “using the bailout bill to turn the banking system into the oligopoly of giant national institutions.”[viii] An oligopoly is a market, such as banking, dominated by a few very large companies.

If any doubt remained, it was put to rest by the minor scandal that has emerged over a quiet change to the tax code made by the Treasury Department. This change allows banks to apply the losses of other banks they buy against their own taxes. In other words, when a bank buys a struggling smaller bank, the buyer can deduct the money lost by the struggling bank against its own tax bill. This is clearly meant to further encourage merger activity—for example, when Wells Fargo bought Wachovia, it paid $15 billion. But Wachovia’s losses total over $19 billion.[ix] Meaning, Wells Fargo was paid for buying a highly valuable bank, for a profit of $4 billion, at our expense.

By way of comparison, the SCHIP program granting health insurance to children in low-income families cost about $5 billion in 2007.[x]

In fairness to the Treasury Department, Secretary Henry Paulson has been urging banks to use our public money to lend more.[xi] But tax breaks speak louder than words. It also might be pointed out that in Britain, banks are being recapitalized in a similar way as here, but the U.K. requires banks to formally agree to make loans with the public money.[xii] The American situation was described by David Walker, former U.S. comptroller: “It is the government’s responsibility to set the terms and conditions on this money…They’re giving it out with no rules.”[xiii]

This tax change may be undone if congress confronts the Treasury, since the legislative branch is supposed to be in charge of the tax code.[xiv] But the intention of the Treasury department to encourage mergers at the top of the banking world is very clear.

In fact, the government is going to great lengths to avoid doing what little the Brits have done. Rather than require our banks to make loans with the bailout money, our central bank, the Federal Reserve, “has already started a campaign to lend directly to damaged financial markets and companies—nearly anyone with collateral…officials have effectively concluded that if banks and financial markets won’t extend credit, it will do part of the job for them.”[xv] This is according to the Wall Street Journal, which also reports that Treasury secretary Paulson “acknowledged that banks aren’t lending enough money despite the government infusion, but said the U.S. didn’t want to nationalize the industry and dictate the loans banks make.”[xvi] Our government will do anything, even supply the economy with credit itself, before it will tell our huge banks what to do.

So to summarize, after creating a national economic crisis by wildly overinvesting in securities representing bad loans, the banks are being paid, by us, to become even larger. In spite of their being too big to fail in the first place, and even if that means the government has to do the banks’ job for them. Of course, with one in ten mortgages in delinquency and job losses mounting, it’s easy to come up with some better uses of our tax money. But it would take a whole lot of us putting down the snack chips, turning off When Celebrities Attack and organizing ourselves to put pressure on the government and change the economic system. The “megabanks” of our “oligopoly of giant national institutions” aren’t going to overthrow themselves.

And you can take that to the bank. The one remaining bank.

Rob Larson is getting bigger too, but it’s the holidays. He’s Assistant Professor of Economics at Ivy Tech Community College in Bloomington, Indiana and blogs at http://theprofitmargin.blogspot.com.

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[i] New York Times, “Labeled As A Bailout, Plan Was Hard to Sell to A Skeptical Public,” October 1, 2008.

[ii] BusinessWeek, “Foreclosure Activity Drops To June Levels,” December 11, 2008.

[iii] Financial Times, “Latest Shot Shifts the Goalposts,” October 15, 2008.

[iv] New York Times, “Banks Are Likely to Hold Tight to Bailout Money,” October 17, 2008.

[v] Wall Street Journal, “The Rescue of Citigroup,” November 24, 2008.

[vi] Financial Times, “US Capital Injection Sets Up Bank Consolidations,” October 22, 2008.

[vii] BusinessWeek, “Will Bank Rescues Mean Fewer Banks?” November 25, 2008.

[viii] New York Times, “So When Will Banks Give Loans?” October 25, 2008.

[ix] New York Times, “Treasury to Review New Tax Break Plan,” November 19, 2008.

[x] Wall Street Journal, “A Worrying Prognosis,” November 25, 2008.

[xi] New York Times, “Paulson Says Banks Must Deploy Capital,” October 15, 2008.

[xii] Financial Times, “Lloyd’s Pledge On Small Groups,” December 3, 2008.

[xiii] New York Times, “Banks Are Likely to Hold Tight to Bailout Money,” October 17, 2008.

[xiv] Financial Times, “Schumer Warns Against Change to Tax Code,” October 31, 2008.

[xv] Wall Street Journal, “Fed Cuts Rates Near Zero to Battle Slump,” December 17, 2008.

[xvi] Wall Street Journal, “Obama Works to Overhaul TARP,” December 17, 2008.