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Kwak (2018) Law and Economism

Abstract

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Johnson and Kwak (2012) Is Financial Innovation Good for the Economy

Executive Summary

There has been a great deal of financial innovation in recent decades but its social value is unclear. In the run-up to 2008, banks took large amounts of risk relative to the size of the economy. This approach was made possible by and sometimes justified in terms of “innovation.” But it also created a great deal of downside risk for the economy—including widespread job losses and a big increase in the fiscal deficit.

Innovation is among the most powerful forces that shape human society. The improvements in the material standard of living enjoyed by most (though not all) Americans are largely due to innovation. One of the principal arguments for free-market capitalism is that it is the economic system that most encourages innovation, because it allows innovators to capture a significant part of the benefits of their work.

Today, financial innovation stands accused of being complicit in the financial crisis that has created the first global recession in decades. (See, e.g., Johnson and Kwak 2010, 105–9). The very innovations that were celebrated by former Federal Reserve chairman Alan Greenspan earlier this decade—negative-amortization mortgages, collateralized debt obligations (CDOs) and synthetic CDOs, credit default swaps, and so forth—either amplified or caused the crisis, depending on your viewpoint.

However, the conventional wisdom is coalescing around the idea that financial innovation is basically good, but just needs to be watched a little more carefully. As Ben Bernanke said in a speech in May 2007: “We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. The dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks. When proposing or implementing regulation, we must seek to preserve the benefits of financial innovation even as we address the risks that may accompany that innovation” (Bernanke 2007).

Intellectual conservatives and bankers have mounted a more fervent defense of financial innovation. Niall Ferguson (2009) argued recently, “We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street.”

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November 2015 version: Value of Connections in Turbulent Times (2015-11)

Link to published version

Abstract

The announcement of Timothy Geithner as nominee for Treasury Secretary in November 2008 produced a cumulative abnormal return for financial firms with which he had a prior connection. This return was about 6% after the first full day of trading and about 12% after ten trading days. There were subsequently abnormal negative returns for connected firms when news broke that Geithner’s confirmation might be derailed by tax issues. Personal connections to top executive branch officials can matter greatly even in a country with strong overall institutions, at least during a time of acute financial crisis and heightened policy discretion.

Abstract

Inequality in the developed world is high and growing: in the United States, 1% of the population now owns more than 40% of all wealth. In Capital in the Twenty-First Century, the economist Thomas Piketty argues that inequality is only likely to increase: invested capital tends to grow faster than the economy as a whole, causing wealth to concentrate in a small number of hands and eventually producing a society dominated by inherited fortunes. The solution he proposes, an annual wealth tax, has been reflexively dismissed even by supporters of his overall thesis, and presents a number of practical difficulties. However, a retrospective capital tax — which imposes a tax on the sale of an asset based on its (imputed) historical values — can reduce the rate of return on investments and thereby slow down the growth of wealth inequality. A retrospective capital tax mitigates or avoids the administrative and constitutional problems with a simple annual wealth tax and can reduce the rate of return on capital more effectively than a traditional income tax. This Article proposes a revenue-neutral implementation of a retrospective capital tax in the United States that would apply to only 5% of the population and replace most existing taxes on capital, including the estate tax and the corporate income tax. Despite conventional wisdom, there are reasons to believe that such a tax could be politically feasible even in the United States today.

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Kwak (2015) Reducing Inequality with a Retrospective Tax on Capital

Abstract

This is a response to Adam Levitin’s article, The Politics of Financial Regulation and the Regulation of Financial Politics: A Review Essay, 127 Harv. L. Rev. 1991 (2014). Levitin discusses various reasons for regulatory capture and highlights several potential solutions that aim to change the political governance of financial regulation. In this response, I highlight the importance of ideology (in this case, the ideology of free financial markets) in producing regulatory outcomes that are good for industry, and therefore the need for solutions that mitigate ideological capture.

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Kwak (2014) Incentives and Ideology

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Kwak (2013) Cultural Capture and the Financial Crisis (draft)

Abstract

Social Security, Medicare, unemployment insurance, and a poorly defined group of similar programs are often called “social insurance.” Social insurance is most often thought of as (a) insurance schemes in which workers make payroll tax contributions and receive benefits following certain insured events or (b) government responses to failures in private insurance markets. Both of these conceptualizations, however, fail to accurately describe some of the programs that are generally considered as social insurance. In this paper, I show that these programs have the following property: in the short term, they are clearly redistributive because we know the relevant outcomes and therefore who will make contributions and who will receive benefits; but in the long term (over one’s lifetime), they spread risk because we do not know what outcomes will occur and therefore who will benefit from the insurance they provide. I propose a new conceptualization of social insurance as government interventions in insurance markets that are redistributive in the short term but that, seen from a lifetime perspective, most people would choose to participate in because of their insurance value. At the margins, it is difficult to define the limits of social insurance. At one extreme, government regulation of automobile liability insurance and individual health insurance imposes risk spreading and redistribution that would not occur in a private market; at the other, public assistance programs such as Medicaid have insurance value for people who do not know what income category they will fall in. The definition of social insurance will always be politically contested because there is no clearly correct timeframe to use when evaluating these programs; proponents can frame social insurance as long-term insurance that benefits most participants, while opponents can frame it as naked redistribution from “makers” to “takers,” without either being obviously wrong.

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June 2014 version: Kwak, Social Insurance, Risk Spreading, and Redistribution (2014-06)

Abstract

Corporations currently can participate in electoral politics in the United States through various means: affiliated PACs, super PACs, 501(c)(6) organizations like the Chamber of Commerce, 501(c)(4) “social welfare” organizations, and traditional 501(c)(3) charitable organizations. Corporate law, as generally interpreted by the courts, places few constraints on the ability of corporate insiders to engage in politics as they choose. I argue that existing statutes and case law could be interpreted to impose greater constraints on corporate political activity. Political contributions should be reviewed as potential violations of the duty of loyalty whenever they could provide personal benefits to board members and executives (e.g., by making a cut in their individual income tax rates more likely). The simplest standard would be to require that insiders must reasonably believe that political contributions (and “charitable” contributions to organizations that engage in politics) will result in a net benefit to the corporation — not just some arbitrary benefit that could be worth less than the value of the contribution itself. This standard would be more consistent with the rest of corporate law, according to which insiders are not allowed to expend shareholder assets without at least some belief that they are doing so for the good of the corporation.

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Kwak (2013) Corporate Law Constraints on Political Spending

Abstract

Americans do not save enough for retirement. One reason is that our retirement savings accounts — whether employer-sponsored defined-contribution plans such as 401(k) plans or individual retirement accounts — are heavily invested in actively managed mutual funds that siphon off tens of billions of dollars in fees every year yet deliver returns that trail the overall market. Under existing law, as interpreted by the courts, mutual funds may charge high fees to investors, and companies may offer expensive, active funds to their employees. This paper argues that the Employee Retirement Income Security Act should be reinterpreted, in light of basic principles of trust investment law and the underlying purpose of the statute, to strongly encourage employers to offer low-cost index funds in their pension plans. Existing Department of Labor regulations should be modified to clarify that the current safe harbor for participant- directed plans (in which participants select among investment options chosen by plan administrators) does not extend to plans that include expensive, actively managed funds. This would improve the investment options available to American workers and increase their chances of generating sufficient income in retirement.

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Kwak (2013) Improving Retirement Savings Options for Employees

Me: Those balloons are really expensive. If we buy five of them, that would cost twenty-five dollars. For that much money you could get two presents. Or five books.

My daughter: But I want five balloons because I’m turning five.

Me: We could return two of your presents and get you five balloons.

My daughter: But I want all of those presents.

Me: Then you only get one special balloon.

My daughter: If you give me five balloons, and you don’t return any of my presents, I will stop the arguing.

She has already mastered the filibuster.

Earlier this year she proved she could be House Majority Leader for the Republicans.

Today I graduated from the Yale Law School. It has been said about many schools, but about no other school is it more true that getting in is hard, graduating is easy-peasy-parcheesi. I’m not entirely sure what to make of the entire experience.

So instead of reflecting on Yale, I’m posting a speech that I drafted fourteen years ago when I got my Ph.D. in history and that I just found on my hard drive. I believe that I wrote it because I applied to speak at that graduation; in any case, I know that I didn’t speak at graduation, so it must have been rejected.

(It amuses me that I still write the same way I did back then.)

 “What is the use of history?” The French historian Marc Bloch put this question on the first page of a book entitled The Historian’s Craft. “The question,” he continues further on, “far transcends the minor scruples of a professional conscience.  Indeed, our entire Western civilization is concerned in it.”

The attentive reader, however, will note that Bloch does not answer the question.  After circling around it for a few pages, he writes, “our primary objective is to explain how and why a historian practices his trade.  It will then be the business of the reader to decide whether this trade is worth practicing.”

Today, in a period of declining enrollments and dwindling institutional support, it is incumbent upon us as historians to say just what our discipline is good for.  But while Bloch set out to convince an intellectual audience of history’s legitimacy as a branch of knowledge, today it is a matter of defending history’s value to the university, the state of California, or society as a whole—a value that is increasingly measured in monetary terms.  How does history serve the economy of California?  How does history train students to be productive members of society?  What is the return on an investment in history?

It is no secret that universities everywhere are becoming increasingly attentive to the bottom line. Because of the resulting shakeup, their various schools and departments are coming to rest along a spectrum that ranges from engineering, applied physics, and business, at one end, to literature, classics, and history, at the other.  The former are prized as the source of both innovation and skilled labor for high-tech economic growth, and are lavishly funded by the corporations that benefit from them.  The latter increasingly appear an atavistic remnant of yesterday’s university, or an obligatory nod toward  a notion of the liberal arts to which few people any longer subscribe.  It is up to us to either accept or resist this devaluation of history.

When I came to Berkeley almost seven years ago, I assumed that history was useful, and that I fully deserved the money the state of California would contribute to my education.  In my first two years, I learned how to argue that point—and to argue it convincingly, I like to think.  Now … I’m not quite so certain.

Which, I think, is a good thing.  We should not accept with complacency our own arguments for our importance.  At this year’s convention of the American Historical Association, I attended a panel on downsizing in the profession.  What I was struck by was the virtual consensus that history is valuable in and of itself, that downsizing is bad not only for historians but for society as a whole, and that it is simply a matter of pointing this out to the public at large, which, upon recognizing this, will presumably give us lots of money.

When did a profession supposedly devoted to critical thinking become so uncritical of itself?  We have all absorbed the truisms about how History with a capital H is essential to a healthy society, but how much history do we really need?  How many historians?

It’s time to face those questions squarely.  Let’s not do what Marc Bloch did, and simply prove to ourselves the intellectual merit of our own research methods.  Let’s face the problem he raised before setting it aside:  “it is undeniable that a science will always seem to us somehow incomplete if it cannot, sooner or later, in one way or another, aid us to live better.”  But at the same time, let’s not give in to the world-weary, overeducated cynicism that says history isn’t good for anything except providing employment for people whose principal activity is publishing articles and books that only they can read.  Let’s find out if history really is good for something, besides esoteric academic debates.

As historians, it is up to us to answer this question.  But it cannot be answered with clever sophistry or impassioned debate; only actions will suffice.  If history is supposed to be essential to the moral conscience of our nation, then we have to stand up for what is right, and not bury our heads in books and journals.  If it is to instill in future generations an appreciation of our shared human heritage, then we must teach history—from elementary to graduate school—with enthusiasm and conviction, not simply to pay the rent.  If our research really does address questions vital to our understanding of the world, we should make it compelling for any reader, not just the academic specialist.  If anyone is to learn lessons from history, it is up to us to draw them for all to see.

And if we can’t live up to these demands, let’s admit that history is merely a form of entertainment, in which case, Bloch said, “all minds capable of better employment must be dissuaded from the practice of history.”

I address this challenge to all of today’s graduates, not just to those of my newly doctored colleagues who will become what are known as “professional historians.”  We came to this ceremony by many paths and will leave it for many futures, but we are all historians.

As for many of us, today is my last day in academics.  I will probably never write another history paper nor teach another history class.  Yet I will remain a historian, because studying history has made me, in part, who I am today.  I have learned a great deal in the past seven years, both in and out of class.  I need no longer, as one of my friends proposed to do in his orals, respond to every question by citing the Reform Bill of 1867.  I have learned that the past invariably shapes the present, and that we cannot understand why something is the way it is without understanding where it came from.  I know that there are many answers to every question, and that the motivations and interpretations of human behavior and experience are endless.  And I know there is perhaps no more daunting task than to truly understand why people do the things they do, or even to understand a single human being.

These, to me, are the lessons of history, and we should all be proud to have learned them.  Some of us will go on to teach them to future students.  But for the rest of us, being a historian does not stop as we leave this theater today.  It only becomes more difficult.

Within the walls of academia, what matters is being right—getting the right answer, the brightest new idea, or the most compelling interpretation.  But too many people think that personal brilliance and the pursuit of knowledge provide a kind of terrestrial sanctification.  The most important thing I learned here is that being right isn’t always what counts.  It’s more important—and more difficult—to live your life well, to treat the people around you with unwavering fairness, respect, and generosity.  And if history is to prove useful, it should help us to meet that challenge.

We who have studied history should know not to overestimate our own intellectual pursuits.  We, too, like the people we study, are human beings condemned to imperfection in an imperfect world.  We should distinguish ourselves by our perspective, our judgment, and our realization that great changes are made little by little, one person at a time.  We have not been trained to be inventors or statisticians or keepers of sacred texts, but to understand the adventures and misadventures of human beings.  In whatever your walk of life, I encourage you to use your training, to draw upon your knowledge of history and your capacity for understanding and say, “I am a historian, and this is where I stand.”  And perhaps, together, we can prove that history, and historians, do matter.

The conventional understanding is that the deliberative self is right and the affective self is wrong. For example, if you ask someone if she wants to save more money than she currently is saving, most people will say yes. That’s the deliberative self talking, thinking about the need to have income in retirement. But in practice, even after they say that, people don’t increase their saving, because the deliberative self isn’t strong enough. So, the policy wonks say, we should create devices to strengthen the deliberative self to increase its chances of prevailing against the affective self.

But how do we know that the deliberative self is right and the affective self is wrong? The deliberative self may be more risk-averse, but does that make it right? And what does “right” mean, anyway? Maybe if we led our lives entirely according to the affective self we would be happier than if we led them according to the deliberative self. We would eat more ice cream now, be poorer later, and figure it out then.

There’s a day-long conference on the Dodd-Frank Act at my school tomorrow. I really should go: I might learn something, I would meet people, it would be good for my career, etc. And I was planning to go. But yesterday I decided that I didn’t want to sit in a room all day and listen to economists and lawyers talk about the financial crisis. Sure, it might be healthy, but it didn’t seem all that enjoyable. So I’m skipping it. That is, my deliberative self did a calculation and decided I would be better off letting the affective self win this one. Put another way, I decided that my deliberative self uses too low a discount rate, which is the opposite of the conventional wisdom: most people think the affective self uses too high a discount rate.

In other words, we’ve reached the point where deliberative types like me are using happiness research to try to figure out how to become happier by shutting down the deliberative self.

*The curious part of that article is when it claims that we get an “Introduction to Legal Reasoning” at Yale Law School. I can say with confidence that there is no such thing, at least not in a form that would warrant capital letters.

The problem for today is broader, and applies to the Bowl Championship Series as well. Where I come from, the point of sports contests is to win. If North Carolina State beats Houston in the final game, they are the champions, even if we know that Houston would win nine games out of ten. The same goes for Miami beating Nebraska in the Orange Bowl, the Giants beating the Patriots in the Super Bowl, or Liverpool beating Milan in the Champions League final. And that’s also true for every other game along the way. The point is to win, not to have the best team.

Nate Silver breaks this down for basketball teams by using different statistical measures for teams’ talent (how good they should be) and merit (how many games they won and against whom). He does this to show how a team’s actual draw compares to the draw it deserved to get based on its performance during the season. The unfairness that results is a combination of a number of factors, such as the fact that some teams get to play close to home.

But the unfairness I want to focus on is that teams tend to get seeded based on talent rather than merit. It’s highly unlikely that the selection committee even tries to select and seed teams based on merit. I did a half-hour of research — Wikipedia, ESPN, Sports Illustrated, a Q&A with the head of the selection committee — and I could not find a simple statement of what the committee’s objective is in selecting and seeding teams. Are they picking the ones that did what sports teams are supposed to do — win games? Or are they picking the ones that they think are most likely to play well in the tournament? No one will come out and say the latter, but it’s pretty clear that they’re not doing the former. The committee considers factors such as how teams have been playing recently, whether key players were injured who are now healthy, margin of victory, even “dealing with adversity” — all factors that imply more that they’re trying to pick the teams that will do best in the tournament.

(This may seem obvious to you, and it doesn’t surprise me either. What surprised me was that I couldn’t find an official statement that this is what they are trying to do — perhaps because giving the committee an actual mandate would only open it up to more pointed criticism.)

This, it seems to me, is just wrong, because it’s not what sports are supposed to be about. It’s like having a committee vote on who should get into the NFL playoffs on Monday night after the regular season ends. It’s like, after each game in the NCAA tournament, having a committee vote on which team should go to the next round; it’ll usually be the team that won, but if they got lucky, or they benefited from some bad calls, or their star was injured in the fourth quarter, or if they don’t match up well with the opponent in the next round, it might be the team that lost. You’re supposed to get into the playoffs by winning, not by having the best team on paper.

The preference for the “best” — rather than the winners — is the product of a culture that values size, speed, and strength over results and that wants to maximize spectacle rather than celebrate achievement. It’s the same culture that insists on trying to pick the two “best” teams to play in an unnecessary and arbitrary football “national championship” game, despite this being a fundamentally impossible problem to solve (except perhaps in the fortunate case where exactly two teams go undefeated). It’s fine for fans to debate which teams are  “better” than other teams, in the probabilistic sense that they would win more often in a series of fair matches. But we shouldn’t organize our championships on that basis.