By William K. Black
(Cross posted at Benzinga.com)
In my first article on the Nobel Laureate Roger Myerson’s failed policies that helped make finance so criminogenic that it drove the ongoing financial crisis I began the exploration of Myerson’s claim that plutocrats constituted the unique advantage of capitalism over a system that forbade privately-owned firms. Myerson calls a system that forbids privately-owned firms “socialism.” He asserts that plutocrats demonstrate the accuracy of Friedrich von Hayek’s assertion of the inherent advantage of “capitalism.” My first article used Myerson’s Prize lecture to explore why his methodology, theories, and recommended policies failed so spectacularly. This article expands on that theme by citing other work by Myerson.
In future columns I will critique another Laureate, Robert Aumann, when I return to the errors that the game theorist Laureates repeatedly make by conflating “rational” behavior with unethical behavior. The central concept of the game theoretical Laureates is that we can build a safe financial system on a foundation of bribing unethical plutocrats not to cause so much harm that they will destroy our economy, our families, and life. Indeed, that formulation is too kind to the game theoretical Laureates and the plutocrats they pander to for the game theorists’ work predicts that the plutocrats will act “strategically” to extort the bribes by threatening to loot the firms and pollute the world to the point of extinction. Such strategic actions are “rational” because they make the plutocrats wealthier. Our surrender to their extortion through the payment of massive bribes is “rational” because, to paraphrase Winston Churchill, we hope that appeasement will delay our entry into the crocodile’s consumption function. In a wonderful example of why it is impossible to compete with unintentional self-parody, the game theorists claim that individual greedy behavior is “rational,” “optimal,” and “efficient” even when it will cause a community that could thrive through cooperation to starve to death.
“Mankiw morality” is the norm among these game theorists – if you are banker it is irrational not to loot “your” bank if the regulatory defenses are weak. It is, of course, rational for plutocrats to use their political power to ensure that regulation is weak. They large banks they control act “strategically” to spark a regulatory “race to the bottom” – a “competition in laxity” that creates deeply criminogenic environments. The game theoretic Laureates I criticize carefully avoid discussing the plutocrats’ political power and the entire concept of a criminogenic environment. They never cite the white-collar criminology literature or George Akerlof and Paul Romer’s classic 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”) and their models implicitly define “control fraud” out of existence. The models also implicitly assume out of existence the form of control fraud (accounting) that has driven the last three major financial crises in the United States. Once we recognize that accounting is the weapon of choice of those running control frauds in finance we also recognize that the Laureates’ games implicitly assume that accounting “outcomes” of firms are objective facts that can be known with certainty. I will be exploring these themes through examining the work of the Laureates who have created the failed games that have led to the criminogenic policy advice that has driven our recurrent, intensifying epidemics of control fraud and the resultant financial crises.
Myerson’s Plea that We Shower Plutocrats with Money and Thanks
In December 2012, Myerson gave a lecture renewing his paean to plutocrats and his claim that they provided the unique advantage of capitalism compared to a system banning all private ownership of means of production (which Myerson called “socialism”). Myerson creates and contrasts a caricature of both “capitalism” and “socialism” rather than a democratic nation with a mixed economy. The slides of the lecture appear to be his Prize lecture without any reconsideration introduced by the financial crisis and the latest accounting control fraud epidemic.
“Fundamental theory of institutions: a lecture in honor of Leo Hurwicz.”
Myerson defines two great problems that a financial system has to deal with – adverse selection and moral hazard. Each of these problems can create a criminogenic environment, and they often work in conjunction with dangerous interaction effects, but the game theoretic models of the Laureates typically (albeit implicitly) assume control fraud out of existence. There is a great irony to this implicit assumption in the context of Myerson’s 2012 lecture in honor of Leo Hurwicz (a co-Laureate of Myerson in 2007) because Hurwicz’s Prize lecture (read for him because his severe health problems prevented his attendance) stressed that it was essential not to make such assumptions.
The official Nobel materials on Hurwicz’s selection for the Prize emphasized this point in an interview about his work.
“‘The way I describe it is, there are two kinds of games in economics,’ Hurwicz says. ‘One is the game where people use only legal moves. Then there is the true game, the one like real life, where the strategies and moves people make, some of them contain illegal gains. So you take into account when you write the rules of the game that the players will try to cheat.’
Since imperfect results can occur in the free market − monopoly power, hidden information (Enron’s off-the-books funds, for instance), pollution, disincentives to make product improvements − Hurwicz and his colleagues wondered, how can regulators (or other players) create incentives so that everyone wins and the efficiencies of a market economy aren’t lost?
‘Leo’s research provided a way to categorize all the outcomes that are achievable in different economic settings,’ says Narayana Kocherlakota, chair of the Department of Economics at the University of Minnesota. ‘He understood that people might not abide by the rules and thought about all the possible games and arrangements and policies that could result. The way economists worldwide think through problems is heavily influenced by Leo’s thinking even today.’”
But Kocherlakota’s description and conclusion cannot both be correct. (Both can be incorrect.) First, neither Hurwicz nor any game designer “designed” a “mechanism” “so that everyone wins and the efficiencies of a market economy aren’t lost” in the context of accounting control fraud such as that designed by Enron’s fraudulent leaders. Second, the most common games designed by the Laureates do not even attempt to prevent real world frauds – they typically simply make it impossible to cheat in the faux game by creating rules of the game that they know would not prevent fraud in the real game. Third, the Laureates’ games almost invariably assume accounting control fraud out of existence by assuming that reported accounting income is an objective fact that the CEO cannot falsify. No one thinks this is true in reality, indeed, the economics literature describes financial accounting as an example of a “credence good” – one whose quality normally cannot be successfully verified by the consumer/investor even after the fact.
Fourth, if Kocherlakota’s description and conclusion were accurate the real world of finance and the world of economic scholarship would have been radically transformed. The literature would routinely discuss the real world of CEOs using fraudulent accounting to loot “their” firms and attempt to design mechanisms that created powerful disincentives against accounting control fraud. The real world would be characterized by such mechanisms. The reality is that the real world is characterized by mechanisms that are counter-incentive compatible – they are intensely criminogenic. If the Laureates’ games and mechanisms were correct we would not be suffering from recurrent, intensifying crises. The crises should have become far rarer and less severe if the mechanisms worked as promised. The fact that the crises have recurred and become far more intense alerts us to the very real possibility that the mechanisms were so badly designed that they had the “unintended consequences” of producing the opposite result of that intended by the Laureates. We also need to consider the likely “strategic” behavior of the fraudulent CEOs to consciously plan and implement mechanisms to aid their control frauds.
Even Myerson’s 2012 model designs a faux game in which the fraudulent CEO with immense wealth and political power is reduced to a dimwit who can be easily defeated by “mechanisms.” The economists’ arrogant conceit is that their “design” of the mechanisms is so “clever” that they easily counter even an epidemic of control fraud generated by adverse selection and moral hazards. The reality is that the game designers “assume a can opener.” They do not defeat fraud, they define it out of existence in the faux game while it becomes epidemic in reality. Elite white-collar criminals recognize reality – they do not even recognize the game designers’ “mechanisms” as purported anti-fraud mechanisms because the designs are so bad that the frauds routinely use them as pro-fraud mechanisms.
Myerson adds an important element to the anti-fraud model. His model is not only incapable of stopping fraud and so badly designed that it will increase control fraud – it also reserves the position of CEO for large firms for plutocrats. Here is how Myerson explained his “basic moral-hazard model” in his December 2012 lecture. He begins with two premises that are often false and dangerous.
- A project’s probability of success depends on manager’s hidden effort.
- To deter abuse of power, manager must have stakes to lose in failure.
For a CEO (which is the critical position – a vital analytical point that the game theorists almost always miss) the “project” is not the relevant issue. The CEO will usually be judged on the firm’s reported performance. Even “project” performance, however, is often a credence good where the defects may be hidden or terrible results may be portrayed as spectacularly successful results by accounting fraud. The firm’s success is frequently not dependent on the CEO’s “effort.” It is far more dependent on the CEO’s integrity and ability to select good managers and then delegate to those managers.
The statement in the second bullet point is even more dubious and dangerous – particularly the phrase that Myerson chose to emphasize. Note how much Myerson is conceding. There is a danger that the CEO will deliberately “abuse” his “power.” The reason he would do so is frightening – he can gain at the expense of the firm by abusing his power. But the situation is worse that it appears on its face, for Myerson’s emphasis springs from his assertion that it is rational for CEOs to cheat the shareholders whenever the CEO would profit from that betrayal of his fiduciary duties.
Note that fiduciary duties and ethics disappear from the discussion under Myerson’s framing. Failing to cheat would not make the CEO moral – it would make him insane. Myerson could be interpreted as being logically inconsistent about his position on morality in this lecture. Only one slide later he referred to “bad-type” managers and “good” ones. Bad and good are normally moral concepts. In the slides discussing adverse selection ethics could be interpreted as existing (fleetingly). In the slide about moral hazard if being a “good” manager means refusing to cheat even when doing so would make him wealthier, the honest CEO is irrational. It appears that the Myerson is using “bad” and “good” in a non-moral manner to describe the extent of the manager’s effort. The magic is in the phrase: “A project’s probability of success depends on manager’s hidden effort.”
The phrase reveals another manner in which Myerson’s model fails to reflect reality. A bad manager could easily increase the chances of a project reportedly succeeding and increase the extent of that success. A fraudulent CEO who causes the firm to commit control fraud can greatly increase the chances and extent of reported success. Most forms of control fraud produce real (albeit unethical) “success.” Accounting control fraud produces fictional income, but it is a “sure thing” that can easily produce record reported income with minimal effort by the CEO. A CEO does not face a dichotomy between shirking and reporting high income. Running a control fraud allows the CEO to have it all.
Bolding a phrase (manager must have stakes) does not make any contribution towards establishing its truth. Recall that Myerson’s self-description is that he is presenting “a basic moral-hazard model.” It should have been a large cautionary clue to Myerson that he was about to remove morality from a purported model of “moral hazard.” The reason that “moral hazard” got its name is that classical economists were far more perceptive about its nature than are the mathematicians who get Laureates for their modern games. Classical economists observed that the presence of moral hazard did not inexorably lead to fraud or abuse. It created a hazard (risk) for the insurance company or bank that those purchasing insurance or borrowing money might engage in fraud or sharp behavior that could cause the insurer or lender to suffer losses. The key to how large a problem moral hazard would cause was the strength of the customers’ moral restraints.
Myerson will soon explain through his use of the imperative (“must”) that he views the key to the CEO and more junior managers having the essential “stake” is that the CEO/manager “must” have great personal wealth at risk through co-investment with the firm. But if such a “stake” is essential we must ask another historical question. Why have firms long existed without the CEO/manager have such a “stake” and without (apparently) disabling “abuse” by the CEO/manager? Myerson’s use of the imperative “must” is logically untenable. One could hire managers one knew well who had a reputation for integrity. CEOs who have displayed integrity over the course of decades are very unlikely to act unethically or to shirk.
Here is how Myerson present the mathematics of his model.
pG = P(success if act good) = 1/2, pB = P(success if act bad) = 1/4,
C = (capital input) = 100, R = (returns if success) = 240,
B = (agent’s private benefit of bad action) = 30. So pGR > C > pBR+B.
Given agent’s collateral A < 60, choose w = (wage if success) > -A
to maximize expected social profit V = pG(R – w) + (1-pG)A – C
subject to: pGw – (1-pG)A > 0, [participation]
pGw – (1-pG)A > B + pBw – (1-pB)A. [G-obedience]
Solution: w = 120-A, and so V = A-40.
V > 0 is not feasible unless the agent has collateral A > 40.
The agent gets moral-hazard rents worth pGw-(1-pG)A = 60-A.
Myerson made up the numbers, but they give an idea of how he conceptualized the issues. To aid understanding, I have multiplied his numbers by $10 million (M) to provide a rough analog to a bank with $1 billion (B) in capital and total assets of $20B. It would represent a mid-sized bank. The largest systemically dangerous institutions (SDIs) would be over 50 times larger. This should help the reader understand that Myerson’s plan would literally call for the largest SDIs’ CEOs to be multi-billionaires.
Myerson has conceptualized an exceptionally high return for a successful firm/project ($2.4B on an investment of $1B), and an exceptionally high chance of investment success (50% with a “good” manager who makes an appropriate effort, 25% for a “bad” manager who shirks). The expected value of the investment if the CEO is “good” is $1.2B (a 20% return on the capital investment of $1B) and $600M (a negative 40% return) if the manager shirks. (Myerson appears to be making the implicit assumption that if the firm/project is unsuccessful the return is zero. I assume in the numbers provided above that the first $1B in “return” under Myerson’s model represents the return of the capital invested and the additional 0.2B in expected return represents the return on the $1B capital investment.) Under Myerson’s model it is critical, therefore, for shareholders to avoid managers who shirk. Myerson states that the CEO’s true “type” (which he labels “good” and “bad”) is “hidden” from the shareholders and that the model allows the CEO to successfully “misrepresent” his type.
The supposedly clever aspect of Myerson’s design of his anti-moral hazard mechanism is to get lazy CEOs to “imitate” the behavior of hard working CEOs. The not-so-clever aspect of the design is that it relies on bribing the lazy CEO to act like a hard working CEO.
“In the basic moral-hazard model without punishment (z=0), add a small probability of the manager being a bad type who only has the pB probability of success. With small A, such bad types would imitate good types to get moral-hazard rents.”
Supplying an approximation of real numbers helps expose difficulties with Myerson’s explanation of his model. First, his model does not provide any basis for assuming that problems with managers represent a “small probability.” Our work in criminology, George Akerlof’s work on markets for “lemons,” and James Pierce’s work on the savings and loan debacle all stress the danger of control fraud creating a “Gresham’s dynamic” that can drive honest firms and professionals from the markets. When cheating creates a competitive advantage market forces become perverse. Myerson’s dogmas are showing. He assumes even the least severe agency problem, shirking, occurs with only a “small probability” and he assumes control fraud out of existence even though he assumes that “bad” managers have the incentive and the ability to “misrepresent” their true “type” in order to keep their defects “hidden” from the shareholders and the board of directors.
Second, the faux cleverness is that Myerson’s “mechanism” that is supposed to prevent injury from moral hazard ignores control fraud and assumes that the “success” of a firm is an objective fact that shareholders can know and cannot be hidden by accounting fraud.
Third, the bribe required to make the lazy CEO perform better under Myerson’s model is not can be enormous and it is larger the less wealthy the CEO is. The bribe is treated by Myerson’s model as socially unproductive, so no CEO unable to provide a minimum of 40% of the firm’s capital can lead a firm that adds value to society. The optimal bribe (game theorists really do talk this way, though they prefer the euphemism “side payment” to “bribe”), for a CEO with no investable wealth, would be $600M – even if the firm is unprofitable. That is a massive bribe – 60% of the total investment. Even for a CEO who makes the minimum investment required under Myerson’s model ($400M) in my hypothetical bank the bribe would be $200M – and it must be paid even if the bank is unsuccessful under a “bad” CEO’s leadership. Myerson uses “A” to represent the CEO’s investment in the bank. If we assume the minimum 40% investment by the CEO under Myerson’s model, “A” becomes $400M. Myerson states that the “moral-hazard rents” (emphasis in original) should equal “60 – A.” Scaling these terms up to illustrate my hypothetical bank the terms would become $600M – $400M = $200M. That is an enormous bribe to pay a bad CEO to act as if he were a good CEO.
Fourth, while Myerson claims that this $200M bribe can induce a “bad CEO” “with small A” to “imitate” the actions of a “good” CEO his model refutes his claim. Again, “A” represents the CEO’s investment in the firm and for a firm the size of my hypothetical mid-sized bank the minimum capital investment in the bank by the CEO under Myerson’s model is $400M (out of a total assumed capital of $1B) – a huge capital investment that would in almost all cases make the CEO the bank’s controlling shareholder. It would also give the CEO the practical ability to structure his own pay, to select who would sit on the board of directors, and to run a control fraud with unusually great power over the bank. Myerson was trying to be provocative in his presentation, but he actually understated his point.
“But the capital that belongs to owners who control the bank provides their primary incentive to avoid irresponsible risks in investing others’ funds. So in a well-regulated financial system, some fraction of invested funds must be capital belonging to the bankers, to limit moral hazard in investment.
Modern economic investments need rich bankers (emphasis in original).”
As my hypothetical mid-sized bank shows, Myerson is not true to his logic. The largest SDIs are over 50 times larger than my hypothetical bank. They have over a trillion dollars in liabilities and purported capital of over $100B. The minimum CEO investment model under Myerson’s model would be over $40B. If the “primary” reason bank CEOs “avoid irresponsible risks” is that an enormous amount of their personal wealth is at risk because it is invested in the bank (over $40B), then only the two or three wealthiest people in the world could even conceivably be trusted under a “capitalist” system to be the largest SDIs’ CEOs. Myerson’s model literally calls for a plutocracy and claims that plutocracy is the essential driver of finance.
Note that Myerson views his claim that professionalism, ethics, and law are not the “primary” reason why bank CEOs “avoid irresponsible risks” and only greed can prevent them from acting irresponsibly as so self-evident that it does not require analysis. If he is correct, then we have the wrong CEOs, the wrong business schools, and the wrong boards of directors – and the wrong economists teaching our students and pandering to the plutocrats’ worst natures.
Note also that Myerson assumes that “owners” “control the bank.” That would almost always be true under his model, with a 40% minimum capital ownership. It is rarely true in reality. Myerson also assumes that “moral hazard” ceases to be a problem if the CEO owns a controlling interest in the bank. That is not true and it reveals a terrible lack of understanding of banks and control fraud. During the S&L debacle, for example, the National Commission on Financial Institution Reform, Recovery and Enforcement (1993) found that S&Ls controlled by a dominant shareholder/CEO were the firms most likely to engage in accounting control fraud. By (implicitly) assuming away control fraud, Myerson has assumed that if the CEO is the dominant shareholder no “agency” problem can exist. That is not correct as his example shows for the 60% of the bank’s capital contributed by other shareholders can be looted by the CEO.
Myerson has also ignored creditors. In my reasonably accurate hypothetical the bank reports that it has $1B in capital and $20B in assets. It has $19B in creditors and CEOs using financial firms as “weapons” of control fraud primarily loot the creditors. Myerson assumes no sanctions for “bad” managers, their ability to successfully “misrepresent” their true type to keep their defects “hidden” from the board of directors and shareholders, and their desire and willingness to routinely make “irresponsible” investments in order to maximize their expected returns even though they know it is likely to harm the shareholders – and to do all of this in deliberate violation of their fiduciary duties. Myerson was presenting in late 2012 – nearly 20 years after Akerlof and Romer made the critical point as forcefully as they could.
“[M]any economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4-5).
Criminologists and regulators confirmed Akerlof & Romer’s observation. Indeed, we originated the term “sure thing” to describe accounting control fraud.
Myerson’s optimal bribe is in addition to the wage that the CEO receives if the firm reports profits. If the CEO has less than $600M invested in the firm and the firm reports profits the CEO receives a wage determined by the formula: w = $1.20B – A (where “A” represents the CEO’s personal investment in the firm). (It is unclear why Myerson adds the $600M investment constraint by the CEO to his “wage” formula.) A CEO that does not invest in the firm would receive a “wage” of $1.2B (half of the total firm return) if the firm reported that it was profitable. This would, of course, produce intense incentives for the CEO to cause the firm to become a control fraud because Myerson’s model assumes that lazy CEOs have only a 25% of running a profitable firm. Myerson’s model implicitly assumes that the CEO cannot use accounting firm to cause an unprofitable firm to report that it is profitable. As Akerlof and Romer (1993) emphasized, accounting fraud is a sure thing, so under Myerson’s logic (which is inconsistent with his model) fraud is the only “rational” strategy for a lazy CEO because it is wealth-maximizing. Indeed, under Myerson’s assumption that even a manager who will not shirk has only a 50% chance of running a successful firm, accounting fraud is the optimal/rational strategy for even hard-working CEOs. Once one (implicitly) assumes away morality control fraud becomes the dominant strategy.
Note that the logic of Myerson’s model about shirking is internally inconsistent. A manager who fails to shirk if he could do so without being punished would have to be “irrational” under Myerson’s logic because he assumes that CEOs that shirk receive enormous value. The figure that Myerson chose for the supposed private value to the CEO of shirking is absurdly large: $300M in my scaled-up example for the CEO of a mid-sized bank. It is such a ridiculous number that it shows that Myerson has no understanding of CEOs. Honest CEOs are like other honest workers – they enjoy productive work. They do not seek to shirk work, and they do not experience a $300M gain by shirking. Myerson’s model either makes CEOs the laziest humans ever discovered or people who would bear an exceptionally high opportunity cost were they to work faithfully as CEOs in accordance with their fiduciary duties. Myerson’s model purportedly assumes rational behavior, but actually assumes widespread irrationality by CEOs. Myerson’s model expressly defines a CEO who passes up a $300M gain he could obtain by shirking as a “good” manager, but his model’s underlying premise should have required Myerson to define such CEOs as irrational.
Myerson assumes that the shirking problem is so severe that no firm would hire a CEO who was unable and/or unwilling to invest at least $400M in a firm the size of my hypothetical bank. Myerson’s assertion has no basis in reality, but using his assertion I have explained why his model requires a $200M bribe be paid to the CEO who makes the minimum capital contribution of $400M.
Myerson’s formula provides that the optimal maximum wage for the CEO making the minimum $400M investment in the bank, should it report it is profitable, is w = $1.2B – A ($400M) = $800M. The third component of the CEO’s total return (again, at the minimum $400M personal investment in the bank) would be the return on his investment. If successful, his portion (40%) of the total return of $2.4B might seem to be $960M, but that cannot be for (absent fraud, which Myerson assumes away) the return on equity is paid only after creditors are paid in full. Our hypothetical bank must pay employees/officers, its general and administrative expenses, and its interest expense on deposits. (We also need to distinguish between the portion of that return that represents the return of his initial investment rather than a return on his investment.) Myerson’s model would lead my (reportedly) successful hypothetical bank to receive a total return of $2.4B. Again, $1B of that represents the return of the initial capital investment. A low ball estimate of these expenses, in a very low interest rate environment, (excluding the CEO’s compensation) would represent roughly 5% of the hypothetical bank’s total assets of $20B ($1B). Even such a low ball estimate would prove too high under Myerson’s model. The total return available to pay the CEO and pay a return to the banks’ investors would be $2.4B – $1B (non-CEO expenses) = $1.4B.
The compensation (as opposed to returns of/on capital) of the bank CEO who made the minimum investment of $400M under my hypothetical (which scales up Myerson’s model to a rough approximation of a bank with $20B in assets) would be $200M (rent/bribe) + $800M (wage) = $1B. The total return (net of non-CEO expenses) available to pay the CEO and produce a (partial) return of the shareholders’ investment in the bank is $1.4 B so the bank could not even return the $1B capital invested in the bank. The CEO’s compensation is a creditor claim that has priority over the shareholders’ claim, so the CEO receives his full $1B in compensation before any return of capital is made to the shareholders. The portion of the return available to partially repay shareholders is only $400M. The CEO who makes the minimum capital contribution of $400M under Myerson’s model would receive 40% of his capital investment – $160M (for a net capital loss of $240M). The other shareholders would receive 60% of the portion of return available to pay shareholders. They would receive $240M, for a net loss of capital invested of $360M. If the bank reports that it is “successful” under Myerson’s model the equity holders will suffer crushing losses because the CEO’s compensation is so massive that it will render the bank unprofitable. If the bank reports that it is successful, the (net) impact on the CEO’s finances will be positive. He will receive $1B in compensation but suffer a $240M loss on his capital investment for a net gain of $760M on his $400M investment. Myerson’s model, however, requires shareholders to be irrational for they suffer severe losses even if the bank reports success and a total loss of capital if it does not report that it is successful.
One cannot save Myerson’s model by assuming that the $2.4B is the net return to shareholders. Such an assumption makes no sense when the CEO’s income is dependent on reported net profits. Under that assumption the CEO’s total receipt of funds from the bank for “success” would be $1B in compensation and $960M (40%) of the net return to shareholders. The CEO would receive the full return of his capital investment of $400M and earn a return of $560M on that investment. That combined receipt of $1B in compensation, the return of the CEO’s capital investment of $400M, and the $560M return on that investment would produce a total return of 390% return on the CEO’s $400M investment. The other shareholders would receive 60% of the $2.4B returns to investors. Backing out the return of their $600M capital investment, their return on investment if the bank reported success would be $1.44B – $600M = $840M (a 140% return on their investment). It is easy to see from this why Myerson’s work has proven highly popular with bank CEOs, proving their rationality.
Under Myerson’s model (scaled-up to my hypothetical mid-sized bank) the CEO making the minimum $400M capital investment in the bank would receive $200M in compensation from the bank as his rent/bribe even if the investment failed. The CEO, however, would lose his $400M investment in the bank for a net loss of $200M if the investment failed. The other shareholders would lose their $600M investment in the bank. We calculate the “expected return” by weighting the two outcomes by their probability (50% chance of success, assuming the CEO is a non-shirker). The expected return to a non-shirking CEO who made the minimum $400M investment in the hypothetical bank would be (0.5 X $1.96B) + (0.5 X – 200M) = $880M. (Recall that his return must repay the CEO’s capital investment of $400M in full before it can begin to provide a return on his investment in the bank. The CEO’s total expected return on investment (compensation + net capital distribution) is $880M – $400M = $480M (120%).
The expected return to the other bank shareholders, assuming a non-shirking CEO making the $400M minimum investment, would be (0.5 X $1.44B) + (0.5 X -$600M) = ($720M – $300M) = $420M. Once more, however, we need to back out the return of the capital the non-CEO shareholders invested in the bank before we can calculate their expected return on capital. Because the expected total return ($420M) to the non-CEO shareholders is less than their investment ($600M) we know that their expected return on investment is negative (by $180M). (Their expected return on investment is a negative 30 percent.) Alas, Myerson’s model requires shareholders to be irrational because their expected return even with a non-shirking CEO is negative. This negative expected value occurs even if we make the wholly unrealistic assumption that the CEO’s massive compensation under Myerson’s model does not cause any reduction in the net payoff to the other shareholders if the bank reports success.
Under any realistic assumptions the expected return of the non-CEO shareholders is far more deeply negative. The only way to prevent this result is to assume an even more ludicrously inflated return if the bank reports success. The return that Myerson assumes for a firm that reports success is already an absurd 140% if one interprets his phrase “R = (returns if success) = 240” (on the investment of 100) (in my hypothetical mid-sized banks these numbers are scaled-up to $2.4B and $1B, respectively) as providing the total net cash flow from the bank investing $1B. In that case the shareholders hope that the cash flow will be adequate to both return the principal amount invested by the bank (a total of $1B) and pay a return on that investment ($1.4B or 140% in this hypothetical). The markets do not offer 140% expected returns – and if they did it would be for grotesquely risky investments in which the probability of a non-shirking manager securing a positive return is minimal – not 50 percent. If one assumes that Myerson really meant by the phrase “(returns if success) = 240” to mean that the net cash flow from the investment was $3.4B (when scaled-up to my hypothetical) so that the shareholders received the return of their investment ($1B) plus a 240% return the result becomes even sillier. Doing so would make the non-CEO investors’ expected value of investing under Myerson’s model barely positive. The markets do not offer such returns on investments that have a 50% probability of success. If they did, we would all be immensely wealthy. A subprime liar’s loan had roughly a 50% chance of success. Banks contracted to receive a yield around 10 percent for making such loans. By 2006, roughly half of all the loans called “subprime” were also liar’s loans. Assuming a 140% return – and assuming that non-shirking CEOs could obtain such a return half the time – was a none-too-subtle means of Myerson stacking the deck in favor of his claim that plutocrats make our economy hum. If he was really assuming that a non-shirking CEO could obtain a 240% return for the firm in its investments (with a probability of 0.5) then Myerson is simply demonstrating the absurdity of his model.
The analytical problems in Myerson’ model illustrate a more general point about the Laureates’ game theoretic models that I am criticizing in this series of articles. The math is exceptionally complex, but the numbers in the models are not real and they are not tested for even the most basic test of reasonableness. As I have shown, the numbers matter – enormously. Using even approximations of the real numbers helps reveal critical analytical flaws missed by model designers. Myerson provides an excellent example of the problems that arise when the model designer gets to make up the numbers until they seem to support his priors (in Myerson’s case, his desire to vindicate von Hayek through Myerson’s paean to plutocrats as capitalism’s core advantage over communism). The ability to make it up, however, removes most of the discipline that math can provide and allows unacknowledged dogma to triumph in the design of the model. The models become “just so” stories – with the dogma obscured by complex equations and the most unclear writing in all of economics.
It is important to emphasize that the combination of the CEO’s exposure to substantial loss should the bank fail to report profitability and his opportunity to receive exceptional income should the bank report profitability creates a strong incentive for CEOs to run control frauds that make (record) reported profitability a “sure thing.” More subtly, one can see that existing shareholders have perverse incentives even if they realize they have invested in a control fraud. If the CEO’s accounting fraud is disclosed they stand to lose most of their investment.
Myerson claims that his model “is simple, but it may offer insights into problems of communism, capturing the implicit logic in some of Hayek’s intuitive arguments”:
“To assume that it is possible to create conditions of full competition without making those who are responsible for the decisions pay for their mistakes seems to be pure illusion.” (Hayek,1935)
Von Hayek’s intuitive argument has broader problems as a defense of “capitalism.” First, Myerson claims that his model demonstrates that the unique advantage of capitalism over communism is extreme income inequality. Under his model the largest SDIs would require a minimum capital investment by the CEO of over $20B in our trillion dollar mega-banks. Myerson asserts that it is essential that the CEO have this much “skin in the game” to meet von Hayek’s requirement that the CEO suffer severe losses if the firm is unsuccessful. Recall that Myerson bolded his central claim about CEOs: “manager must have stakes.” Forbes’ list of the World’s wealthiest demonstrates that under Myerson’s (and von Hayek’s) reasoning our central economic problem is insufficient plutocrats.
Myerson’s model requires not only thousands of billionaires, but thousands of billionaires who would demonstrate such extreme competence as CEOs that they would double the chances of a firm investment being successful. We need billionaires with such exceptional competence in over a thousand industries and many thousands of firms. The wealthy dilettantes who inherited their wealth are of no help in filling our need for proficient plutocrats to serve as CEOs.
In fairness, Myerson’s model would soon answer an aspect of our plutocrat gap. Because the non-shirking CEOs’ expected return on their investments under Myerson’s optimal “moral hazard model” is 120% those CEOs will quickly become multi-billionaires. It is not clear who will have the income to buy their firms’ products, however, because the non-CEO shareholders’ expected return is negative even when the CEO is a non-shirker.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @williamkblack
By god you’re right. The paper uses a series of invented numbers with no identifiably sound methodology behind their inclusion. The only conclusion one can draw is that he uses these particular numbers because they give a particular result. It’s junk and the man is apparently paid for entirely non-productive work.
More simplistically, here’s how _any_ CEO would “game” the system where-by firms require the CEO to purchase a 40% share in the company they lead.
First, we’ll ignore the bootstrap problem and assume Jane Doe is named CEO of company XYZ. Upon Day 1, she buys a 40% equity stake in a company worth $1B and a share price of $100.
Jane Doe sees her exit strategy. She announces a long-term project that will triple the firms profits. The shareprice moves as a result, say, to $120. Anticipating this, she tenders her resignation (behind closed doors) which triggers the “CEO Succession Plan”. Now she knows that the successing CEO will be required to purchase 40% equity in the company, so she knows she can sell all (or substantially all) of her 40% equity to the successor at this inflated price.
The successor, John Doe (no relation), is likewise “rational” and executes a similar strategy. Thus, this essentially becomes a Ponzi scheme.
Again it seems, two words seem to appear in close relationship: von Hayek and erroneous-assumptions. In John Maynard Keynes’ The General Theory of Employment, Interest and Money appendix to Chapter 14 there occurs a curious section in which the ubiquitous von Hayek’s name also prominently appears as it does elsewhere throughout JMK’s collected writings. Below is a copy of that passage:
A peculiar theory of the rate of interest has been propounded by Professor von Mises and adopted from him by Professor Hayek and also, I think, by Professor Robbins; namely, that changes in the rate of interest can be identified with changes in the relative price levels of consumption-goods and capital-goods.(1) It is not clear how this conclusion is reached. But the argument seems to run as follows. By a somewhat drastic simplification the marginal efficiency of capital is taken as measured by the ratio of the supply price of new consumers’ goods to the supply price of new producers’ goods.(2) This is then identified with the rate of interest. The fact is called to notice that a fall in the rate of interest is favourable to investment. Ergo, a fall in the ratio of the price of consumers’ goods to the price of producer’s goods is favourable to investment.
By this means a link is established between increased saving by an individual and increased aggregate investment. For it is common ground that increased individual saving will cause a fall in the price of consumers’ goods, and, quite possibly, a
(1) The Theory of Money and Credit, p. 339 et passim, particularly p. 363.
(2) If we are in a long-period equilibrium, special assumptions might be devised on which this could be justified. But when the prices in question are the prices prevailing in slump conditions, the simplification of supposing that the entrepreneur will, in forming his expectations, assume these prices to be permanent, is certain to be misleading. Moreover, if he does, the prices of the existing stock of producers’ goods will fall in the same proportion as the prices of consumers’ goods.
greater fall than in the price of producers’ goods; hence, according to the above reasoning, it means a reduction in the rate of interest which will stimulate investment. But, of course, a lowering of the marginal efficiency of particular capital assets, and hence a lowering of the schedule of the marginal efficiency of capital in general, has exactly the opposite effect to what the above arrangement assumes. For investment is stimulated either by a raising of the schedule of the marginal efficiency or by a lowering of the rate of interest. As a result of confusing the marginal efficiency of capital with the rate of interest, Professor von Mises and his disciples have got their conclusions exactly the wrong way round. A good example of a confusion along these lines is given by the following passage by Professor Alvin Hansen:(1) ‘It has been suggested by some economists that the net effect of reduced spending will be a lower price level of consumers’ goods than would otherwise have been the case, and that, in consequence, the stimulus to investment in fixed capital would thereby tend to be minimized. This view is, however, incorrect and is based on a confusion of the effect on capital formation of (a) higher or lower prices of consumers’ goods, and (b) a change in the rate of interest. It is true that in consequence of decreased spending and increased saving, consumers’ prices would be low relative to the prices of producers’ goods. But this, in effect, means a lower rate of interest, and a lower rate of interest stimulates an expansion of capital investment in fields which a higher rates would be unprofitable.’
(1) Economic Reconstruction, p. 233.
Both in JMK’s text and footnotes are scattered other references of noted error (one of which casually noted there was not even a mention of the roll of money in their economic theory – IIRC) on the part of von Hayek or other acolytes of that thought process; here the faulty foundations are exposed in (my) bolded section. Von Hayek’s foundations can be shown to be faulty, how sound can the edifice he builds upon those foundations be? Or those edifices built by subsequent ideological acolytes and fellow travelers. Not only have the pseudo-philosophic ramblings of von Hayek been used to sustain a smörgåsbord of economic daft prescriptions masquerading as valid theory, the irrational paranoia encapsulated has been used to deregulate and thus unbind the most rapacious segments a society can produce. Such edifice is without substance; like a pipe-dream, will implode as soon as the fires that feed it go out.
Copied passage from John Maynard Keynes, The General Theory of Employment …, Macmillan – St. Martin’s Press for Royal Economic Society ©1973 (now some have claim to have read ca. 569 words from JMK – res ipsa loquitur)
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