"Misapplying the theory I mislearned in college."
By James Kwak
One of the central dramas of the early seasons of The Wire is the cat-and-mouse game between Avon Barksdale’s drug operation and the detectives of the Major Crimes Unit. The drug dealers started off using pagers and pay phones. When the police tapped the pagers and the phones, Barksdale’s people switched to “burner” cell phones that they threw away before the police could tap them. By Season 4, Proposition Joe advised Marlo Stanfield not to use phones at all.
Well, apparently, Wall Street currency traders don’t watch The Wire. I don’t think anyone was surprised to learn that major banks including JPMorgan, Citigroup, Barclays, RBS, and UBS conspired to manipulate currency prices — something that regulators have been investigating for over a year and a half. One common strategy was cooperating to time large transactions in order to manipulate daily benchmark rates at which other client transactions are executed.
By Simon Johnson
At today’s daily briefing, White House spokesman Josh Earnest communicated the president’s threat to veto any trade promotion authority (TPA) that “could undermine the independence or ability of the Federal Reserve to make monetary policy decisions”. (The question was posed at minute 42:50, Mr. Earnest’s answer starts at 43:31, and the lead up to this quote starts around 45:20.)
Mr. Earnest’s statement seems clear enough, but what potential TPA is he talking about? Either the White House is confused or some other communications strategy is at work here. Either way, Mr. Earnest is describing some imaginary version of TPA that is simply not on the congressional table.
He most certainly cannot be accurately describing the bipartisan Portman-Stabenow amendment, currently before the Senate. This amendment specifically goes out of its way to state that it would not “restrict the exercise of domestic monetary policy.”
“In section 102(b), strike paragraph (11) and insert the following:
“(11) Currency manipulation.–The principal negotiating objective of the United States with respect to unfair currency exchange practices is to target protracted large-scale intervention in one direction in the exchange markets by a party to a trade agreement to gain an unfair competitive advantage in trade over other parties to the agreement, by establishing strong and enforceable rules against exchange rate manipulation that are subject to the same dispute settlement procedures and remedies as other enforceable obligations under the agreement and are consistent with existing principles and agreements of the International Monetary Fund and the World Trade Organization. Nothing in the previous sentence shall be construed to restrict the exercise of domestic monetary policy.”
The Portman-Stabenow amendment is focused entirely on “protracted large-scale intervention in one direction in the exchange markets,” i.e., the situation when a foreign central bank acquires a massive amount of foreign assets (typically dollars) in a successful attempt to keep their currency undervalued – and therefore their exports much cheaper than they would otherwise be.
This is not something that the Federal Reserve does – nor anything that it is likely to do in the foreseeable future.
Reference to the IMF principles and agreements here has a clear meaning for anyone who follows international currency and macroeconomic issues. The US Treasury was involved in drafting the IMF agreements in the 1940s and has kept a firm hand on the pen at every stage of the way since – including the very latest versions. There is no way that any serious person could claim – or even imagine – that relying on IMF principles would impede the operation of the Federal Reserve and its monetary policy.
Congressman Sandy Levin, ranking Democrat on the House Ways and Means Committee, made this point forcefully this afternoon in a major floor speech – and put the issue in exactly the right broader context with regard to the Trans-Pacific Partnership as a whole.
“The International Monetary Fund has up-to-date guidelines that define currency manipulation and are intended to prevent it. There is nothing wrong with the spirit or even the letter of those guidelines. Unfortunately, the IMF cannot enforce those guidelines because currency manipulators are able to essentially stall action in that forum.”
“Arguments that prohibiting currency manipulation in TPP is impossible, for political or technical reasons, remind us of previous claims about trade agreements not being able to help defend forests or discourage child labor.”
“For example, some prominent people have asserted that U.S. monetary policy would be put at risk if currency disciplines are included in TPP. I responded to that argument in a highly detailed blog post months ago. I have seen no serious rebuttal of the points I made in that post – or to similar and related points made by Simon Johnson, Fred Bergsten, and many other notable economists, ranging from Art Laffer to Paul Krugman. Nevertheless, those who oppose currency disciplines continue to raise this false argument.”
“TPP should address instances in which countries buy large amounts of foreign assets over long periods of time to prevent an appreciation of their exchange rate despite running a large current account surplus. The Federal Reserve does not engage in such practices. That is why the U.S. already agreed to and even insisted upon what is in the current IMF guidelines.”
“And now there is the claim that including currency disciplines in TPP would be a “poison pill” and that our trading partners would walk away from the table. There is no way to accurately judge this issue until it is properly brought to the negotiating table. To the contrary, the fact that the Administration says this only creates the risk of a self-fulfilling prophecy. It is irresponsible to make this claim. Indeed, our trading partners in TPP would greatly benefit from these disciplines. Many of them are the victims of manipulation every bit as much as we are.”
“A progressive trade agreement for workers and the middle class must address currency manipulation, which has caused millions of job losses and contributed to wage stagnation over the past decade. President Obama is right that we should write the rules and not accept the status quo. But if we fail to address currency manipulation in TPP, we are essentially letting China write the rules and are accepting an unacceptable status quo.”
By James Kwak
“In my many years of experience working in compliance, do you know how many fixed and variable annuities I’ve seen being invested in IRAs??? Countless.
“Investing a tax deferred investment within a tax deferred account simply does not make sense, except for very very few exceptions. … And when brokers answered me honestly as to why they picked annuities over mutual funds or even plain vanilla stocks??? Payout baby!!!”
That’s a compliance officer at Wells Fargo talking about the kinds of abuses that brokers — who advise clients about where to put their money, even if they aren’t “registered investment advisers” — inflict on their customers. For context: The benefit of an annuity is that taxes on earnings are deferred until withdrawals — but you get that benefit in any IRA, so there’s no point in putting an annuity (which has higher costs than an ordinary mutual fund) in an IRA. Yet in this case the brokers were pushing annuities because of the (legal) kickbacks they were getting from the annuity providers.
By Simon Johnson and Andrei Levchenko
The Obama administration is lobbying hard for Congress to pass a trade promotion authority (TPA) and to quickly approve the Trans-Pacific Partnership (TPP), a free trade agreement that is on the verge of being finalized.
The administration and its supporters on this issue, including leading Republicans, argue that the case for TPP rests on basic economic principles and is only strengthened by the findings of modern research. On both counts their claims are greatly exaggerated – particularly with regard to the notion that more trade, on these terms, is necessarily better for the United States.
There is a strong theoretical and empirical case – dating back to David Ricardo in 1817 – that freer trade should make countries better off. However, modern-day trade agreements, including those currently being negotiated, are very different from earlier experiences with trade liberalization.
The TPP is not only – perhaps not even mostly – about freer trade, and thus who gains and who loses is very much dependent on what exactly are the details of the agreement. The exact nature of the provisions matters and at this point, because the TPP text is not available to the public, we cannot be sure whom this trade agreement will help or hurt within the United States or elsewhere.
Outside of agriculture, international trade is already substantially liberalized, and thus the gains from further reductions in tariffs are most likely limited by the fact that tariffs are already quite low.
And the scope of modern-day trade agreements has expanded – primarily into areas in which the economic theory case for mutual benefits is far from clear.
Perhaps the most prominent example is intellectual property rights (IPRs), including patents. Contrary to the mutual benefits of international trade in general, there is no clear-cut theoretical case that stronger enforcement of IPRs will benefit all parties.
In the world in which the developing countries can imitate technologies of developed countries, improving intellectual property rights protection in developing countries is actually likely to make them worse off. This is intuitive: ignoring the developed countries’ IPRs allows developing countries to adopt better technologies faster, increasing welfare there. In the case of medicines, for example, forcing lower income countries to fully respect all patents will mean more expensive treatments and less access to life-saving drugs.
What is more, it may even be the case that the developed countries themselves will benefit from weaker IPRs in the poorer countries (though of course this is not a necessary outcome). This is because poorer countries tend to have lower wages, and as production shifts to the poor countries due to imitation, prices paid by rich countries’ consumers fall. Helpman (1993) contains the modern classic exposition of these results. (Precise references to the research cited here are at the end of this article.)
The second example is provisions that require liberalization of inward investment in oligopolistic industries. For instance, recent US trade agreements with Central America/Dominican Republic, Peru, Panama, and Colombia contain specific clauses liberalizing investment in the financial services industry (as well as government procurement and investment more broadly). Again, the theoretical case that these provisions will be mutually beneficial is not straightforward.
For instance, if an industry is uncompetitive, countries may gain from retaining the domestic oligopolistic firms. Entry by foreign firms may not increase competition but instead primarily result in transferring the profits abroad. Brander and Spencer (1985) develop these ideas for cross-border trade; a recent paper by Fiorini and LeBrand (2015) focuses on inward investment by foreign firms.
The third example is the potential for a negative impact of international trade on the quality of domestic institutions. The standard argument for mutual gains from trade assumes that international exchange of goods does not lead to changes in the institutional environment – including who has secure property rights (as in land), as well as enforceable rights as a worker (including occupational safety standards).
There have been historical episodes in which trade booms led to worse institutional outcomes, such as property expropriation by elites. Do and Levchenko (2009) develop a theoretical model of one possible mechanism for such an effect. Historical instances of this include the cotton boom in Central America (Do and Levchenko, 2006), and sugar in the Caribbean (Dippel, Greif, and Trefler, 2015).
To be clear, we are not saying that this is a likely impact of TPP. But it is a possible impact of any free trade agreement (or other form of trade liberalization). This only confirms the point that the details matter in terms of determining who does well and who may do very badly.
We remain confident that there is a potential TPP that could be negotiated that would involve gains for all trading partners. But whether this is the case depends completely on the specific rules that are being written.
Given that these rules are secret (from us), we have no way of judging what is or is not in the TPP. Congress will vote soon on TPA, to greatly increase the odds of passing TPP, without there being first a proper public discussion of the TPP details. This is not a triumph of democracy – and it is not likely to lead to better economic policymaking.
Simon Johnson is a professor at MIT Sloan. Andrei Levchenko is an associate professor at the University of Michigan.
Brander, James A. and Barbara J. Spencer, 1985. “Export subsidies and international market share rivalry,” Journal of International Economics, Elsevier, vol. 18(1-2), pages 83-100, February.
Dippel, Christian, Avner Greif, and Dan Trefler, 2015, “Trade Rents and Coercive Labor Market Institutions,” NBER Working Paper 20958,
Do Quy-Toan and Andrei A. Levchenko, 2006, “Trade, Inequality, and the Political Economy of Institutions,” IMF Working Paper 06/56, February.
Do Quy-Toan and Andrei A. Levchenko, 2009, “Trade, Inequality, and the Political Economy of Institutions,” Journal of Economic Theory, 144:4, 1489-1520, July.
Fiorini, Matteo and Mathilde Lebrand, 2015 “Foreign Lobbying, Barriers to FDI, and Investment Agreements,” mimeo, EUI.
Helpman, Elhanan, 1993. “Innovation, Imitation, and Intellectual Property Rights,” Econometrica, Econometric Society, vol. 61(6), pages 1247-80, November.
By Simon Johnson
As Congress debates the trade promotion authority, TPA, the issue of currency manipulation remains firmly on the table. The administration and Republican leadership insist that language discouraging currency manipulation should not be included in the TPA (and also not in the Trans-Pacific Partnership, TPP, a trade agreement currently under negotiation). Many Democrats and Republicans continue to argue in favor of prohibiting currency manipulation.
On Tuesday, the Treasury Department and White House claimed that the amendment proposed by Senators Rob Portman (R., Ohio) and Deborah Stabenow (D., Michigan) would actually impede the ability of the Federal Reserve to conduct monetary policy. This is absurd. The Portman-Stabenow amendment clearly and precisely addresses protracted one-way intervention in foreign exchange markets, i.e., large-scale purchases of foreign assets by a central bank. The Federal Reserve does not engage in such activities – nor will it engage in this kind of intervention in the foreseeable future. US monetary policy involves buying and selling domestic assets. The Fed does not buy foreign assets on any significant scale. There is nothing in this amendment that would impede the workings of US monetary policy. To suggest otherwise is to mischaracterize the nature of this amendment.
There are instead three main issues of substance worth further consideration.
First, can we measure currency manipulation? The answer here is clear: yes. It is true that there is often disagreement about the extent to which a particular currency is undervalued or overvalued (a point made by Ian Talley in the Wall Street Journal). But the most important episodes of prolonged competitive undervaluation are the ones that do the most damage – and in these instances, for example with China in the early 2000s – there is no disagreement.
A country with a massively undervalued exchange rate will accumulate a lot of foreign exchange reserves while running a current account surplus – and its stock of foreign assets will become large relative to its own economy (and relative to the world economy, if the country in question is big). There was really no ambiguity about what China was doing. Unfortunately, however, there were political problems that prevented the International Monetary Fund and the US Treasury from being sufficiently clear on the nature and extent of this manipulation. (I was the chief economist at the IMF from early 2007 through August 2008.)
Second, do countries currently manipulate their exchange rates on a massive scale? For the most part, the extent of manipulation is at a relative low (as Robert Samuelson argues in the Washington Post). But this does not mean that we should forget about this issue – the incentive to manipulate (keep an exchange rate undervalued in order to boost a country’s exports) will likely return in the future, for example when a country experiences a slowdown in growth. In fact, the Treasury Department is raising concerns along these lines with regard to South Korea’s current behavior.
And the fact that manipulation is relatively less important in country strategies at this moment – for example, in China and Japan – means that this is a good moment in which to negotiate the issue. This is not about confrontation with current policies; it is about preventing future action that can be damaging to the US economy.
When currency manipulation again becomes significant – and when it does great damage to parts of US manufacturing and to our service sector – it will be too late to attempt a negotiated response. Now is likely the best time to shift official thinking on what can be regarded as reasonable trade practices for the coming decades.
Third, if the US insists on addressing currency manipulation in the TPP, would this derail the agreement? No, it would not – precisely because the US would be taking up this issue in a constructive negotiated framework.
Look carefully at the countries involved in TPP – Australia, Brunei Darussalam, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, and Vietnam. All of them have a great deal to fear from other countries manipulating exchange rates so as to gain an unfair competitive advantage. If we can shift the rules so as to strongly discourage currency manipulation, this will help all our trading partners.
The most effective – and completely fair – way forward is to have countries voluntarily agree not to manipulate their currencies. Everyone understands that there is some leeway provided by how any such negotiated guidelines would operate (and how currency undervaluation is measured).
The point is to get our major trading partners to agree not to undervalue their currencies on a massive scale. When it next happens on that scale, there will be no ambiguity. But it will also be too late to do anything about it in a negotiated framework.
President Obama is right that the TPP is about writing the rules for the next century of international trade. We should want to get these rules right.
By James Kwak
“At present, when zero interest rates make capital costs as low as they have ever been but corporate profits are at record levels, there needs to be much less concern with capital costs and more concern with the distributional aspects of capital taxation.”
That’s Larry Summers — with whom I have often disagreed in the past — at a Brookings event on the tradeoff between equality and efficiency. For most of our lives, government policy in the United States and most of the developed world has been focused (at least in theory) on efficiency: colloquially speaking, making the pie bigger rather than worrying about how the pie is divided up. Rising tide, boats, you know the rest: Laffer Curve, unleashing the job creators, and so on. Inequality is something we profess to regret while doing nothing about it.
By James Kwak
Unemployment is down to 5.4%! Yay!
That was the summary of last week’s unemployment report. Yet the two-track “recovery” — about to enter its seventh year — continues. Average hourly wages increased by only 0.1% in April and 2.2% for the past twelve months, which amounts to basically nothing when you take inflation into account.
This is what the new normal looks like. Wages barely rise during periods of economic “expansion” (you know, the opposite of recession), then fall when unemployment spikes during a recession. In the long run, that means that average real earnings actually go down, and household income can only keep up if people work more hours. Yet the number of full-time jobs is lower today than it was before the financial crisis.
By James Kwak
I’ve written several times about what I call the Economics 101 ideology: the overuse of a few simplified concepts from an introductory course to make sweeping policy recommendations (while branding any opponents as ignorant simpletons). The most common way that first-year economics is misused in the public sphere is ignoring assumptions. For example, most arguments for financial deregulation are ultimately based on the idea that transactions between rational actors with perfect information are always good for both sides — and most of the people making those arguments have forgotten that people are not rational and do not have perfect information.
Mark Buchanan and Noah Smith have both called out Greg Mankiw for a different and more pernicious way of misusing first-year economics: simply ignoring what it teaches — or, in this case, what Mankiw himself teaches. At issue is Mankiw’s Times column claiming that all economists agree on the overall benefits of free trade, so everyone should be in favor of the Trans-Pacific Partnership, among other trade agreements.
By James Kwak
The neolithic political ideology of Thomas and Friends is so overbearing and obvious that it’s not worth writing about (except in parody, which I won’t attempt here). Duncan Weldon has taken up the more interesting question of what Thomas, Percy, and their friends can tell us about the economy of Sodor, that strange island trapped somewhere off the coast of Great Britain and in a weird time warp that vaguely resembles the mid-twentieth century.
Like Duncan, I have watched plenty of Thomas videos, in my case in the company of my three-year-old son Henry. One thing that has often struck me about Sodor Railways is the vast amount of excess capacity. The most common plotline goes like this: Some engine has a job to do. However, said engine chooses to do something else out of vanity, unwillingness to go out in bad weather, curiosity, or something similar. Late in the episode, either the engine realizes the error of his ways and does his job, or some other engine does it for him. In either case, the original engine learns his lesson: that it is best to be Really Useful and not to cause Confusion and Delay. (Only, he never really learns the lesson — see the next episode.)
By James Kwak
Is it the money?
Federal Reserve Chair Ben Bernanke, the man who saved the global economy, is becoming an adviser for Citadel, a hedge fund management company. Bernanke will provide advice to Citadel’s fund managers and will also meet with its clients (that is, the limited partners who invest in those funds).
It’s easy to see why Citadel wants Bernanke. He’s a smart man. He knows the inner workings of the world’s central banks as well as anyone. Although he won’t be a registered lobbyist, he can pick up the phone and get anyone in the world to answer, if he wants to. And, perhaps most importantly for the bottom line, the wow factor of having Bernanke meet with investors will help immeasurably with sales — bringing investments in the door.
The bigger question, as always, is why Bernanke wants Citadel.
By Simon Johnson
The political debate about finance in the US is often cast as markets versus regulation, as if “more regulation” means the efficiency of private sector decisions will necessarily be impeded or distorted. But this is the wrong way to think about the real policy choices that – like it or not – are now being made. The question is actually what kind of markets do you want: fair and well-functioning, with widely shared benefits; or deceptive, dangerous, and favoring just a relatively few powerful people?
In a speech on Wednesday, Senator Elizabeth Warren (D., MA) laid out a vision for better financial markets. This is not a left-wing or pro-big government agenda. Senator Warren’s proposals are, first and foremost, pro-market. She wants – and we should all want – financial firms and markets that work for customers, that encourage innovation, and that do not build up massive risks which can threaten the financial system and bring down the economy.
Senator Warren puts forward two main sets of proposals. The first is to more strongly discourage the deception of customers. This is hard to argue against. Some parts of the financial sector are well-run, providing essential services at reasonable prices and with sound ethics throughout. Other parts of finance have drifted, frankly, into deceiving people – on fees, on risks, on terms and conditions – as a primary source of profits. We don’t allow this kind of cheating in the non-financial sector and we shouldn’t allow it in finance either.
The unfortunate and indisputable truth is that our rule-making and law-enforcement agencies completely fell asleep prior to 2008 with regard to protecting borrowers and even depositors against predation. Even worse, since the financial crisis, the Securities and Exchange Commission, the Justice Department, and the Federal Reserve Board of Governors proved hard or near impossible to awake from this slumber.
We need simple, clear rules that ensure transparency and full disclosure in all financial transactions – and we need to enforce those rules. This is what was done with regard to securities markets after the debacle of the early 1930s. The Consumer Financial Protection Bureau (CFPB), for which Senator Warren worked long and hard, has started down a sensible road towards smarter and simpler regulation. The CFPB needs to go further – including on auto loans – and for this it needs renewed political support.
The second proposal is to end the greatest cheat of all – the implicit subsidies received by the largest financial institutions, structured so as to encourage excessive and irresponsible risk-taking. These consequences of these subsidies have already caused massive macroeconomic damage – this is why our crisis in 2008-09 was so severe and the recovery so slow. Yet we have made painfully little progress towards really ending the problems associated with some very large financial firms – and their debts – being viewed by markets and policymakers as being too big to fail.
If you could visit a casino with the prospect of keeping all your winnings, while your losses would be partially or completely paid by someone else, how much would you gamble? You would bet a huge amount – presumably as much as the house allows. Big banks are run by smart, rational people. The incentives they face – which themselves have worked long and hard to retain – are not acceptable from a broader social point of view.
Senator Warren wants to cut through the complex morass of modern regulation. Force the biggest half dozen banks to become smaller, simpler, and more transparent. Limit the tax deductibility of interest for large highly leveraged financial institutions, so they choose to fund themselves with relatively more equity and less debt.
And reform the emergency powers of the Federal Reserve – to strengthen its ability to deal with genuine disasters while also ensuring an appropriate level of democratic review and control. The days of secretive bailouts should end.
Senator Warren’s main point is this:
“without some basic rules and accountability, financial markets don’t work. People get ripped off, risk-taking explodes, and the markets blow up. That’s just an empirical fact – clearly observable in 1929 and again in 2008.”
Of course you cannot outlaw all cheating or prevent all forms of future potential macroeconomic problems. But the legislative framework and presidential priorities matter. This is demonstrated by what happened since the 1980s, when the deregulation of finance distorted incentives in very ways that proved very dangerous.
We can choose now to make markets function better. Put in place simpler, clearer rules and enforce them.
This is a completely centrist agenda. As a result, there is real potential here for bipartisan policy initiatives – and there are senators on both sides of the aisle who show signs of being willing to go to bat for exactly these kinds of sensible pro-market ideas.
All presidential candidates, Republican and Democrat, would be smart to embrace this agenda.
By James Kwak
Beeping iPads! Buzzing phones! Zapping watches! Soon, apparently, we won’t be able to complete a thought without being interrupted by some “intelligent” piece of technology.
The solution, according to Steven Levy, is yet more technology:
a great artificial intelligence effort to comb through our information, assess the urgency and relevance, and use a deep knowledge of who we are and what we think is important to deliver the right notifications at the right time. . . .
the automated intake of our information will allow us to “know by wire,” as super-smart systems learn how to parcel things out in the least annoying and most useful fashion. They will curate better than any human can.
First of all, I’m skeptical. So is Levy, apparently; just a few paragraphs up, he writes, “the idea of One Feed to Rule Them All is ultimately a pipe dream.” The same factors that make it impossible for one company to create a perfectly prioritized feed make it impossible for one company to create a perfectly prioritized stream of notifications.
Dan Davies put together a brilliant roundup of the clever business models that financial technology startups are pitching to their investors — and why most of them are deeply flawed. Some of them apply much more broadly than to just the financial services industry. Number three, for example — “Hoping that a load of people who actively mistrust each other will trust you instead” — is a decent description of the business-to-business marketplaces that Ariba was trying to build when I worked there back at the beginning of the millennium.
I’d like to add two more general principles that apply to technology companies that are trying to serve the financial services industry — mainly learned during my years working at an insurance software company before going to law school.
(I’m going to try switching to a Brad DeLong-style approach in which I put the beginnings of my Medium posts here, and then you can decide if you want to read more or not. I can’t put the whole post here because they have thirty-day exclusivity.)
By James Kwak
Did you know that blogging is dead? That’s what I hear, anyway. I plan to say something about it once I figure out if I have anything to say on it.
Anyway, as you have probably noticed, I do most of my sporadic writing over at Medium these days. Since I last checked in here, I wrote stories about:
- Why I crippled my smartphone;
- The misleading campaign against the estate tax; and
- The fallacy on the first page of Gregory Mankiw’s textbook
I also posted an essay by Walt Glazer about inequality.
By James Kwak
Supposedly President Obama is making “middle-class economics” one of the key themes of his final two years in office. I don’t really know what this is supposed to mean in a country where people making ten times the median household income call themselves “middle class” and there are tens of millions of people in poverty.
For starters, I think it’s important to understand the distribution of wealth in the country as it stands today. That’s the theme of a story I wrote on Medium earlier this week, “The Magnitude of Inequality,” which uses charts and pictures to try to convey just how unequal a society we live in.
Yesterday I published another story on Medium about one of Obama’s “middle-class economics” proposals: the forthcoming Department of Labor rule that will try to protect people’s retirement savings from financial advisers’ conflicts of interest. It’s a complicated topic to understand, and the administration proposal will undoubtedly help—but not very much, given the scope of the retirement security problem.
By Simon Johnson
In the early and mid-2000s, Citigroup had compensation practices that can fairly be described as a disaster for shareholders (and for the broader economy). Top executives, such as then-CEO Chuck Prince, received big bonuses and generous stock options. Lower level managers and traders were paid along similar lines. These incentives encouraged Citi employees to take risks and boost profits. Unfortunately for shareholders, the profits proved largely illusory – when the dangers around housing and derivatives materialized fully, the consequences almost destroyed the firm.
The market value of Citigroup’s stock dropped from $277 billion in late 2006 to under $6 billion in early 2009. The shareholders could easily have been wiped out – they were saved from oblivion by a generous series of bailouts provided by the federal government (see Figure 7 in the final report of the Congressional Oversight Panel; direct TARP assistance was $50 billion but “total federal exposure” was close to $500 billion). In the next credit cycle, the experience for Citi shareholders could be even worse. So it is entirely reasonable for shareholders to look carefully at, among other things, the details of how executives and other key employees are paid – and to understand the current incentives for taking and managing risk.
But Citigroup is resisting efforts to disclose fully the structure of relevant compensation contracts. What is Citigroup hiding now?
The specific issue is a request by Richard Trumka, president of the AFL-CIO, for Citigroup to disclose precisely how employee compensation is affected when a person takes a government position. (See David Dayen’s article in the New Republic for more detail and context, including requests for similar information from other large banks. I use Mr. Dayen’s very helpful links to documents below.)
As Mr. Trumka puts it, “Like many institutional shareholders, the AFL-CIO supports the use of compensation plans that align the interests of senior executives with the long-term interests of the company. We oppose compensation plans that provide windfalls for executives that are unrelated to their performance.”
Citigroup’s compensation arrangements remained troubled long past the financial crisis. In 2011 shareholders rejected Citigroup’s executive compensation plan, in part because of concerns about the incentives for then-CEO Vikram Pandit. (Mr. Pandit was subsequently eased out of Citigroup, on generous terms relative to the value he provided to shareholders.)
The current board of directors has stated repeatedly that the problems with these policies are now fixed, precisely because executive compensation is now related to performance – including what happens after decisions are taken (see, for example, the company’s 2014 proxy statement).
But Mr. Trumka is flagging a major issue – and one the board does not want shareholders to review or apparently even understand in detail. When an executive or other manager leaves Citigroup to join the government, what exactly happens to their deferred compensation? What is the precise wording in their contracts and how much money is involved?
Goldman Sachs offers a lump-sum payment to employees who leave to join the government (see section 9 in this filing.) The logic here is that a government official should avoid any appearance of a potential conflict of interest; see Mr. Antonio Weiss’s ethics statement to Treasury in November.
Such an arrangement obviously raises an important issue for shareholders. If deferred compensation is supposed to encourage more careful risk-taking, then acceleration of vesting and immediate payments will tend to do the opposite.
Citigroup argues that its arrangements are different – and that vesting will continue on the original schedule. It’s hard to see how this can be a credible commitment. If a Citi executive becomes, for example, Treasury Secretary or US Trade Representative or First Deputy Managing Director of the IMF (all positions occupied by Citi alums), how can such a person continue to gain in significant material fashion from Citigroup’s performance? Anyone with broad responsibility for economic policy and financial sector oversight should not be in a position to gain or lose large amounts of money from the performance of a single financial firm (let alone one of the world’s biggest banks, with interests spread around the globe.)
Presumably the board of directors can – and would – make an exception for anyone joining the government at a sufficiently senior level. Some statement of policy along these lines would presumably provide helpful guidance to shareholders, who are entitled to agree or disagree with the details.
In any case, Mr. Trumka is only requesting more disclosure of Citigroup’s precise arrangements. And, not satisfied with the lack of response from Citigroup, the AFL-CIO is now asking that shareholders be allowed to vote on making these details known, as part of the process surrounding the 2015 annual meeting of stockholders. The proposed motion reads,
“RESOLVED: Shareholders of Citigroup (the “company”) request that the Board of Directors prepare a report to shareholders regarding the vesting of equity-based awards for senior executives due to a voluntary resignation to enter government service (a “Government Service Golden Parachute”). The report shall identify the names of all Company senior executives who are eligible to receive a Government Service Golden Parachute, and the estimated dollar value amount of each senior executive’s Government Service Golden Parachute.”
“For purposes of this resolution, “equity-based awards” include stock options, restricted stock and other stock awards granted under an equity Incentive plan. “Government service” includes employment with any U.S. federal, state or local government, any supranational or international organization, any self-regulatory organization, or any agency or instrumentality of any such government or organization, or any electoral campaign for public office.”
Citigroup has asked the Securities and Exchange Commission for permission to exclude this proposal from its proxy statement, i.e., for permission not to put the issue before shareholders. (See Mr. Dayen’s article for more details.)
What exactly is Citigroup hiding this time?