Bad Assumptions—“The Invisible Hand of the Marketplace” Edition

Folks-
It’s past time to go over some of the bad assumptions that have been made that allowed some of us to make bad decisions, and why these assumptions are so wrong. I’ll tackle two of the biggest ones in this essay.

For several years now I’ve been saying that Communists and Free-Marketeers (often Neo-Cons) make the exact same fundamental error in their respective basic assumptions. Both are great theories, but completely fail in real life. They fail because they both make the assumption that everyone will do what is best for everyone all the time, instead of taking advantage of anyone, and that policing is not necessary. Communists claim that the government, once in control of the marketplace, will police itself. Oddly, Free-Marketeers claim that once the government gets out of the marketplace, the marketplace will police itself. Both are completely, and very obviously, wrong.

The big problem with a completely free market, and Adams’ “Invisible Hand of the Marketplace,” is that it requires transparency in order to work. If you have no policing mechanism, or one that is ineffective for any one of dozens of reasons, then all you need is one person near the top, or a few lower down, to be dishonest or incompetent to bring the entire system down. Just ask Bernard Madoff’s investors. Communists put that trust into the hands of just a few people in political power, which is why the Soviet Union is no longer with us. Free-Marketeers put that power into the hands of corporate heads without supervision, which is why we’re in our current economic mess, not to mention the last several economic messes, including the tech bubble, the S&L collapse, the Great Depression, and so on.

The assumption by the Free-Marketeers is that “The Invisible Hand of the Marketplace” will punish the dishonest, corrupt, or incompetent through the customers and investors that would avoid them. The reality, which any neutral observer would report, is that the people that the “Invisible Hand” is supposed to punish when they are incompetent or corrupt are the ones in control of the information that the investors and customers need to make sound decisions. Distort the information and prevent the punishment until it’s too late.

Another important assumption of the Free-Marketeers that is wrong is that increases in efficiency are always a good thing. You often hear when one company takes over another that the increase in efficiency by eliminating redundancy will improve things. Often you won’t hear what things will improve. What it really translates as is firing people that have the same job at the other company will improve the bottom line of the combined company. That’s true, it probably will. If this kind of combination happens when the economy is in a boom cycle, the effect of people losing their job can even be fairly benign. However, this isn’t always, or even usually, the case. Often the effect of people losing their job is that these people have less money to throw around to buy things—like the things their former company made, or services they provide, and decrease their participation in our economy.

Let’s just take the efficiency argument out to it’s logical conclusion. An increase in efficiency is an attempt to reduce the capital outflow while maintaining income, or in other words, you don’t pay as much out as you get paid. This sounds good at first. Companies can increase efficiency by using less material or by eliminating jobs that don’t help the company as much. The problem is as a company starts getting significantly more efficient, the economy starts to feel the burden. More money from the economy tends to go to the company, and less comes out. In fact, a company that is 100% efficient has no capital outlays, just income. It would have no employees, even executives (hence, no payroll) and would produce nothing (so no cost of manufacturing or providing a service,) while paying no taxes or dividends. This kind of company would simply suck money out of the economy without contributing anything, being a kind of economic black-hole. Conservatives would argue that Government fits this description, but a company of this kind has no employees and produces nothing, and the government does not fit either definition by a large amount. A religion might come closer, but still doesn’t hit that target (too many employees.)

This is what most companies strive for. One of our problems that we are facing is that we won’t have a sufficient proportion of our population working and participating in our economy to keep it going, meaning fewer people are buying products and services, making companies get rid of employees, causing our economy to spiral downward. As large companies consider downsizing, or whatever they are calling layoffs today, the executives need to be asking themselves the question Henry Ford (yeah, I know) asked when someone pointed out to him that he didn’t have to pay his workers so much: “Then who would buy my cars?”

The reality is that the economy works best with a certain amount of inefficiency, and the hardest part of this to explain to people is that the amount of inefficiency that economy works best with is a constantly moving target. Most people want to hear a specific number, but that number will change depending on economic circumstances, specifically the ratio of jobs to labor. If there are a lot of jobs openings going unfilled, you can have an efficiency level that is high, because most people who want to work are doing so. If there are few jobs available, a greater amount of inefficiency will help to absorb these people and keep them participating in our economy. This may involve taking pay cuts at the executive level, or giving up hours or benefits at the worker level. Flexibility is key.

So, what are the solutions to these issues? Giving money without strings attached to corporations is not going to make the situation better. The New York Times has reported several times that the original bank bailout money is being used not to free up the credit market for either homeowners or businesses, but rather to pay off debt, buy other banks, and hang onto for later. We need more than this to improve our situation. We need money to be used to create jobs and improve our country. We need oversight of our corporations. The SEC and FDIC need to be doing their jobs, and we need to be certain that the next time money is handed to these people that it goes to where it is needed by our definition, not theirs.

To constantly keep the correct efficiency level of our corporations, the best way is to pass the “Employee Free Choice Act.” Negotiations are the best way to make sure we have the right staffing level, not simple corporate decision making, because corporations will always try to reduce staffing levels and payroll. Unions prevent that, but sometimes even they get out of hand. The best way is for Unions and businesses to negotiate often, at least yearly. This may seem a waste of time, but how else are you going to make sure employment levels are optimal?

In addition we need to be investing money as a country. This is what most conservatives, whether crackpot Free-Marketeers or not, would say individuals do when they get tax breaks, while failing to acknowledge that Governments can invest as well. Most of them fail to see that putting money into infrastructure or education is the way governments invest. We all benefit when we can contact each other more easily, when we can travel faster and with less damage to our vehicles, when power sources are steady, and when someone who otherwise couldn’t afford an education gets it and invents something we need, like a new cure. We have to fix our roads, bridges, communications, and educate our people. In short, corporate aid needs to have strings attached and can’t by itself be expected to pull us out of this depression.

Higher education is a good solution both short-term and long-term to our problems. Giving people grants to stay in school in the short term reduces the labor pool, increasing wages, and in the long term increases the number of job options for those people and their wages when they attain them. It also makes them a bigger asset to the company that employs them. This is a win-win for the country.

Most importantly, we need to call those who insist on sticking to the completely free market idea crackpots, just as we do with Communists. Brand them with a catchy name, such as the “Free-Marketeers” as I have (feel free to copy me.) They have been completely discredited in the last couple of years, and we need to make sure they do not try to regain their respectability, or they will. Theirs is a simple and seductive chant. If we don’t make sure our children are aware of the dangers, then they will surely try to repeat our mistakes under the spell of these snake oil salesmen.

What we need to do NEXT Part 2

This is the second part in a series. For the introduction and first part, read yesterday's entry. By the way, normally I include end notes for each individual blog post. This time I'm going to create end notes for the entire series. I should have mentioned in the first post that these suggestions are being posted in no particular order.


Wage Disparity

Now, once we have taken care of the coming credit crunches, we need to deal with a serious problem of income disparity. Are you aware that in 2005 the average CEO made over 821 times what the lowest paid employee that worked for him or her made? Ten years earlier it was about 275 times. So, if the average company has an employee making California’s minimum wage of $8 per hour, then the CEO of said average company was probably making around $6,568 per hour, and making around $13 Million per year (assuming 40 hour work weeks and 50 weeks per year.) That compares to the roughly $16,000 that the employee made. So the CEO made in less than 3 hours what his or her lowest paid employee made in a year.

I’m going to be honest. I really don’t believe that any CEO is worth that much. I might have a different opinion of this if executive pay rates went up only while a company was doing well. This has not been the case. Studies show that executive pay rates go up regardless of how a company is doing. Executive pay boards, which are used at most companies to determine how much company executives should be paid, are usually made up of CEOs at other companies. Imagine if you could have your friends decide how much you should get paid. That is exactly what these CEOs are doing, and it explains why executive pay can go up even when the CEO of the company is running the company straight into the ground.

So, how do we tackle this? Do we increase minimum wage to $400 per hour? Oh, heck no! That really would cause inflation and monetary devaluation. Let’s not go there!

I have a much better way of dealing with this.

Let me sketch this out instead of giving a detailed plan. You’ll see why later.

Instead of setting the minimum an employee can make, we set up a maximum disparity between the lowest paid employee and the highest paid employee or executive at a company. If the company goes over that multiple, then it forfeits all tax deductions.

Wait, what would be the outcome of that? Well, some companies would choose to increase the minimum pay of their employees to allow the executives to keep being paid well. That would increase the disposable income of those employees and increase the tax base simultaneously. Some companies would choose to pay their executives less, leaving more money for the company to invest in expansion, diversifying their product lines, or research. Some companies would choose to do neither. These companies would end up paying the government higher taxes, which could help offset tax breaks for individuals. Most companies would do some combination of these.

Now, how would we flesh this out? My first suggestion is to set the multiplier to 100 to 150 times the minimum employee’s pay. This ensures an executive pay of $1.6 to $2.4 million annually at a minimum. If the company wants to pay their lowest compensated employee more, then the executive’s pay would only go up. At $10 per hour the executive compensation goes up to $2-3 million.

Next, we count all compensation in this formula excepting only commission pay. Stock options? Count. Stocks? Count. Company condo? Count. Vacations? Count. Sold that multi-million-dollar super-computer to the government and got a $5 million dollar commission? Not covered. You made it, it’s yours. The best businessmen often pay their salesmen better than they pay themselves, realizing that a good salesman will bring in business that they can’t get themselves.

Now there are a couple of areas that I haven’t filled in yet even in my own mind. Do we want to implement this plan immediately, or phase it in over time? Do we want the cut-off point to be a hard cut-off, or do we want to phase-in the reduction in tax-breaks? How do we count contracted or temporary employees? Do we count the employees of a firm contracted to do certain kinds of services, such as janitorial firms? These can, and should, be debated at length.

One of the things I really like about this plan is there is so much room for compromise. Go ahead, change the multiplier! Count stock options differently than straight pay! Leave out corporate jets! Phase it in over time, or not! Allow companies to wait until the current executive contracts are over before it counts! All is negotiable!

It also allows every company the flexibility to determine what is an acceptable way to meet these goals. They can pay their executive less, or their employees more, or some combination. Maybe paying all of their corporate taxes is perfectly acceptable to some companies.

The upshot is that employees are going to be paid more, and more will be paid in taxes to the government. This is a win-win situation for our country.