Fighting Foreign Corruption

Thanks in large part to the internet connecting the world like never before, the first decade of the third millennium saw unconditional convergence. The poorer countries didn't have to become significantly less corrupt in order to approach the technological frontier, they just had to let their citizens get online and connect with the world.  This naturally resulted in an increase in outsourcing and trade as global coordination was made possible. 

With all of the growth coming from emerging markets, multinational corporations based on developed countries are very eager to do business there.  The problem they have is that they have to follow the Foreign Corrupt Practices Act while their competition does not. Not only do corporations have to contend with connected local businessmen, they also have to worry about emerging market companies who have fewer scruples and no significant consequences for their actions. If they are caught red handed in corruption, their businesses in the developed world might be at risk of civil penalties but it is very simple to avoid those issues - they just stay under the radar and avoid doing business in jurisdictions where they are liable.

One tool that can be used is to go after the corrupt officials themselves. The Magnitsky Act was designed to go after corrupt Russian officials who were involved in the torture and death of Sergei Magnitsky after he uncovered hundreds of millions of dollars being stolen by Russian tax officials. They are not allowed to enter the United States or use the banking system.

One of the police officers tried to challenge the law in UK libel court and had his case thrown out. This takes away one of the key tools that targets of these sanctions can use to fight back.

This act by itself and others in the future won't solve the problem of corruption, but it should help on the margin. If individuals think that acting in corrupt manner will close off their access to safe havens in the developed world, they might think twice.

Government Shutdown Links

1. Nate Silver on the political impact of the shutdown. Absent a crisis, it doesn't look like it will be significant for midterm elections.

2. Larry Summers insults Peter's 20 under 20 fellowship. Larry Summers isn't thinking hard enough about what the program is designed to do. If he did, he wouldn't be so quick to criticize it.

3. A transcript of Tyler Cowen's talk about thinking in stories. I've linked the talk in the past, but the following lines need to be re-emphasized often:

"As a simple rule of thumb, just imagine every time you're telling a good vs. evil story, you're basically lowering your IQ by ten points or more...

...what kind of stories should we be suspicious of? Again, I'm telling you it's the stories that you like the most, that you find the most rewarding, the most inspiring."

While thinking in stories on the margin is probably a mistake, the interesting implication is also about how telling stories can make those around the storyteller turn off their brains temporarily. It's probably why almost every highly regarded academic or executive has a few go to stories that they refine and tell over and over again - it's very effective.

4. Robin Hanson is praising profanity. The theory is that profanity helps vent aggression, gauge emotional toughness and helps groups figure out when they are pushing people up to or beyond their limits. 

"So it makes sense that today profanity is more common in work groups that depend closely on one another, and who have high levels of physical and emotional stress....

...I take recent increases in campus speech codes that basically ban any talk that anyone might offend anyone as further evidence that schools are more about signaling status than about gaining productivity."

Game Theory of the Government Standoff

We are a couple of days into the government shutdown. The GOP doesn't want to pass a continuing resolution without a concession from the Democrats, while the Democrats don't want to grant any concessions to the GOP after they gave away what they felt to be too much in previous negotiations over the federal budget and debt ceiling.

During this standoff, Obama apparently attempted to scare the markets.

Obama dismissed talk on Wall Street that Washington will solve its problems, warning that the fight this time is putting not only government operations at risk, but the debt ceiling as well.

“I think this time it’s different,” Obama said in the interview. “I think they should be concerned.”

Tyler Cowen's analysis of the situation is broadly accurate - a market panic which would result in a solution won't occur because there would be no reason for the market to panic in the first place if a solution would result from that panic. Assuming he understands the nature of markets, Obama is probably more concerned with getting Wall Street donors talking to congressmen than he is with helping cause a market panic in order to force everyone to act.  When thinking about what would cause markets to panic, a conclusion we should draw from this is that the markets won't panic about the situation until and unless even a market panic has some chance of not resolving the situation. The market crash after the first TARP vote failed falls into this category. In our current situation, it means that if the political institutions require a market panic in order to act then things will probably occur on a very last minute basis, perhaps just as the Treasury is running out of ways to borrow money despite almost hitting the debt ceiling. 

Right now the political situation looks like a zero sum game. Either the GOP lose by not even getting a small concession to show for their trouble or the Democrats lose by going back on their word about not negotiating until a continuing resolution is passed. Unless both sides figure out a solution they can rhetorically pass off as a victory there isn't an obvious compromise on the table.

So Warren Buffett is probably right when he says that the US will approach but not cross the point of extreme idiocy. 

The Direction of Global Inequality

Which way is global inequality going? 

This should be a question with a simple answer. First, the question must be clarified. Usually answers to this question refer to the Gini coefficient, where a number close to 1 implies all of the wealth is owned by a few and a number close to 0 indicates that income is distributed more evenly.  If the question is asking about the direction of income inequality in various countries around the world, the answer is obvious: It is going up.

The above chart from a 2011 OECD report on income inequality highlights that income inequality has been rising in most countries around the world. It may be that national inequality is more important than global inequality, as electoral (or revolutionary) politics have a history of working more on a national basis than a global basis.

Still, the direction of global income inequality is still interesting for its own sake. A World Bank working paper, Global Income Inequality by the Numbers: In History and Now by Branko Milanovic looks at three different ways of measuring global inequality.

Concept 1. Inequality between countries.

Concept 2. Inequality between countries weighted by population.

Concept 3. Inequality between individuals of the world.

The first two are easy to measure while the third metric is much harder to get data for until the 1980's. Concept 2 is clearly superior to concept 1, as smaller countries should not be weighted the same as significantly larger countries. By the same measure, concept 3 is superior to concept 2, as wealth in developing countries is less significant if it is wholly in the hands of a few. The only downside to concept 3 is the inherent data problems as surveys of the very poor and the very rich will often be skewed.

Looking at concept 2 and concept 3, it appears that worldwide inequality has actually been falling during the 2000's. It may be a little unintuitive that inequality can go up everywhere but down in total. But those in the bottom third of the income distribution have seen their real incomes rise between 40% and 70% over the past 20 years. This has created a new middle class and the income distribution has become somewhat more equal overall even if countries where people are coming out of poverty are also creating many new US dollar billionaires.

Whether or not this trend will hold is another question entirely. The internet gave a boost to the economic institutions of almost every country in the world, so from the mid 2000's up until the financial crisis we had unconditional convergence between developing and developed countries. Going forward, institutional quality might again begin to cap the growth of developed countries around the world. And if that happens, world inequality may start to increase yet again. 

About the Recent Spate of Large IPOs

In the wake of the Twitter IPO announcement, Tyler Cowen asks if the return to public equities is now lower. His theory, about a wealthier world that causes successful companies to stay private for longer seems flawed but he brings up an interesting question.

It is worth thinking about what has changed recently where we now see many more mega IPOs.  In 1986, Microsoft had its IPO, raising $61 million dollars with  valuation of almost $800 million dollars. This would be $1.7 billion dollars in 2013 dollars. In 1993 Allstate had the biggest initial public offering ever up to that point by a US company. It sold $2.12 billion worth of stock at a price that gave it a valuation of $11.8 billion dollars or $19 billion in 2013 dollars. This large IPO was possible at the time because it was a spinoff from Sears.

More recently, Linked-in went public in 2011 for $4.5 billion and Facebook went public in 2012 for $90 billion. With Facebook now comfortably above its IPO price, Twitter is planning on going public with analysts estimating its IPO market capitalization between $10 and $20 billion dollars.

There are many differences between the world that spawned the Microsoft IPO and today’s markets, but the below might be the most important:

1. Sarbanes Oxley raises the cost of going public. When Sarbanes Oxley costs average over a million dollars the cost benefit analysis of going public doesn't make sense until a company has a significantly higher valuation/revenue stream than it would have needed in the past.

2. With many companies putting off going public a new financial ecosystem developed to fund these companies. Late stage VC firms like Andreessen Horowitz entered into the market. Not only do they have billions of dollars they need to deploy but they actively help the companies they invest in. This further raises the opportunity cost for companies thinking about going to the public markets.

3. A growing secondary market in shares of startups lets many founders and early employees diversify a significant amount of their new worth out of the company. When these employers feel financially secure this reduces the incentive for an immediate IPO.

4. With the internet and globalization, network effects are much more important and markets are much more likely to be winner take all. Once the winners are established their market capitalization will be significantly higher than companies in the past. This doesn't stop companies from going public sooner by itself, but it does mean that by the time the company feels that it is stable enough to be traded on the public markets its market capitalization will be much higher.

Given all of these factors, the higher market capitalization of IPOs makes a lot of sense. What this means for public equity returns is more complicated. 

The first factor prevents many companies from going public until they are much more successful. This includes companies that go on to be successes but there are also companies that end up as failures or frauds that would be detected by tougher accounting laws that public market investors are never exposed to. Small companies will also often sell themselves to larger companies rather than enter the public markets. Overall it is difficult to calculate the direct effect of this factor on public market returns. 

The factor that really penalizes public market investors is that a healthy secondary market means there are not as many situations where a company will go to market merely for the sake of allowing its management team to cash out. When there is demand for liquidity, the people on the side of the trade giving liquidity will on average make a higher return. The reduction of this factor could lower returns for public market investors in general. At the very least it should cause a reduction in the size premium. And from the chart below, we see that size was never a particularly attractive risk premium to be long in the first place.  Momentum, market return, value and even the risk free rate have outperformed the classical size risk premium factor.

Source: Ken French’s Data Library

The winner takes all (most) nature of many of markets today is both a blessing and a curse for public equity investors.  It isn’t always private companies like Facebook or Twitter who create new markets, as Apple investors from the early 2000s know very well. At the same time, other public companies, Microsoft is an example that comes to mind, will often spend billions of dollars trying to be the winner in a new market but fail miserably.  And if companies really are sustainable pseudo-monopolies, then public market investors have a chance of benefiting from investing in them even after IPOs.

When thinking about what impacts public market returns it is fun to think about things like the impact of mega IPOs will be but it is better to double check theory again the basic fundamentals. We currently have an equity market that is yielding over 6% while investment grade debt yields, depressed by quantitative easing and low rate expectations, are below 4%. Until the past few years, investors in bonds have been paid a premium over earnings yield because they are taking on inflation risk and their earnings will not go up. The last time this happened we have to go back to a time period when equities were viewed as a realm for uncouth gamblers and everyone knew that railroad bonds were the key way to keep their money safe.

 Source: Bloomberg, Barclays

Given the current valuation dynamics, it isn’t likely that the average return on publicly-held companies has moved lower. 

Naming the Decade

When talking about an event between 1980 and 1989 we call it the eighties. When talking about an event between 1990 and 1999 it is the nineties. But the one from 2000 to 2009 is confusing. Wikipedia was somewhat helpful.

Orthographically, the decade can be written as the "2000s" or the "'00s". Some people read "2000s" as "two-thousands", and thus simply refer to the decade as the "Two-Thousands", the "Twenty Hundreds", or the "Twenty-ohs". Some read it as the "00s" (pronounced "Ohs", "Oh Ohs", "Double Ohs" or "Ooze"), while others referred to it as the "Zeros". The single years within the decade are usually referred to as starting with an "Oh", such as "Oh-Seven" to refer to the year 2007. On January 1, 2000, the BBC listed the noughties (derived from "nought" a word used for zero in many English-speaking countries), as a potential moniker for the new decade. This has become a common name for the decade in the UK and Australia, as well as other Anglospheric countries.

Others have advocated the term "the aughts", a term widely used at the beginning of the 20th century for its first decade.

The "two-thousands" might have seemed good at first, but those using it probably forgot that it refers to the whole millennium and not just the first decade of that millennium. Two contenders make sense - the "Twenty-ohs" and the "aughts".  The first is accurate, if three syllables, and the second has historically been used, even if it sounds like you are being told what to do when someone brings up the decade. But one thing is clear - we can't let it be called "the noughties". That would just be awkward. 

At least this confusion won't happen in the teens. 

Copyright Extension and Star Trek

The current crop of writers doesn't really like the core fan base of Star Trek.  The director of the new films, J.J. Abrams, was too philosophical. And the feeling from the fans is largely mutual as the latest movie was voted the worst Star Trek movie ever at a recent convention. The head writer Bob Orsi had some words for these Star Trek fans who didn't like the explosion and action in the Star Trek movie that wasn't about Khan but was in fact about Khan:

 STID has infinetly more social commentary than Raiders in every Universe, and I say that with Harrison Ford being a friend. You lose credibility big time when you don’t honestly engage with the FUCKING WRITER OF THE MOVIE ASKING YOU AN HONEST QUESTION. You prove the cliche of shitty fans. And rude in the process. So, as Simon Pegg would say: FUCK OFF!”

This whole mess would be largely avoided if the Star Trek intellectual property was in the public domain. They'd still probably be making bad Star Trek movies, it just wouldn't be as offensive when there were other options. Big studios wouldn't be the only game in town when it comes to characters and a universe that has been part of people's lives for many years.

If the 1909 Copyright act was still in effect, Star Trek would be in the public domain after 56 years. The original series first aired in 1966, so by 2022 the basics of the original Star Trek universe free to anyone who might be able to do it justice. Under current law, it is in the hands of the current rights holders until at least 2061 and likely longer since copyrights get extended when Mickey Mouse gets close to the public domain due to Disney's lobbyists. 

But Star Trek fans should look on the bright side, if Star Trek ever does enter the public domain the debates over which material is canon will get even more confusing.

Pareto Assurance Contracts

Alex Tabarrok blogs about assurance contracts, an idea he originally wrote about in the 90's. An assurance contract helps get around the public goods problem.

In an assurance contract people pledge to fund a public good if and only if enough others pledge to fund the public good. 

...

What a dominant assurance contract adds is that the entrepreneur agreeing to produce the public good if k or more pledge also agrees that if fewer than k pledge he will pay a prize to those who did pledge.

Many companies have used the power of the internet combined with assurance contracts to create new businesses. Groupon assures businesses that if they engage in a promotion they will have a minimum number of customers, while Kickstarter and Indiegogo fund products or ideas that can be closer in nature to public goods because without the funding many of the projects they support wouldn't exist. The existence of a product in the market place that large groups of people would wish to purchase isn't the most common example of a public good, but it seems to qualify even if the good itself is a private good.

It is important to note that Kickstarter figured out a better way than dominant assurance contracts to fund their projects. Rather than forcing entrepreneurs to risk large payouts to potential funders (or arbitragers who can seek out projects certain to fail), the Kickstarter business model is to provide extra benefits to funders. They allow project creators to offer different levels of rewards, depending on the choice of the funder. The rewards can be capped, so only the first X amount of people to fund at a given level are given significant rewards while late coming crowdfunders will get slightly inferior rewards that are still better than what the general marketplace will get.

This is a solution where all sides benefit (assuming the people kickstarting the project didn't miscalculate their rewards), so perhaps the type of contracts used by Kickstarter and other crowd funding platforms should be called Pareto assurance contracts.

Things going on in the world

1. New Zealand is leading the way in IP law by banning software patents. If they were a larger country this would have more of an impact, but if this were a larger country the lawmakers probably would have been bribed to preserve the rent-seeking status quo for patent trolls.

2. Kim Jong Un's ex lover was executed for producing sex tapes. I'd say his wife Ri Sol Ju caught him watching the tapes. But a more likely version of the story is that she decided to flex her power to get rid of many of her former rivals. If the wife is that bloodthirsty then it suggests that the chances for long term North Korea liberalization are lower than they would be if the situation were different.

3. I can't believe that Soros dicussing his HLF purchases is insider trading, it sounds like outsider trading to me. It also sounds like Ackman is desperate to try to get revenge on an investor who bet against him and withdrew his money from Ackman's fund.  On the other hand, it looks like these Canadian directors got away with things they shouldn't have when they issued themselves options before announcing "spectacular" drill results.

4. The Justice department clarified its stance on how it is going to turn a blind eye towards recreational marijuana use in Washington and Colorado and that recreational use by adults (assuming they aren't driving or giving it to minors) isn't a priority in other states either. It's unclear why these changes didn't come four years earlier or why shutting down medical marijuana dispensaries in California was such a large priority, but it is a welcome change.

The Market's Exit Interview

On most days, CEOs can probably pretend that what is happening to the stock is beyond their control.  But some days the stock is all about them.

Today, Microsoft's stock price is reacting to the news that Steve Ballmer is going to retire within the next 12 months.  The market capitalization of MSFT is currently $285 billion. Yesterday it was about $270 billion. Microsoft's jump in stock price means that people think whoever gets picked to replace him will make Microsoft approximately $15 billion more valuable than it would have been if Ballmer remained at Microsoft indefinitely.

It could be worse, Microsoft is only up 5.8% at the moment. When Carly Fiorina left HP the shares rose 7.5%. And the leaving executives will own large amounts of the stock that is appreciating in value in response to their leaving. So this hit to their pride is balanced by a boost to their pocketbook and this is before whatever ridiculous severance they've negotiated for themselves is also taken into account.

Edit: It appears Ballmer doesn't have an additional retirement package, so he's going to have to content himself with the over $700 million he made on his stock holdings from the market's reaction to his impending retirement. 

Disclosure: I talk about a lot of stocks. It should be assumed that I might own any mentioned in my blog posts either directly or indirectly and I'm not trying to get the reader to buy or sell anything since they should do their own research.