Topic: Finance, Banking & Monetary Policy

Martin Feldstein vs./ Fed Chairman Powell and Irving Fisher

In a November 27 Wall Street Journal article, “Raise Rates Today to Fight a Recession Tomorrow,” Martin Feldstein reminded us he has been repeatedly cheerleading since 2013 for the Fed to raise interest rates faster and higher “to prevent the overvaluation of assets” whose prices “will collapse when long-term interest rates rise.” I critiqued one of Feldstein’s similar articles in 2017.

November 27 was an odd time to be fretting about overvaluation. The day before Mr. Feldstein’s article appeared, a headline in the same newspaper – “Stocks, Bonds Face Year in Red” – observed that “stocks, bonds and commodities are staging a rare simultaneous retreat” 

Yet Feldstein urged the Fed to keep pushing short-term rates higher (3.4% “will not be high enough”) to somehow ease the pain of a supposedly inevitable increase in long-term interest rates (even if inflation stays near 2%), and to also make it easier to lower short-term rates in response to some future recession, a recession probably caused by the Fed raising rates too much (see graph).

Mr. Feldstein defined “overvalued assets” in terms of historical averages. “The price-earnings ratio is nearly 40% above its long-term average,” he warned. But that is because long-term interest rates are more than 50% below their long-term average. The yield on 10-year Treasury bonds averaged 6.5% since 1970, ranging from 1.8% in 2012 to 13.9% in 1981.  The p/e ratio almost always moves higher when long-term interest rates move lower.  

Why are long-term interest rates so low? Because inflation has remained persistently low, and because the Fed can’t push short-term rates much above inflation for long without provoking asset liquidation and recession.  The graph uses the GNP deflator (blue line) to gauge inflation because it covers the whole economy and is available over many decades. The fed funds rate clearly rises with higher inflation and falls with lower inflation, so the notion of raising the funds rate to reduce inflation is self-contradictory. Even before Irving Fisher (1896) economists such as Thornton and Mill understood that nominal interest rates rise and fall with inflation, with real interest rates being cyclical but relatively stable.   

Fed funds rate tracks inflation

When Feldstein predicted a stock market crash “when long-term interest rates rise” he explicitly did not predict a rise in inflation. His prediction relied instead on a key conceptual ambiguity: What does a “normal” interest rate mean, and why should we presume that global bond markets gravitate toward such a historical norm?

Former Senator Phil Gramm and Michael Solon, writing in the December 11 Wall Street Journal, redefine “normal” to mean arbitrarily excluding the high interest rates of 1977-82 and also the low interest rates of 2009-2018. After further subtracting inflation, this leaves them with a postwar trimmed average rate of 1.2% for real Treasury “borrowing costs” (presumably a weighted blend of short-term and long-term rates). “This suggests,” they conclude, “that if the Fed could meet its 2% inflation target during this recovery, Treasury borrowing costs might stay close to the 3.2% range.” 

The authors nevertheless raise concerns that if borrowing costs rose to 4.8% – which implies 3.6% inflation – it could become difficult to roll over the accumulated Obama-era debt without the Fed monetizing too many Treasury bills and bonds (paying for them by crediting bank reserves that currently pay interest). They conclude, convincingly, that firm spending caps and making peace on trade would make the future economy far more predictable and secure.

The day after Feldstein’s article, Fed Chairman Jerome Powell questioned the wisdom of continually raising short-term interest rates regardless of economic reality.  His comments greatly increased prices of stocks and bonds until “Tariff Man Tuesday” terrified world investors. Yet Chairman Powell’s changing conjectures about the fed funds rate being either near or far from to some unknowable “neutral rate” seem nearly as arbitrary and unsettling as Mr. Feldstein’s divinations about U.S. long-term rates reverting to an ancient average.

To sum this all up: 1. Stock prices have been high relative to earnings because bond yields have been low; 2. Bond yields have been low because the fed funds rate has been low; 3. The fed funds rate has been low because inflation has been low. 

Anyone predicting a sizable increase in long-term interest rates must also be predicting a sizable increase in inflation. Because inflation is largely a global phenomenon, however, it would be extremely challenging to persuasively predict higher inflation (and therefore higher bond yields) while much of the world economy is struggling to expand, the dollar has been rising and commodity prices falling.

Progressive Corporate Governance Reforms

This blog post is part of a larger series on “Stock-Market Short-Termism” (see also my entry on share-buybacks). I will be assessing one proposed cure, corporate governance reforms, and will argue that it is likely to be iatrogenic.

 

I.

On August 15, 2018, Senator Elizabeth Warren formally introduced her “Accountable Capitalism Act”, that would, inter alia, require of all firms generating $1 billion or more in revenue that “no fewer than 40% of its directors are selected by the corporation’s employees.” In mandating that corporations include employees qua stakeholders in the firm’s major decisions, government would be putting its thumb on the scale in shifting the balance of power away from the corporate governance outcome that has emerged in the free-market: shareholders today exclusively determine the composition of the board of directors. Moreover, progressive politicians and academics would be putting a thumb in the eye of their long-standing bete-noir, the “shareholder value paradigm”.

Employee representation on the board is known as “co-determination”, part of a larger constellation of corporate governance institutions that comprise the “Rhenish model” of capitalism. Its primary exemplar, Germany, is trumpeted as the prepossessing poster child of this alternative to shareholder über alles “Anglo-capitalism”. In her press release, Senator Warren makes this inspiration explicit, claiming that she is “borrowing from the successful approach in Germany and other developed economies”. Germany’s co-determination is praised by its progressive proponents not just for its greater “economic justice”, but because it has “held back the forces of short-termism”. In a policy brief for the Roosevelt Institute titled “Fighting Short-Termism with Worker Power”, economist Susan Holmberg argues that co-determination will create “resilience against the pressures of short-termism”. Senator Warren penned an op-ed in the Wall St. Journal to accompany her formal press release, in which she argued that her bill would be a corrective against corporate executives being overly focused on “producing short-term share-price increases”.  

How, exactly, would greater employee influence over corporate governance combat short-termism? Proponents argue that employee representatives would prevent both exorbitant CEO pay and excessive share buybacks. Because the typical employee has a longer tenure at the firm than the typical shareholder, employees are therefore better custodians of the firm’s revenues, with an eye toward long-term viability, not the maximization of the next earnings report.

 

II.

The first of many red flags that appears as we proceed along this train of reasoning is that the Germanic model did not evolve organically as the result of firms realizing that increasing employee representation was in their own self-interest. As Holmberg herself notes, the 1976 Employee Co-Determination Act and related legislation impose this corporate governance paradigm on German firms, requiring that 50% of the supervisory board represent employees rather than shareholders. Conversely, in the United States, it remains perfectly legal for a firm to so structure its charter. The fact that few firms avail themselves of this eminently superior option should give one pause. The fact that German capitalism is so-characterized speaks less to the economic merits of co-determination and more to the political adroitness of its advocates.  

When considering the likely effects Warren’s plan would have on U.S. firms, the lessons of the U.S. experience with unions will be instructive. In fact, it’s hard not to view mandatory employee board representation as a rearguard action by a labor movement that has seen private sector union membership decline from a post-war high of 34% in 1954 to just under 7% today.[1] In many respects, employee board quotas are the functional analogue of a union granted a legal monopoly to represent the employees of a given firm. While board quotas may be more efficient than unions insofar as they avoid the bargaining costs associated with bilateral monopoly, they nonetheless serve to tilt the balance-of-power over major firm decisions toward employee interests.

The first devil lurking in the details of Warren’s plan is: who counts as an employee for the purposes of allocating director votes? All employees, including management below the C-suite? Or only non-managerial employees? However the definition is generated (and gerrymandered), an insuperable problem arises, one that similarly confronted unions. A firm’s employees do not have homogeneous preferences. More senior employees on the brink of retirement have a different time-horizon than do younger employees. Employees who intend to snag a few years of experience before moving to another firm or another industry differ from employees who are dreaming of a company watch on their 20th anniversary. These varying constituencies will have starkly different preferences as to how the firm’s free cash flow is allocated: higher wages now, more long-term capital investment that will pay off in decades, or shoring up the solvency of the employee pension plan? Similarly, skilled employees will be far less averse to R&D that leads to technology - complementary to their human capital - than will the unskilled employees with whom it competes. Thus, the category error baked into co-determination is the conceptualization of “employees” as an undifferentiated bloc. Whoever the median employee voter places on the board will inevitably take actions that result in intra­-employee redistribution.

When considering the preferences that employees broadly do share, it is naïve to think that they will always redound to the long-term benefit of the firm. First, employees of all shapes and sizes uniformly prefer that less cash flow be allocated to share buybacks and dividends. Indeed, champions of co-determination celebrate the extent to which it will serve as a brake on such equity outlays. But, again, we must keep in mind the fallacy of composition: when all firms reduce outlays, the cost of capital for firms with profitable investment opportunities rises and these firms are then unable to grow (read: hire new workers) as quickly.

Moreover, employees won’t necessarily want to reinvest earnings into long-term investments like CAPEX and R&D. And forget returning this surplus to the consumer in the form of lower prices. Instead, they will be inclined to leverage their legislatively-conferred bargaining power to divert profits into wages and benefits in excess of the marginal product of their labor. Despite the romance and sloganeering, this is as much an instance of rent-seeking as corporate Ferraris and “excessive” stock buybacks. On top of higher compensation in the present, employee representatives will attempt to commit a greater percentage of the firm’s future cashflow into retirement and pension plans, rather than R&D projects with an uncertain future payoff that will anyhow make half of them redundant.

 

III.

Employee representatives will have an interest in other measures that similarly reduce the long-term flexibility of the firm. Other than pre-committing future cashflows to non-productive investments such as pension plans, employees will also prefer greater job security. In raising the costs of replacing an unproductive worker, they are thereby raising the ex-ante costs of hiring generally. Greater employee protections mean that the firm faces higher costs when restructuring the skillset and human capital composition of its workforce to meet the always-evolving market landscape. The relative prices of the highly heterogeneous labor pool are constantly in flux, and firms must be able to nimbly rebalance their personnel to adapt and stay competitive. Moreover, overly rigid job protection reduces a firm’s ability to temporarily downsize its workforce in response to exigent circumstances. Co-determination advocates might claim that buybacks, dividends, and executive bonuses should be jettisoned before employees when times get tough. But the fact of the matter remains: reducing the degrees of freedom by which a firm might respond to a given short-term adversity compromises its long-term viability. Employee representatives on the board are trading economic efficiency and adaptability for the sake of incumbent employees today. But who can blame them? They are merely responding to their constituency.      

These ossifying effects are not armchair speculation. Far from sagely stewarding tax revenues for the benefit of posterity, public sector unions have managed to rack up $4.4 trillion in unfunded liabilities, darkening the long-run fiscal outlook for many states and municipalities. The much-lamented decline in manufacturing employment in the U.S. is a story first of firms escaping the unionized Midwest to the South, and then the radical restructuring and downsizing of a less protected workforce to a small coterie of highly skilled employees intensively utilizing technology. This explains why U.S. manufacturing output has risen over the past several decades despite the precipitous drop-off in employment: to the immense benefit of U.S consumers. This process would have been seriously stymied if employees were dealt an artificially strong hand at the table via legislative fiat.

Building on a considerable theoretical literature that predicts greater employee bargaining power will reduce research into R&D and other productivity-enhancing investments,[2] subsequent meta-analyses of the empirical effects of unions confirm that they are associated with lower productivity growth, lower profits, and lower stock market valuations.[3] It’s worth noting that, particularly since 1980, Western European total factor productivity (TFP) growth has dramatically lagged behind that of the United States.[4] Insofar as unions do correlate with productivity increases, the mechanism appears to be via increased communication between workers and management. This is a goal that any half-competent management will attempt voluntarily, but that is impeded by Section 8(a)(2) of the National Labor Relation Act’s prohibition on employer-sponsored unions.

 


[1] Bureau of Labor Statistics, Union Members Summary

[2] Baldwin (1983); Grout (1984); Connollay, Hirsch, and Hirschey (1986)

[3] Doucouliagos and Laroche (2003, 2005)

[4] Fernandez-Villaverde and Ohanian (2018))

Central Bank Digital Currency Threatens Financial Privacy and Economic Growth

Various proposals for “central bank digital currency” (CBDC) have been under discussion for several years now. The central bank of Ecuador launched a digital currency in 2015 — and shut down the failed project three years later. A number of economists have addressed the topic.

What is a CBDC? It is a payment medium that would be denominated in the established fiat money unit, not in any new unit. There are two main models: (1) a digital token that, like traditional coins and currency notes, and like Bitcoin, passes peer-to-peer without going through the interbank clearing system, presumably validated by a distributed-ledger blockchain system; and (2) account balances that individuals and businesses can directly hold on the books of the central bank, retail versions of the balances that commercial banks presently hold there for interbank payments. The latter model is not really properly called a currency, being a deposit-transfer system, but it is put under the “digital currency” umbrella because it resembles fiat currency notes in being a liability of the central bank, and as such a “final” means of payment, and because transactions would settle nearly instantly on a single balance sheet.[1]

The debate over CBDCs was recently revived by the IMF’s Managing Director Christine Lagarde in a speech suggesting, rather tentatively, that central banks should consider issuing some kind of digital currency so as to keep up with the times. (Why on earth the IMF continues to exist, long after the demise of the Bretton Woods system that it was created to support, is a question for another time.)

Should the Fed Raise Rates Now to Combat Future Recessions?

Many macreconomists believe that the Fed needs to keep raising rates now so it can lower them in future to combat a recession.  See, for example, my colleague Martin Feldstein’s recent op-ed in the WSJ.

I have always been puzzled by this argument; it seems to assume an asymmetry in the effects of raising versus lowering rates. 

Specifically, if raising rates now will hurt the economy just as much as lowering them later will help, why is the net effect beneficial? To a first approximation, one might expect a symmetric effect, which makes the standard case for higher rates now unconvincing.

Share Buybacks: Mismeasured and Misunderstood

In March of this year, Forbes published an article with the following lede:

The Economist has called them “an addiction to corporate cocaine.” Reuters has called them “self-cannibalization.” The Financial Times has called them “an overwhelming conflict of interest.” In an article that won the HBR McKinsey Award for the best article of the year, Harvard Business Review has called them “stock price manipulation.” These influential journals make a powerful case that wholesale stock buybacks are a bad idea—bad economically, bad financially, bad socially, bad legally and bad morally.

There is no shortage of hand-wringing over “excessive” stock buybacks, either in the academic literature or in the popular media. Such criticisms are misguided in two crucial ways. Methodologically, they overstate the scale of the problem (such as it is) by observing gross payouts instead of payouts net of issuance, and by neglecting the extent to which firms are simply substituting low-interest debt for equity financing. Second, while accusing shareholders of myopia and executives of cupidity, such critics are not taking a properly panoptic view of the function that buybacks serve in the broader equity ecosystem.    

I.

A 2018 report by the Roosevelt Institute cites a statistic that lies at the heart of alarmism over the size and scale of stock buybacks:

Over the last decade-and-a-half, firms have sent 94 percent of corporate profits out to shareholders, in the form of buybacks, as well as dividends, leaving companies to argue that there is little available for employee compensation or investment.[1]

But other recent research dramatically qualifies such despair. Harvard researchers Jesse Fried and Charles Wang offer a persuasive rejoinder to concerns over the scale of equity outlays:

During 2007-2016, S&P 500 firms distributed to shareholders more than $4.2 trillion through stock buybacks and about $2.8 trillion through dividends. These cash outflows, totaling $7 trillion, represented 96% of these firms’ net income during that decade. But during this same period, S&P 500 firms absorbed, directly or indirectly, $3.3 trillion of equity capital from shareholders through share issuances. Net shareholder payouts from S&P 500 firms were therefore only about $3.7 trillion, or 50% of these firms’ net income.[2]

Moreover, this figure pertains only to those firms listed on the S&P 500, which are relatively mature, vs. publicly traded firms not listed on the index. When accounting for unlisted public firms, who are net importers of capital, the share of corporate income channeled into buybacks and dividends falls further, to 41%.[3] Yet net equity outlays don’t necessarily translate into a reduced cash position. Low-interest rates mean that firms can afford to reorient their balance sheets away from equity and toward debt financing. In fact, in the years 1989-2012, fully 42% of equity payouts were offset by a debt issuance that same year.[4] In a recent working paper, Mark Roe takes direct aim at this argument:

Low interest rates pushed corporate America to substitute low-interest debt for stock. Viewed as a capital structure decision, the double trend—more low-interest debt, less equity—fits the short-termist critique poorly. Overall, public firms have more cash, not less.[5]

Not only do public corporations retain more of their earnings than is indicated by gross equity outlays (including debt financing, total corporate cash balances rose from $3.3 to $4.5 trillion between 2007-2016[6]), there is evidence to suggest that this extra liquidity is flowing into long-term investments such as R&D. Again quoting from Fried and Wang:

Further, we show that public firms deployed much of this capacity for investment in R&D and CAPEX. In absolute terms, total investment (R&D and CAPEX) rose to a record level. And relative to revenues, total investment rose to levels not seen since the late 1990s economic boom.

If anything, these large gross capital movements, and net equity outlays, are a sign of economic efficiency, not destructive short-termism. As John Cochrane explains in the Wall St. Journal, if Company A is short on investment ideas but long on cash, and Company B is facing the opposite situation, a share buyback allows investors to reallocate their capital to its higher-value use (in the hands of Company B).[7] Nonetheless, critics maintain not only that the scale of buybacks is immense, but that their influence is malign.

II.

i.

Share buybacks, to the extent that they are in fact occurring, are highlighted as one of many symptoms of a greater pathology plaguing our economy: short-termism.

Contra the proponents of the efficient markets hypothesis, who argue that prices on the stock market incorporate all extant information about a firm’s current and expected future profits - discounted accordingly - there exists a considerable economics literature that grants the premise that shareholders are rational, but that posits that this individual shareholder rationality does not aggregate to rationality at the market level. One such market failure is said to obtain in publicly traded equities, known variously as “short-termism, “quarterly capitalism”, or, more formally, the “myopia hypothesis.”

While accusations of stock-market short-termism are intellectually buttressed by different arguments[8], the most common strain of the “myopia hypothesis” proceeds as follows: the managers of publicly traded firms, whose shares trade in deep and liquid markets, are hostage to the over-diversified and under-informed marginal shareholder, who moves the share price not in response to new information about a firm’s fundamentals, but in response to the latest, easily digestible quarterly earnings report. Instead of undertaking investments in the present that might have a substantial return several years down the road, managers are induced to mimic the priorities of transient shareholders uninterested in a firm’s long-term strategy. Future-oriented firms that resist this temptation will be penalized, finding it more difficult to raise capital. This will in turn affect their bottom line, jeopardizing their ability to even survive to the point at which they would reap the returns from their long-term investments.

The seeming insuperability of such incentives has led to calls for a variety of legal remedies: from relatively minor vesting restrictions on executive stock options to a wholesale paradigm shift from our free-wheeling “liberal market economy” to a Franco-Germanic-Japanese style “coordinated market economy” in which patient, farsighted institutional bloc-holders substitute for a dispersed set of myopic, over-diversified shareholders.[9]  While few policymakers have the stomach to commit hari-kari on our institutional innards in such a wholesale fashion, more “modest” proposals are advanced (and often achieved) by figures such as Barack Obama and Elizabeth Warren on a routine basis, but without the redeeming Swiftian irony or humor.[10] One such cure proposed for the short-termism disease is a restriction on share buybacks. I will spend the remainder of this post summarizing why critics find buybacks to be problematic, countering this diagnosis with arguments as to the important role that buybacks play in equity markets, and will suggest that this proposed “cure” is likely to be iatrogenic.

On Fiscally Neutral Monetary Policy

Of many interesting things said during Cato’s 36th Monetary Conference, one in particular tempted me to rush to the podium to give its author a big hug. The speaker, Joe Gagnon of the Peterson Institute, was calling into question the now-conventional wisdom that, to avoid interfering with the efficient allocation of credit or otherwise involving itself in matters best left to Congress, the Fed must stick to purchasing Treasury securities, and nothing else.

“It puzzles me,” Joe said (at 00:31:36)

why people think that the Fed should only allocate credit to the government. Why is that the obvious thing to do? …What seems to me more neutral would be [for the Fed and central banks generally to] hold the market basket of all assets, and then conduct their policy proportionately in all assets. That doesn’t favor anybody or any sector — it’s neutral. It seems like the natural way to go.

Think tank employees, and employees at different think tanks especially, aren’t generally inclined to hug one another. But if one is, you can bet your boots its because the other fellow said something he’d have liked to have said himself.

In fact I’ve long been planning to write a post on the issue Joe raised, making an argument quite similar to his. I even started the project, present title and all, several months ago, only to shove it into my “drafts” folder, where it’s been gathering dust ever since. Thanks to Joe, I’m finally inspired to finish what I started.

Index Funds: Promise or Peril? Part II

This is the second entry in a two-part series on the rise of index funds in U.S. equities markets. This post is for the intrepid reader interested in a thorough survey of the empirical and theoretical literature concerning the implications of institutional investors. In the first entry of this series, I disputed the mechanisms by which index funds are argued to exert an outsized influence on the firms within their portfolios. But in this second entry, I will instead grant this key premise of the anti-trust advocates’ argument: index funds, either individually or as a group, have a significant degree of influence over major decisions made by the firms in their portfolio. But the anti-trusters then go on to argue that index funds will deploy this power to induce these firms’ management to restrict intra-industry competition. While management at any given firm in an industry will be unwilling to unilaterally disarm, the fact that index funds are simultaneously invested in all of the publicly-traded incumbents in an industry allows for a solution to the prisoners’ dilemma dynamic which would otherwise thwart efforts at oligopolistic collusion.

I.

In this post I will grant the premise that index funds, as the plurality shareholders of a given firm, will be able to select for a management team and board of directors willing to pursue their preference for maximizing total industry profits instead of individual firm profits. In this sense, we have a principal-agent model in which the principal (index funds) keeps its agent (the firm’s management) on a tight leash. This power indeed presents the potential for index funds to diminish the value of the individual firm, thereby harming the other shareholders. Yet this same governance dynamic which allows for the possibility of such speculative, thinly substantiated harm to shareholders[1]<, similarly offers a corrective for a much greater and empirically ever-present agency cost which confronts all publicly traded firms: managerial rent-seeking.

Since the publication of Berle and Means’ The Modern Corporation and Private Property in 1932, the Ur-text of corporate governance theory, scholars have elaborated on and formally modeled the profound asymmetry between a corporation’s relatively small and cohesive management team and its dispersed shareholders (Manne 1964; Clark 1986; Easterbrook and Fischel 1991). Shareholders face a collective action problem vis-a-vis the managers who allocate their capital on their behalf: no individual shareholder is sufficiently incentivized to incur costs monitoring the management to ensure these funds are being directed toward their profit-maximizing use, because any gains which accrue from such monitoring must be distributed amongst the shareholders pro-rata, and cannot be internalized by the individual who does the monitoring.

Compounding the asymmetries which inhere in the ownership vs. control relationship are a variety of state and federal laws which increase the collective action costs faced by shareholders when attempting to replace bad management. In two highly influential law review articles, Bernard Black discusses a variety of legal impediments to coordinated shareholder action, ranging from costly SEC disclosure requirements, encumbrances on proxy campaigns, and legislation such as the Williams Act which regulate tender offers[2][3]. A more recent analysis by Gilson and Gordon (2013) indicates that many of these regulatory frictions persist. Whenever transaction costs to takeovers are raised, the market for corporate control becomes less liquid, allowing for a firm’s management to extract greater wealth transfers from a firm’s creditors and shareholders. Alan Schwartz put the effects of such legislation bluntly in his 1986 article Search Theory and the Tender Offer Auction which predated the rise of index funds: “Capital markets cannot overcome the inefficiency the Williams Act creates”.

Between their structural disadvantage as monitors and the institutional deformities introduced by the political process, shareholders face a severe principal-agent problem vis-a-vis management. A massive literature, known as the “Managerial Power Perspective”, has emerged to document the ways in which corporate charters and compensation practices have in practice been disproportionately shaped by CEOs and other senior executives (see Bebchuk and Fried’s 2004 book Pay Without Performance, as well as Bebchuk, Cohen and Ferrell 2009, for an excellent overview). Exorbitant salaries, golden parachutes, and poison pills are some of the many ways in which, according to this perspective, corporate governance in practice deviates in a pro-management direction from the “optimal contract” which would otherwise obtain in a competitive, low-transaction cost landscape of symmetrically informed arms-length deals between management and shareholders. Indeed, many of the same progressive concerns, such as income inequality, which animate the anti-trust proposals of the “common ownership” paradigm are similarly leveled against the menacing figure of the rent-seeking, imperial CEO. 

It is ironic, then, that the rise of index funds is likely to be ameliorative of this very principal-agent problem. The “common ownership” paradigm argues that index funds have perverse incentives insofar as they will induce management to reduce intra-industry competition, thereby harming the firm’s other shareholders. This amounts to an intra-shareholder wealth transfer. However, even according to this perspective, index funds will not be willing to abide the classic example of a wealth transfer from shareholders to management[4]. Such managerial rent-seeking can come in many forms: salary in excess of marginal product of labor, personal consumption of perquisites, “empire building” which entrenches management by raising its replacement cost, and so on ad infinitum. In such instances, index funds will not countenance this non-profit-maximizing behavior, because it is not in pursuit of maximizing total industry profits. Instead, index funds will be incentivized to minimize managerial rent-seeking, the benefit of which will redound to all of the firm’s shareholders. I will now discuss both the theoretical and empirical literature which demonstrates that index funds can, and do, leverage their role as large institutional investors to combat managerial malfeasance, misfeasance, and general misbehavior.    

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