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Democrats need to stop throwing everything they can at Trump

By Norman Solomon. This article was first published on The Hill.

Democrats need to stop throwing everything they can at Trump
© Getty Images

Thirty-five Democrats in the House have sent a letter to Attorney General Loretta Lynch urging her to appoint an independent Special Counsel because Donald Trump “has repeatedly engaged in actions constituting unauthorized foreign policy in violation of the Logan Act.”

Dating back to 1799, the law has resulted in a grand total of one indictment (during Thomas Jefferson’s presidency) and no conviction. But the Logan Act remains a convenient statute to brandish against disruptors of foreign-policy orthodoxies.

The Jan. 12 letter — relying on an arcane and wobbly relic of a law — is an example of opportunism that isn’t even opportune. Worse, it’s an effort to spur Justice Department action that would establish a dangerous precedent.


When the letter charges that “in several cases Mr. Trump’s actions directly contravene and undermine official positions of the United States government,” the complaint rings hollow. In our lifetimes, countless private citizens — and quite a few members of Congress — have sought to contravene and undermine official U.S. positions. Often that has been for the better.

The members of Congress who signed the letter should know that. Many are ostensibly aligned with the kind of dissent that has been — and will be — essential to pull this country away from disastrous wars overseas. More than half of the letter’s signers — 19 of the 35 — are in the Congressional Progressive Caucus.

It should be obvious that the Logan Act is antithetical to free speech and other vital liberties. The law provides for up to three years in prison for “any citizen of the United States” who — without authorization from the U.S. government — “directly or indirectly commences or carries on any correspondence or intercourse with any foreign government,” with intent to influence that government “in relation to disputes or controversies with the United States.”

Steve Vladeck, a professor of law at the University of Texas, points out that the First and Fifth Amendments “do not look too kindly on either content-based restrictions on speech (which the Logan Act clearly is), or criminal laws that do not clearly articulate the line between lawful and unlawful conduct (which the Logan Act may well not do).”

In recent decades, the specter of the Logan Act has been used to threaten legislators who went outside an administration’s policy boundaries. In 1975, Sens. George McGovern and John Sparkman faced accusations that they’d violated the Act by going to Havana and talking with Cuban officials. In 1984, President Ronald Reagan said that Jesse Jackson’s efforts in Cuba and Nicaragua may have violated the Logan Act.

Later in the 1980s, Reagan’s National Security Council considered invoking the Logan Act to stop House Speaker Jim Wright’s involvement in negotiations between the Sandinista government and the Contra forces that the CIA made possible in Nicaragua. Twenty years later, in 2007, another House speaker — Nancy Pelosi — faced accusations that she’d run afoul of the Logan Act by going to Damascus and negotiating with Syria’s President Bashar al-Assad.

Now, it’s sad to see dozens of Democrats trying to throw the Logan Act at Trump when there are so many crucial matters to address — healthcare, civil rights, environmental protection, social programs and much more. While a multitude of legitimate and profound issues are at hand — with an urgent need to concentrate on blocking the GOP’s legislative agenda — the letter clamoring for a Logan Act investigation of Trump is an instance of counterproductive partisan zeal run amuck.

The idea that a U.S. citizen — whether Donald Trump, Jesse Jackson or anyone else — does not have a right to dialogue with officials of foreign governments is pernicious and undemocratic. We should assert that right, no matter who is in the Oval Office.

While some members of Congress are indignant that Trump’s actions “directly contravene and undermine official positions of the United States government,” the history of U.S. foreign policy warns against automatic deference to official U.S. positions. Citizens have often been wise when they sought to contravene and undermine the U.S. government’s positions.

Today, entrenched forces in Washington remain committed to foreign policies more in line with what Martin Luther King Jr. called “the madness of militarism” than the statecraft of real diplomacy. Citizens should push back against officials at either end of Pennsylvania Avenue who cite the Logan Act as an argument for conformity or use it as a tool for intimidation.

Norman Solomon is co-founder of the online activist group, which has 750,000 members. He is executive director of the Institute for Public Accuracy.

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Kenneth Arrow’s (Ignored) Impossibility Theorem

William K. Black, February 22, 2017     Bloomington, MN

Kenneth Arrow, one of the giants of economics, has died at the age of 95.  He became a Nobel Laureate in 1972.  As a young lawyer in 1977, I saw him in action as an expert witness on the subject of risk.  The context was setting the rates for shipping oil through the Trans-Alaska Pipeline System (TAPs).  Arrow testified about the risks of oil prices falling.  The FERC administrative law judge thought such a scenario was ridiculous.  Within four years, oil prices fell sharply.  Arrow’s experience was a common one for economists dealing with lawyers – the ALJ ignored him.

The New York Times obituary for Arrow is revealing about how the conventional wisdom distorts economic theory in a predictably skewed fashion.  It begins by discussing Arrow’s “impossibility theorem,” which states that where there are more than two choices it is impossible to construct perfect majority choice systems.

The author of the obit stressed the impossibility of such systems being optimal.  Contrast that emphasis with the author’s treatment of Arrow’s work on “general equilibrium.”

Professor Arrow proved that their system of equations mathematically cohere: Prices exist that bring all markets into simultaneous equilibrium (whereby every item produced at the equilibrium price would be voluntarily purchased). And market competition puts society’s resources to good use: Competitive markets are efficient, in the language of economists.

Professor Arrow’s theorems set out the precise conditions under which Adam Smith’s famous conjecture in “The Wealth of Nations” holds true: that the “invisible hand” of market competition among self-serving individuals serves society well.

That is one way to phrase it, but a more accurate, parallel way to phrase Arrow’s work on general equilibrium would be as an “impossibility theorem.”  Arrow actually proved that it was impossible for general equilibrium to occur.  The “precise conditions” in which economists can guarantee that a market transaction “serves society well” is the null set.  There is no market that meets those “precise conditions” because they are impossible to meet.

Market competition does not inherently “put society’s resources to good use” and “competitive markets” can be enormously inefficient.  In a Gresham’s dynamic, for example, the more competitive the market the more CEOs put society’s resources to bad uses and the more inefficient the results.  When hit men compete to murder spouses, the price of hiring hit men declines, but this does not serve society well and it is not efficient.  (The same is true for competition by cigarette company CEOs.  When companies prosper by increasing greenhouse gas emissions it, eventually, does not serve society well and it is not efficient.

The author of the obit accurately reflects the conventional economic wisdom in the two paragraphs that I quoted.  The conventional economic wisdom is flat out wrong.  As I have emphasized in prior posts, a prominent economist (who loves general equilibrium) admits that the conventional wisdom would only be true under the “silent” “assumption” that “God” mystically ensures that buyers and sellers do not act in a “self-serving” manner that harms society and reduces efficiency (Athreya 2013: 104).  We should call it the Arrow-Debreu-McKenzie (ADM) “impossibility theorem,” but instead orthodox economists make the hilarious (implicit) assumption that God loves laissez faire so much that he prevents all predation.  As Dr. Athreya phrases it, the “ADM God” prevents CEOs from even considering the possibility of predating on customers.

The author of the obit understands most of these points.

[Arrow] made clear, his powerful conclusions about the workings of competitive markets held true only under ideal — that is to say, unrealistic — assumptions.

His assumptions, for example, ruled out the existence of third-party effects: The sale of a product by Harry to Joe was assumed not to affect the well-being of Sally — an assumption routinely violated in the real world by, for example, the sale of products that harm the environment.

Note, however, that the author does not go back and correct his earlier errors and he never states that the ADM general equilibrium model shows that it is impossible for laissez faire to produce general equilibrium.

He also fails to inform readers that orthodox economists’ twin “dystopian” assumptions (Athreya 2013) make it impossible for laissez faire to guarantee either efficiency or socially desirable outcomes. The twin dystopian assumptions are self-interested behavior and rationality.  Orthodox economists such as N. Gregory Mankiw define actions by CEO, such as the refusal to “loot” the firm, as “irrational” rather than “moral” because it would harm the CEO’s “self-interest” (Akerlof & Romer 1993: 65).

The punch line to the defining economist joke is “assume a can opener.”  To “silently” assume an ADM God,” however, takes that joke to an unprecedented level worthy of a superlative humorist.

“Modern macro economists” have surpassed micro economists’ supreme act of humor.  Modern macro silently assumes an ADM God – and invariably describes its use of general equilibrium models as “rigorous.”  One imagines the rigor of “modern macro” proponents as they begin their incantations, using an analog to a pilot’s pre-flight checklist.  Step one:  silently assume an “ADM God.”  Step two: silently assume that the “ADM God” is the patron of laissez faire and acts rigorously to prevent any predation by CEOs (even though the express dystopian assumptions would produce widespread CEO predation).  Step three: Define steps 1 and 2 as the “rigorous” treatment of “micro foundations.”  Step four: chant the mantra endlessly and with a straight face.  Step five: do not fly on the ADM plane – and blame the crashes on “governmental interference” with the otherwise inerrant ADM checklist.

A last nerdy note.  The author of the obit stresses repeatedly how impressed he is by Arrow’s general equilibrium math.  The math only general equilibrium, however, because the model assumes away reality.  If the model attempted to deal with reality, without the “ADM God’s” aid, the math would produce indeterminacy or spiral away from equilibrium into bubbles and market breakdowns.  The math would also show that laissez faire is frequently criminogenic and would produce epidemics of elite fraud and other predatory abuse.  Arrow made his absurd assumptions in his model not because they reflected reality, or proved reliable in prediction, but to make the “system of equations mathematically cohere.”  When the math fails to explain reality and predict events it is a grave error (rather than a cause for celebration) when economists assume out of existence reality and torture the model until the math “coheres.”

The ultimate failure of economics as a field is to:

(1)  worship an economic model that is criminogenic,

(2)  hide that disaster from the public by assuming “silently” an “ADM God” that contradicts the model’s express assumption,

(3)  continue to worship and proselytize that model when its silent assumption of an “ADM God” repeatedly produces criminogenic policies and epic predictive failures, and

(4)  praise your models as “rigorous,” “scientific,” and “transparent,” and

(5)  define critics as anti-scientific and demand that their critiques be excluded as heresy.

Arrow was brilliant and well meaning.  We celebrate his life and mourn his passing.  The opportunity cost to our field is how much he could have accomplished had his research not been so distorted by neoclassical dogma.




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More on the Economic Hardship of Young Adults

By Yves Smith. This article was first published on Naked Capitalism.

In the US, the cost of the aftermath of the crisis has fallen heavily on young people, mainly due to bad policy responses to the crisis that we’ve described at length as it was happening: the failure to restructure bad loans (particularly mortgages) and impose costs on banks and investors, not just homeowners; the refusal to engage in enough fiscal spending, not just during the crisis but in deficit fights during the Obama Administration. That isn’t to say that other groups haven’t suffered too. Remember that older, less educated whites have suffered a decline in lifespans, which is unheard in anything other than post-USSR economic collapse. And even though some people in their 50s and 60s are sitting pretty, virtually all the ones I know outside McKinsey and top Wall Street circles are looking at working till they drop.

But young people have suffered in a very large way and don’t have any reason to expect much improvement. And the impact on them of diminished earnings early in their career is more serious than taking a hit for a similarly long period later in one’s working life. Various studies have found that lower earnings at the start of one’s career lead to diminished lifetime earnings.

Reader UserFriendly flagged two disheartening sightings on how young adults are suffering. As we’ll see, the report from Fortune is directionally correct in showing how much lower typical incomes are for young people now versus in the 1980s. However, they over-egged the pudding by taking a period of time that ended with pre-recession peak incomes that it took the better part of a decade to reach again.

I also do not like the Boomer versus Millennial framing in that it implies Boomers were responsible for Reagan-era policies. Deregulation and the Fed crushing labor started in the Carter era, although Reagan cemented neoliberalism as the dominant ideology. The so-called “Greatest Generation” backed Reagan. The propensity to vote for Reagan correlated extremely highly with incomes. Needless to say, the oldest Boomer voters in 1980 would have been 25, which is too young to be very well off, save perhaps by inheritance. Boomers did not vote in Reagan; when you look at the breakdown by age cohort, it was not until you got to 30 year old and over groups that you saw Reagan getting the majority vote (interestingly, young people then also voted more heavily for Anderson than their elders).

Nevertheless, young adults had a good run in Reagan years before the nasty hangover of the 1990-1991 recession kicked in. From Fortune, summarizing a report by a group called the Young Invincibles, using Fed data:

The report found that millennials—15 to 34-year-olds in 2013—were worth roughly half as much as the boomer generation and are earning about 20% less in comparison to young adults in 1989. While millennials earned $40,581 on average in 2013, members of the boomer generation earned $50,910 annually in 1989.

Meanwhile, young adults with debt and a degree in 2013 earned roughly the same as those who had no degree at all in 1989: $50,000.

The lower number on the paycheck has also materialized in the form of a lower net worth. While Millennials are worth about $10,900, the Boomers were worth $25,035 at the same age.The lower number on the paycheck has also materialized in the form of a lower net worth. While Millennials are worth about $10,900, the Boomers were worth $25,035 at the same age.

While this does not break down income by age group, this chart illustrates how using 1989 as the basis for comparison over-eggs the pudding, since it was the peak year in a strong recovery after a severe recession (the Fred chart is interactive, so if you visit the site, you can see the values for each year. Unfortunately, the series does not go back before 1984):

Needless to say, one of the factors driving the lackluster post 2007 results is the lousy quality of jobs. 94% of the new jobs created in the Obama era were part-time or temporary.

The lack of a steady job makes it hard to save for a down payment and hard to have enough in the way of steady earnings to qualify for a mortgage. And in our society, where the property rights of tenants are generally poor (unlike some other societies) and landlords can and do raise rents aggressively, owning real estate historically was the way that the middle class accumulated wealth for retirement. The 30 year mortgage matched the typical productive earning years of the (male) head of the household. When he retired, he would own his house rent free and face much lower costs, or could move into a smaller home and free up equity. Housing was a tax-advantaged forced savings vehicle; the traditional model provided a wealth buffer for retirees even when real estate appreciated only at its long-term historical level of a mere 0.5% real price growth per year.

The resolution of the crisis again turned the old model on its ear. Housing before the crisis was at strained valuations in relationship to average incomes and rentals. Yet the priority after the crisis was to restore home prices to their former levels. Now in fact, outcomes have varied considerably, with the top 10% communities that have done well in the “recovery” seeing turbo charged home price gains (which in New York, San Francisco, and increasingly other major cities have been amplified by Russian and Chinese flight capital).

These high average prices have had a secondary effect: the McMansionization of what used to be starter homes. I see this in Birmingham, Alabama where my mother lives in an affluent suburb with the best school district in the state. Most of the houses near her are 1950s ranch or split-level homes, and when sold, they are either razed or have big additions made to them. Down the hill, a somewhat busy street was clearly one of the first to be developed, and when my parents moved there in the 1970s, it was full of nicely maintained classic 1940s starter homes on small plots. There are still a very few left, but when they are sold, they are replaced with new structures with at least double the old square footage of living space that max out the available land.

As a Washington Post story indicates, it isn’t just the terrible state of the incomes and balance sheets of the young that are keeping them from owning homes; it’s also that modest homes are going the way of the dinosaur. Key points from the article:

Here’s a look at some of the ways that home buying is becoming more difficult for young buyers:

1. More deals are falling through. The share of home sales that fail is on the rise, with more issues arising for people buying starter homes, according to a report released this week by Trulia…The fail rate was higher for starter homes, with 7 percent of deals falling through at the end of 2016…

New home buyers are more likely to face issues with their loans because they haven’t gone through the process and usually don’t have as much equity as older borrowers, [Felipe] Chacón [of Trulia]says. They are also more likely to be buying homes with loans secured by the Federal Housing Administration, which require smaller down payments but have more restrictions, he says.

2. They don’t have many options. One of the main challenges affecting all kinds of home buyers is that there is a shortage of homes on the market. Still, those shortages are growing most for low- and midpriced homes in many markets, according to Trulia. Inventory for starter homes fell by nearly 11 percent nationally at the end of last year when compared to the end of 2015, the company found. That compares to a drop of 6.5 percent for premium homes, or the priciest homes in the market…

3. More people are being priced out of the market. Mortgage rates have increased since the election, putting a squeeze on young home buyers. Rates for 30-year fixed-rate mortgages rose to 4.2 percent last week from about 3.4 percent at the beginning of October. Those higher mortgage rates pushed down the median mortgage that millennials can afford by 9 percent, according to a report released Thursday by Fitch Ratings.

It also doesn’t help that the list prices for starter homes are rising, according to Trulia, requiring bigger down payments. For aspiring buyers, that can mean having to move to a less-expensive area, or putting off the purchase until they have more cash in the bank.

As UserFriendly said by e-mail:

I know exactly who’s fault it is, that is half the problem. It’s like I live in a bubble because next to no one understands anything about economics and so many people only understand politics to the extent that the GOP is more racist and therefore always bad. It’s maddening. It’s especially maddening for people my age, who graduated in 2008. I’d say it’s a reasonable argument that between Clinton and Obama I am about $200k worse off than I would be. So are most of my peers. Which makes my blood boil when I see them cheer him.

I litteraly have no life to look forward to. Out of the 14 years of my adult life I don’t think there has been a single one where my debt load has decreased. Which is completely unsustainable but thanks to uncle joe there is nothing I can do about it.

The young are between student debt, background checks that result in anyone with even a minor incarceration record putting themselves at a big career disadvantage, and the surveillance state so hemmed in as to make it very unlikely that they will revolt. But the Soviet Union didn’t fail due to an internal uprising but due to its inefficiency, the erosion of its legitimacy and the withdrawal of support of its citizens. The US has massive, unsustainable military, higher education, and health expenses and no plan to reduce their growth, much less to shrink them. I’m not sure how this ends, but on current trajectories, it will end badly.

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A foreign policy of cruel populism

By Vijay Prashad. This article was first published on The Hindu.

Getty Images/iStockphoto

Leaders like Donald Trump are offering a harsh cultural agenda to address the West’s economic problems

Just before he was inaugurated as the U.S. President, Donald Trump laid out some principles of what appeared to be his non-interventionist foreign policy. “We will stop racing to topple foreign regimes that we know nothing about, that we shouldn’t be involved with,” he said in North Carolina. “Instead our focus must be on defeating terrorism and destroying ISIS, and we will.” What Mr. Trump implied is that his administration would not conduct regime-change operations — such as against Iraq in 2003 during the George W. Bush administration — and certainly not indulge in nation-building outside the United States. He promised nation-building within the United States and to enhance the military “not as an act of aggression, but as an act of prevention”.

The tenor of Mr. Trump’s statements suggested that the United States would have a much less interventionist foreign policy. It would not be overthrowing governments or struggling to rebuild them into a liberal, market-friendly paradise. The concepts of regime change and nation-building — so fundamental to the consensus within the U.S. since the 1990s — now seem to be in retirement. Mr. Trump’s main concept — America First — suggests that he would take the country into an isolationist period, with foreign adventures off the table and with the United States gradually pulling out of alliances such as NATO.

Misplaced targets

The U.S. President’s agenda is part of the emergence of a cruel populism that has emerged across the West, inaugurated by the Brexit vote in the United Kingdom. The heart of this cruel populism is that the people of the West have been ignored by their ‘globalist’ leaders, who care more for free trade deals than for the haemorrhaging of jobs in their own homelands. In this they are correct. What makes them cruel is that rather than actually get to the heart of joblessness — which is partly due to unshared productivity gains through mechanisation — they offer a harsh cultural agenda to solve an economic problem. It is hatred of Muslims and other religious, sexual and ethnic minorities that focus the attention of Mr. Trump and France’s Marine Le Pen, Holland’s Geert Wilders and Germany’s Frauke Petry. They want to do such things as ‘de-Islamise’ their countries, ban minarets and secure their borders against refugees.

Building walls against migrants — simple campaign fodder — will not address the economies of the West, which are fundamentally integrated with the rest of the world. The global commodity chain has enabled Western corporations to enjoy large profits as countries in the chain struggle to underbid each other on wages and regulations.

To secure and control this global commodity chain, the West has used its vast military footprint — from bases to aircraft carriers — and it has used its military and political power to pressure countries to honour intellectual property rights and to fix currencies to advantage the global elites. No wonder, then, that the eight richest persons have as much wealth as the poorest half of the world’s population. This global 1%, with a majority in the West, has truly benefited from globalisation.

Isolation from this global commodity chain would seriously threaten the reproduction of wealth for this small minority. It is unlikely that the cruel populists — for all their ranting against free trade regimes — would be able to move an agenda that undermines this global footprint. Their isolationism is more rhetoric than policy. Economic sovereignty is not possible for their states, which is why they strive for cultural sovereignty. Demagogy is the prize for this kind of populism. ‘Keep out the Muslims’ stands in for economic policymaking.

Inhumane intervention

We have not entered into a period of isolation. Nor is the old doctrine of humanitarian intervention alive and well. It has certainly been set aside. Our new period, with the cruel populists in power, is defined by ruthless inhumane intervention. Bombs will fall, no doubt, but these will not be dropped to draw countries into the global order. Their purpose will be to encage areas seen to be lesser and inherently dangerous.

The doctrine of humanitarian intervention came into its own in the 1990s, when the United States began to justify its military operations based on the idea of ‘human rights’. Wars against Iraq and Yugoslavia as well as designations of Iran, Iraq, North Korea, Libya and Syria as ‘rogue states’ set the terms for humanitarian or liberal interventionism. The general idea was that these states were holdouts against globalisation and that pressure against them — sanctions or armed force — was utterly justified. A notion of universal humanity guided this theory, since it was assumed that violence would tutor lesser societies into the global commodity chain. The idea of ‘regime change’ required the idea of ‘nation-building’ to complete its task. Not only would governments be overthrown, but they would be replaced by regimes that acceded to the neo-liberal policy slate and to the institutions of globalisation.

The cruel populists do not accept the theory of universal humanity. For them, the world’s people are divided along the axis of culture — Christendom, on one side, against Islam, on the other. Mr. Trump has vowed to rebuild the U.S. military so that “no one will ever mess with us”. What is this military to be used for? “I would bomb those s******,” Mr. Trump said of the Islamic State and its oil infrastructure. “I’d blow up every single inch,” he said, so that “there would be nothing left”. But the use of force does not end there. “And you know what, you’ll get Exxon to come in there, and in two months — you ever see these guys? How good they are, the great oil companies. They’ll rebuild it brand new.” It is suggestive that Mr. Trump’s Secretary of State is Rex Tillerson, who ran ExxonMobil for 10 years. Would ExxonMobil re-build the oil infrastructure for Iraq? No. “I’ll take the oil,” Mr. Trump said brashly and against international law.

The U.S. President’s instinctual militarism is evident with his appointment of Generals to his cabinet and his habit of continuing to call them by their military rank. These are not ordinary Generals. They have demonstrated a virulent anti-Muslim streak, which is in keeping with the cruel populism of the Trump agenda. Such prejudice blinds them from reality. Against all logic, Defence Secretary James Mattis said, “I consider ISIS nothing more than an excuse for Iran to continue its mischief.” That Iran and the Islamic State are fierce adversaries is of no consequence. For this General, they are both in the camp of Islam. War against them is instinctual. It will not be to draw the people in their societies into the global order. Inhumane intervention serves as a prophylaxis against the fantasy of cultural sovereignty.

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Quis custodiet ipsos custodies? Jean Tirole’s Proposal to Appoint Felons to Monitor CEOs

William K. Black February 18, 2017     Roma, Italia (5th in my series on Jean Tirole)

When in Rome, trot out a venerable Latin quotation from Juvenal: “Who will guard the guards?”  I have “buried the lead” in this series of article about Jean Tirole by relegating my discussion of his proposal for fixing the problem of the criminal CEO – appoint a criminal “monitor” – to the fifth article in this series.  His proposal is in his 2001 article titled “Corporate Governance.”

Tirole’s proposal for optimal monitoring of CEOs is supposed to prevent predation by CEOs against shareholders.  Tirole begins his article with a catalog of some of the many ways that CEOs predate on shareholders.  His list includes this passage.

They may collect private benefits by building empires, enjoying perks, or even stealing from the firm by raiding its pension fund, by paying inflated transfer prices to affiliated entities, or by engaging in insider trading [p. 1].

Tirole defines “insider trading” by the CEO as a form of “stealing from the firm.”  Tirole’s proposed “natural” way to prevent the CEO from stealing from the firm through insider trading is to have the shareholders hire a “monitor” of the CEO who will be compensated through –insider trading.  The insider trading by CEOs that Tirole deplores and the insider trading by the monitor that Tirole proposes both constitute felonies.  Tirole refers to “insider trading rules,” so he knows that insider trading is prohibited [p. 13].  He does not, however, either note or discuss the fact that his proposal calls for shareholders to induce the monitor to commit a felony, making them co-conspirators.

Tirole’s optimal (and he thinks “natural”) method should have set off a series of warning bells in his own head.  Tirole seeks to institutionalize the felony of insider trading.  His euphemism for the monitor’s proceeds of his felony is a classic – “adequate incentives.”

A natural approach would be to hire a designated monitor and to provide this monitor with adequate incentives.  Suppose for instance that the monitor is given at the initial stage s options at striking price equal to par…. That is, the potential monitor will be able to buy (before the final outcome is realized) s shares costing [par] each and paying dividend R each in case of success and 0 in case of failure [emphasis in original, p. 12].

Tirole then explains that the monitor and the CEO will simultaneously gain from insider trading if the CEO behaves properly.

Assume that the entrepreneur indeed behaves. The passive monitor's options are valueless if there is no monitoring. Their expected dividend is then … equal to the striking price. Suppose in contrast that the monitor incurs cost c, and thereby receives (privately) the signal. In case of a bad signal he knows that the shares are overvalued … and therefore does not exercise the options. A good signal implies an undervaluation and an expected profit … per option; so the monitor exercises the options, which reveals that he has received the good signal [p. 12]

Let me translate Tirole’s plan into English and explain its legal implications.  Officers of a firm cannot “tip” other people through the release of “private” information about the firm and the person receiving private information from the officer in what they know to be a breach of the officer’s fiduciary duties cannot trade on that leaked information.  Doing so constitutes insider trading, which is a felony.  A conspiracy to commit a crime is itself a crime.  The CEO under Tirole’s plan knows that the monitor intends to trade on private, insider information that the CEO is leaking to the monitor.  Tirole’s plan is for the CEO and the monitor to conspire together to commit a crime.

The purpose of Tirole’s plan is supposed to be preventing the CEO from predating on the shareholders.  Tirole’s answer to the problem of CEO predation is to add a predatory monitor to conspire with the predatory CEO.

What could possibly go wrong with Tirole’s plan?

It turns out that Tirole knows that his “optimal” plan is illegal and that it would fail and increase predation by bad CEOs against shareholders.

In practice, though, this natural way of creating passive monitoring is not frequently observed. This is perhaps due to the fact that the entrepreneur and the designated monitor have an incentive to collude. Suppose for example that the monitor commits, in exchange of a bribe, to always exercise the options.  Incentives to monitor are then destroyed and so are the incentives for the entrepreneur to behave.17 (One possibility is that the bribe is paid from corporate resources (reducing the probability of success …but without any consequence for the entrepreneur, who receives compensation based on the exercise on the options) [pp. 12-13]).

“Is not frequently observed?”  The true statement would be “is never observed.”  Even Tirole knows that Tirole’s plan would be disastrous – and he understands only a tiny portion of the reasons it would increase CEO predation and harm the economy.  Tirole’s admission that his plan would fail and make CEO predation worse does not discourage him.  He lives so deep down the rabbit hole of orthodox economics that his every urge is to keep digging seeking the elusive pixie that will make laissez faire work.

A market has more integrity. Any participant in a stock market for example de facto has call (as well as put) options on the shares of the firm, in very much the same way our designated monitor had call options. But with a market (cum insider trading rules) it becomes much harder for the entrepreneur to capture the passive monitoring process. This may explain why in practice managerial compensation is based on the value of the firm's stock and thus on "anonymous passive monitoring" rather than on the exercise of options by a designated monitor. More work on the relationship between market monitoring and the "optimal collusion-proof passive monitoring scheme" is warranted, though.

Why does a “market” have more “integrity” than a monitor?  Tirole’s answer is that the transaction costs of the CEO bribing many shareholders are far higher than bribing a single monitor.  Tirole even drops a footnote to explain that CEOs could probably bribe the monitor very cheaply, which does not say much for the monitor.  Tirole does not stop to analyze the implications for other supposed corporate monitors such as outside auditors, appraisers, and credit rating agencies.  Shareholders while harder to bribe, should be vastly easier to deceive than an expert monitor with access to insider information.

Tirole, however, assumes that shareholders can “monitor” CEO performance.  Worse, he assumes that the stock price is the accurate product of that monitoring and that it is therefore appropriate to base CEO compensation on the current (short-term) stock price.  Remember, he is writing these things shortly after the collapse of the largest bubble in history – the stock market bubble in dot-com shares and after a series of crises driven by CEOs inflating the stock price to enrich themselves.  Naïve is too weak a word to use to describe Tirole.

Tirole is also self-contradictory, for he premises his criminal insider-trading plan on the explicit assertion that shares are systematically mispriced in the markets due to the shareholders’ inability to know whether the CEO was “behaving” or “misbehaving.”  He says that the reason that the monitor will profit is that the markets “undervalue” the firm’s shares if the CEO is “behaving” and “overvalue” its shares if the CEO is misbehaving.  Those premises require that the stock markets are not able to discern whether the CEO is a fraud or “good” person.  Two paragraphs later, he inexplicably (and implicitly) makes the opposite assumption.

It is the last sentence of the quotation above, however that is most telling about Tirole’s crippling dogmas.  He asserts, without any attempt at logic or evidence that what economists need to be doing is “more work” on his “optimal collusion-proof passive monitoring scheme.”  No, economists need to stop this search for the holy grail of laissez faire.  There is no such thing as a “collusion-proof” scheme for CEOs.  Because a “scheme” for CEOs cannot be “collusion-proof,” orthodox economists also need to stop talking about “optimal” CEO “schemes.”  Precisely because there is no reliable way to prevent CEOs from colluding, there cannot be an optimal CEO “scheme.”

Assumption is the Mother of Error

Tirole’s proposal to encourage the CEO and the monitor conspire to engage in illegal insider trading implicitly assumes out of existence one of the most important drivers of CEO fraud – the magnitude of the reported profits.  He relies on the explicit, but false, assumption that shareholders can “verif[y]” the firm’s true profitability.  This allows Tirole to make the implicit, but false, assumption that the CEO’s reports of the firm’s profits are irrelevant because the the CEO’s reports cannot deceive shareholders.  Tirole then makes the explicit, but false, assumption that if the CEO “behaves” the firm’s chance of being (truly) profitable increases.  Tirole implicitly, but falsely, assumes that he need not determine whether if the CEO behaves the firm will falsely report profitability because Tirole has explicitly assumed that the CEO’s inflation of reported firm profits cannot influence shareholders.  Tirole then implicitly, but falsely, assumes that the magnitude of true profits and the magnitude of the CEO’s inflation of reported profits have no effect on the monitor, the CEO, or the shareholders’ actions.  The magnitude of the gain from fraud, however, is critically important to CEO and monitors under Tirole’s own model (if one inserts reality into his assumptions).  Each of Tirole’s assumptions is contrary to reality and multiple fields’ literature findings.

Part of the problem is that Tirole fails to understand that what it means under orthodox economists’ twin dystopian assumptions of self-interest and rationality for a CEO to “behave” is that he will lie, cheat, steal, maim, and murder.  This contradicts the definition of “behave” that humans use and it has powerful and perverse consequences for Tirole’s plan to encourage felonies in order to prevent CEO abuses that he ignores.

Three Real World Examples of the Frauds that Tirole Ignores

First, Tirole assumes that the monitor will receive $0 if the CEO sends the “bad” signal – if the monitor sends the accurate (bad) signal to the shareholders by refusing to exercise his stock options and buy the firm’s overvalued shares.  Tirole’s plan, however, is premised on the monitor’s incentive to become rich by engaging in insider trading when the private information he receives is the good signal that the CEO is “behaving.”  Why would the monitor not profit by insider trading when he received the private information that the CEO was “misbehaving?”  The monitor simply has to short the shares – secretly so that the shareholders do not learn what he is doing.

Second, Tirole ignores what would happen if the monitor learned that the CEO was bribing EPA inspectors to ensure that the firm could get away with illegally disposing of toxic waste in a manner that would harm public health.  In Tirole’s terms, the toxic CEO is “behaving” rather than “misbehaving” because it is far cheaper for the firm to pay the small bribes in order to gain a huge cost advantage over honest competitors that safely dispose of their toxic waste.  The monitor would therefore send the “good” signal to shareholders by exercising his stock options.  The public would realize that the stock was undervalued and would react by biding up the stock price.  The CEO’s stock would surge and he would be wealthy.  Tirole says that he designed his “corporate governance” proposals to help all stakeholders, but his actual proposals would encourage the CEO and the monitor to collude to predate on the public and honest competitors.

Third, what if the monitor found that the stock price had surged due to the CEO running a different kind of fraud in which he predated primarily on the creditors and shareholder by using accounting fraud to inflate the firm’s reported profits and hide its real losses and insolvency.  The advantages of this form of accounting control fraud include the fact that it is a “sure thing” and it leads the firm to report record profits that will cause a sharp increase in the firm’s stock price.  Under Tirole’s twin dystopian assumptions, the monitor would exercise his stock options when he discovered the CEO’s fraud.  The monitor would publicly praise the firm and its CEO.  The monitor would later, gradually and secretly, sell his shares in the company before it collapsed.  The CEO does not need to bribe the monitor to send the “good” signal that the CEO is “behaving.”  The monitor will eagerly send the false signal because exercising his stock options and covering up the CEO’s accounting control fraud are the two things he needs to do to become wealthy from sharing in the CEO’s fraudulent “sure thing.”  If the monitor were to take a bribe from the CEO it would materially increase the risk that both could be prosecuted.  Tacit collusion would be the optimal strategy whenever the CEO and the monitor were corruptible.

These three examples of how Tirole’s proposal to encourage the CEO and the monitor to conspire to commit the felony of insider trading illustrates would produce an epidemic of elite fraud illustrate the saying about what a “tangled web” we weave when first we practice to deceive.  The Swedish Central Bank, of course, did not find it remotely disqualifying to award their “Nobel” prize to Tirole.  The recipients of the world’s top prize in economics can get the economics hideously wrong and propose to make bad ethics and criminality ubiquitous in the C-suite without any negative repercussions.  The thing that could be disqualifying would be for to propose effective regulation of CEO compensation to reduce the perverse incentives that are the norm

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