Fake news: To ban or not to ban?

Following the revelation that Cambridge Analytics used Facebook to define personal profiles to be targeted in the Trump election campaign, there are now “calls for more transparency on the internal algorithms that internet platforms use to promote stories, limits on the “harvesting” of personal information for political purposes, and disclosure by tech companies of who funds “sponsored content” on their websites (FT, 31-3-2018)”.

The emergence of accessible and free (cheap) information through social media created a situation similar that in the XIX Century when cheap printing made a daily occurrence the proliferation of all kinds of pamphlets promising miracles or disasters. Like many today believe without reserve what is said in the press or shown on TV, our ancestors believed in the written word.

Obviously, like cheap printing, social media attracts all types of crooks and loonies as well as politicians. What is different this time is that state-sponsored organizations are taking a greater advantage of the naivety of social media users. But even this is not entirely new. In the past foreign governments have also sponsored radio and press sympathetic to their propaganda.

Fortunately, our ancestors did not impose a ban on printing otherwise we would live in a different world. They simply waited patiently that the general public learned to distinguish the fake from the true and that a more trustworthy press emerged.

Likewise, we should resist any bans on social media. Otherwise, we would end up as in China, Russia or Turkey where only social media acceptable to the respective governments is tolerated.

This is not equal to a complete lack of regulation. Indeed, a soft type of regulation similar to what applies to the advertising industry is more than enough. One should distinguish between what is an acceptable exaggeration, or a non-harmful lie, from those that should give grounds to liability.

For the later, one needs to have rules on secrecy and sponsored messages that strike the right balance between privacy and responsibility.

Likewise, in what concerns the right to use personal information to build profiles and marketing strategies one should not go beyond what now distinguishes what is proprietary or public information used in market studies.

Finally, in what concerns forcing the social-media to provide tools that allow its users to protect against lack of privacy or to avoid spam from fake news, these are necessary but should be solved by business competition. It is desirable that more social networks other than Facebook flourish to provide less or greater degrees of secrecy.

For instance, among my Facebook friends there is one keen to share theories of conspiracy as well as Putin’s and communist propaganda. Now I have only two options, either to block him completely or to block one by one the sites he shares. However, it makes sense for Facebook to add an extra option to block everything that he shares. But this should not be enforced by regulation. I simply need to wait that Facebooks realizes that it risks losing members like me and come up with a solution out of their business sense.

In choices between regulation and liberty one should generally err on the liberty side. So, let us not rush into too much regulation of the social media.

Capitalism and globalization

Will capitalism conquer the world? May be yes, but, per se, this is not a desirable outcome, because some diversity in economic systems is always beneficial for humankind.

What is more relevant is to assess whether the globalization of capitalism will be a positive or negative force in the current world. In this regard the balance between positive and negative impacts is clearly positive. I shall explain why below, but first let me explain why anti-capitalism movements are often also anti-globalization.

The detractors of globalization have three main lines of attack, namely that: globalization kills local and national cultures, that multinationals exploit non-unionized labor and lax regulations in poor countries and destroys national sovereignty and decision centers. Anti-capitalist advocates attribute to capitalism whatever they think is wrong in society. For instance, feminists blame capitalism for the unfair treatment of women, animal rights groups blame it for animal maltreatment, environmentalists say it is responsible for the destruction of nature and “climate change”, civil rights groups charge capitalism with promoting racism, peace activists attribute war and conflict to capitalist greed, moralists claim that commercialization and consumerism are responsible the loss of religious and social values, consumer-advocacy groups accuse capitalism of putting profits before people.

As explained in previous chapters none of these charges withstands the most simple scrutiny, let alone the counter-evidence provided recently by the turn to capitalism of former socialist and communists systems in China and other less developed countries.

First, and foremost, the globalization of capitalism accelerates the eradication of extreme poverty on a global scale, with the consequent positive effects on health, education and consumption. But, as is normal, accelerating economic growth also has its side effects, namely in terms of environment and demography. Likewise, it will accelerate the rise in the capital/labor ratio and the consequent impact on their relative share of income, which needs to be tackled through an increased capital ownership by workers either directly or through pension funds.

Nevertheless, the major impact of globalization will be through changes in political systems and regulations. Globalization unleashes forces that simultaneously strengthen and weaken the case for regulation. For example, greater freedom of movement for goods, labor and capital weakens the role of national governments. But the fear of sudden mass movements with disruptive consequences on infrastructure and employment calls for global regulation. Thus, using a parallel with monetary theory, the question whether the world is an optimal jurisdictional area for all the fundamental principles of capitalism is critical.

Without detailing all the issues let me just illustrate with a few. For instance, can we conceive of a global corporation reporting and paying taxes to single world entity? Or, can we anticipate an international court to judge violations of the rule of law? Would it rule under a system of common or civil law? Most of these question remit to the fundamental problem of how to structure different levels of government from a local to a global level and the respective enforcement apparatus, within a democratic system.

Although a body of generally-accepted international law is being developing slowly, it will probably take some centuries before a comprehensive system makes its mark. In the end, the fastest route may still be a progressive economic and political integration at the regional level like in the European Union.

In conclusion, although capitalism and globalization are both desirable and reinforce each other, any non-synchronized acceleration in one of them may backfire into a joint relapse.

The control of rent-seeking behaviour

Initially business regulation focused on anti-trust policies and barriers to entry. However, rent-seeking behaviour is not exclusive of natural or government sponsored monopolies and oligopolies. Rent-seeking is generally defined as the pursuit of payments beyond those necessary to have the service or factor supplied. Although most of these situations involve licensing, e.g. as in the case of doctors, taxis, drugs etc., or natural monopolies (as in the case of land), there are situations where market dominance may create the same type of rent-seeking behaviour.

I shall illustrate this with two examples related to new technologies and distribution, that is, – rent seekers vs. innovators and distributors vs producers.

With free entry, innovators will enjoy only a temporary monopoly until new imitators come in and drive profits to zero, thus eliminating any rents. However, in sectors subject to winner-takes-all economics that is no longer the case, because innovators can only compete until one of them dominates the market. That is, inventors become like lottery players, playing in the hope of winning a jackpot. Those who get it either retire or become a kind of private equity fund (doing little or no new research) but buying up any new innovators that threaten their dominance.

This eat-or-be-eaten is not always negative. Indeed, many so-called serial entrepreneurs thrive on finding new business opportunities and not on running them for long periods and therefore welcome the possibility of cashing-in and having a higher turnover in their investments. The problems exist when the acquirers use bundling and financial power to stop prematurely the natural selection of the winners.

Consider for example the social network Facebook’s acquisitions of Instagram and WhatsApp, for 20 billion USD, in order to secure dominance in global photo-sharing and mobile messaging. Can we be sure that those services had already achieved their position of winner-takes-all through competition or did they reach it prematurely by being acquired by a dominant player in the same space?

It is important to note that most of those payments were in Facebook shares, which may be seen as counterfeit currency if they are excessively overvalued because of the expected longevity of its oligopolistic position. So who is rent-seeking, the innovators or their acquirers? Probably both, because the innovators capitalize on the anticipation of a wider monopoly position while the acquirer achieves a higher valuation on the assumption that it will be able to maintain its dominant position and capture the rents achievable through such position longer than normal.

However, it is not uncommon that the acquirer ends up writing-off many of such acquisitions and ends up being the “sucker” while the tech entrepreneurs cashes in hefty gains. So, as long as this processes increases rather than limits entrepreneurship, the potential for market perfecting policies on the part of regulators is very limited.

This is possible because inventors also hold a monopolist position. This is quite different from the position of distributors and suppliers. To the extent that retailers manage to concentrate their retail outlets in a few locations their stores achieve a local oligopolistic situation which allows them to pursue rent-seeking. These oligopolies are often reinforced by local planning and licensing regulations.

For instance, during sudden recessions consumer demand contracts and retailers try to stop falling sales through discounts and lower prices. However, these reductions are transferred to their suppliers so that they manage to protect their profit margins throughout the recession. They are able to do so because suppliers no longer have direct access to end-user clients . Therefore, most of the adjustment takes place at the producers level. However, in contrast to the tech sector, here a write-off in the producers’ investment generates a reduction in entrepreneurship but the distributors will not incur write-off losses.

A similar process occurs in sectors (e.g. petrol stations) where the producers are in an oligopolistic position while the retail distributors are many and receive a fixed payment. Obviously, in this case, the producers are the only able to pursue rent-seeking.

That is, there are cases where producers impose a fixed price to retailers e.g. soft drinks, ice cream, petrol and domestic gaz. And the opposite, cases where distributors impose a price to producers, e.g. research, supermarkets, etc. Such practices are certainly anti-competition and may justify some form of regulation. However, in those sectors where both producers and distributors have oligopolistic power (e.g. IT and healthcare) it is not clear whether regulation can add much value.

In conclusion, striking the right balance between market perfecting regulation and intrusive messing up it is not always easy. For instance, in the financial sector excessive regulation often results in the protection of the incumbents which have the resources needed to cope with heavy regulation. Nevertheless, in most domains, whenever the right level of regulation cannot be ascertained, one should err on the low side.

Maximizing profits or stakeholder value

The role of firms has been in a slippery slope ever since finance theory began replacing the pursuit of profit maximization by maximization of shareholder or firm value.

Before outlining this evolution let me recall first why for-profit organizations choose to incorporate and its consequences in terms of finance.

Following Veblen (1923), one may say that a “corporation arises out of a collective credit transaction whereby funds supplied … are entrusted to the corporation as a going concern … therefore, an impersonal incorporation of liabilities to the stockholders, and by employing these liabilities as collateral (formally or informally) it will then procure further capital by an issue of securities (debentures, typically bonds) bearing a stated rate of income and constituting a lien on the assets of the corporation.” For him, the two main consequential facts were: a) an inflation of credit (increased leverage), and b) a capitalization of funds, essentially liabilities, with fixed charges. This way the value of a firm could be gauged by the value of its securities traded in exchange markets.

So, in the 1930s, people began questioning whether the profit or return maximization rule used in economic theory to optimize the allocation of resources through market exchanges. In particular, if it was appropriate to ignore the non-pecuniary motives that so often drive business or if a focus on current income would be myopic, ignoring uncertainty and long term considerations.

The non-pecuniary motives were rule out, on the usual grounds that on average they would have a small impact, but different schedules of future income could not be compared unless using an appropriate index of time preference to convert future income into its present value.

Hence the suggestion that investors replace profit maximization by maximization of investment value, defined as the discounted value of an expected income stream.

However, this shift was not a simple question of semantic. While under profit maximization the optimal business expansion proceeds until the marginal return on capital equals the rate of interest, for the maximization of investment value stockholders must consider if their shares will be worth more or less following the expansion.

That is, the rate of earnings on the new investment must exceed not only the interest cost of borrowed money but also the rate of earnings required by stockholders to maintain the value of their shares. This rate is the opportunity cost for stockholders and, although it is not an out-of-pocket cost, it can be interpreted as a cost for the corporation.

As shown in Durand (1952), the required return is higher than the interest rate and therefore the optimal level of expansion as determined by the schedule of investment value is smaller than the level determined by the schedule of total return. Most importantly, the required schedule of the rate of return depends on the method used to capitalize earnings. For instance, with capitalization based on operating profit the interest rate and the required rate of return coincide up to the point of zero borrowing, while if capitalization is based on net profit the required rate schedule will be always above the interest rate curve.

Under the net profit approach the required return curve defined as a function of financial leverage has a maximum which implies the existence of an optimal capital structure. This is at the core of the heated debates on the cost of capital and the neutrality of capital structures mentioned previously (see Modigliani and Miller (1959) and Durand (1959)). For reasons given above the subsequent academic literature choose to ignore the theoretical implications of the choice of capitalization method and proceeded with a theory of corporate financing based on the concept of neutrality of capital structure.

From the 1960s onwards, this otherwise reasonable substitution of profits by investment value was used to justify the linking of management compensation to the stock market which led to the uncontrolled rise of their compensation relative to shareholders and employees. Whether the cost of this side-effect of shifting from profit-based compensation to stock market-based compensation exceeds the benefits of a better selection of investments through investment value is an unsettled empirical matter.

What a cursory look at the history of this process shows is that the pursuit of stockholder value maximization, which was initially welcomed, come to be also increasingly criticized for generating “short-termism”.

A living symbol of the shareholder value theory was Jack Welch during his tenure as CEO of General Electric from 1981 to 2001. But, according to Steve Denning (Forbes, June 26, 2013) he became one of the strongest critics of shareholder value. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal… Short-term profits should be allied with an increase in the long-term value of a company.”

It is interesting to notice that, instead of narrowing the constituency that management has to serve, he not only enlarged it substantially but also demoted investors to a secondary role. Under managerial capitalism, this is consistent with a rising perception of management (and not the owners) as the real rulers of corporations.

In summary, history has shown that moving from corporate profits to stakeholders value made the metrics to assess performance more vague and accountability more diffused, while leaving unsolved the supposed short-termism of corporations and compromising their future by transforming them into major self-serving bureaucracies.

Given that this process generated many market and fiscal distortions one has to consider whether regulators and tax authorities opposed them or were accomplices on this evolution. The role of regulation is difficult to ascertain because of the successive cycles of excessive/deficient deregulation-regulation-deregulation. So, there is little empirical evidence on which one can rely.

However, there is a common sense perception that excessive regulation damages small investors by treating them as children while protecting the big players which have the scale and resources needed to cope with the cost of regulation. Likewise, the recurring shifts in the taxation of dividends and capital gains distorts most serious attempts to estimate long-term investment returns. There is nevertheless a large field of taxation – subsidization - where it is easier to assess if regulation (or lack thereof) contributes to an unfair leveled playing field. I will illustrate that below through various examples.

Is the informal economy part of market capitalism?

Expressions like informal sector or informal economy and many similar expressions (e.g. underground, black market, shadow economy, under the table, "off the books", "working for cash" or moonlighting) are used to describe all activities that typically are undeclared for one (or all) of the following intents: payment of taxes, law and regulation or statistical reporting. Such activities are often paid in cash and are estimated to represent about 20 to 40% of GDP in developed economies and less developed economies, respectively (the percentages in terms of employment are higher).

Since they involve mostly self-employed, small businesses and part-timers one would imagine that they are part of the competitive market sector. Indeed, some even think of them as the best entrepreneurial antidote to the entry barriers often found in the formal sector. However, this would extend its rationale too far, because the informal economy includes activities that in terms of amounts and moral values are substantially different. We can appreciate that by classifying some of those activities in six groups defined on the basis of the amounts transacted and the legality of the activities as shown in the following table.

The colouring used highlights the degree to which the various activities are similar to formal and open competitive markets. Potentially only the yellow and orange activities may be included in the market capitalism sector, because free and competitive markets demand equal opportunities in the face of the law. There is obviously scope to transfer through legislation some activities from the red coloured areas into less serious offense categories. For instance, some governments may legalise and regulate the sex and soft drugs trade. Indeed, in some countries the tax authorities sometimes advocate such policies to raise tax revenue.

However, in itself this does not guarantee that they may be added to the market capitalism sector because many cannot be carried out in an open and competitive manner. In fact, this problem also affects many of the activities in the orange group because of problems of information asymmetry. For example, if someone discovers a loophole in the tax code he or she cannot advertise it otherwise the tax authorities will move to close it.

To simplify, we will assume that only activities that fit in the yellow group are part of market capitalism. And, because there are so many activities in this category we assume that they will add up to a substantial part of the market economy. So, let´s examine what drives the growth of this sector.

The economic rationale for those involved in these activities is basically two-fold: economies of scale and abnormal profits. Economies of scale usually derive from two situations – either the participants are too poor to pay the minimum “overhead” imposed by the formal sector or their demand is insufficient to cover such costs. In most advanced economies the “overhead” costs typically include sales taxes, personal and corporate income taxes, compulsory employee insurance, accounting and administrative requirements that easily cost as much as the net salary of those employed in the formal sector.

For example, those on low income often are forced into inefficient household production of junk food at a cost of $4 because they cannot afford the $5 price of a burger at the local McDonald. However, they would be better off by paying $2.5 at the street corner from someone working in the informal economy. Likewise, imagine a middle class neighbourhood where every resident has a small garden that only requires 4 hours of work per month. So, a full-time gardener would need to sign in 40 residents. What if there are only 20 residents? Well, he could still live as a part-time gardener in the informal economy with a net income equal to what he would earn net in the formal economy working for 40 residents.

Without exception, governments fail to appreciate the relevance of an adequate balance between activities carried out in the household sector, the informal sector and the formal sector using two contradictory arguments – the need to promote a level playing field (the informal sector is a source of unfair competition for the formal economy) and the need for social policies to protect the weak working in the informal sector and the low paid sectors in the formal economy. The policies used to squeeze the informal sector include both a stick (persecution, fines and taxes) and a carrot (fixing a minimum wage or granting a minimum income for the unemployed on condition that they do not carry out any paid activity).

Such policies are often ineffective, contradictory and very costly. Yet, a common sense policy would simply aim at reducing the formal economy “overhead” on both sides. That is, creating a semi-formal sector with a small overhead (e.g. 25%) and reducing the current overhead costs of the formal sector by another 25%.

Unfortunately, the current level of sales taxation is high and rising creating a strong incentive for those seeking abnormal profits in the informal sector to risk a lose-lose war with the tax authorities. Nevertheless, there is much to gain from a quasi-formal sector by empowering the poor to rely on their own initiative and entrepreneurship rather than on government hand-outs. Therefore, creating such sector is also part of the fight to promote market capitalism as a pillar of human well-being.