After a wave of enthusiasm for “industrial policy” in 1983 and 1984, the idea now seems dormant at the national level. The advocates of industrial policy, placed on the defensive by pro-market forces and a robust economy, were compelled to backtrack from their initial assertions that a government agency could successfully pick “winners” among private sector firms. Since picking winners is the core of industrial policy, its once-bold proponents were reduced to advocating a drab patchwork of reforms.
More recently, however, several state governments have jumped on the industrial policy bandwagon as if the entire national debate had never occurred. Over a dozen states, principally in the “rust belt” of the upper Midwest and the Northeast, have funded agencies whose unabashed goal is to pick winners. According to Michael Finn of the Michigan Venture Capital Fund, “What we’re trying to create is the environment for the same type of phenomenon as Silicon Valley.” In the past four years, the Michigan fund has invested $48 million in 23 new companies.[1]
The amount of state activity suggests that industrial policy may be heading for a comeback at the national level. If the resurrection of industrial policy coincides with a serious recession, it may not be possible for advocates of the market to defeat it again with generalized assertions that the market can pick winners better than a government agency. Market advocates must be able to articulate precisely why this is true.
Any industrial policy that dispenses government subsidies to businesses is automatically a policy of picking winners. When a government agency grants firm A’s request for a subsidy but rejects firm B’s request, it is perforce picking winners. Indeed, picking winners—in the sense of spotting “winners” ahead of the market and nurturing them—is the best result advocates of industrial policy could hope for; the only other alternatives for a subsidy program are propping up losers and random redistribution.
What exactly is a “winner”? Industrial policy advocates seem to accept a fairly conventional economic criterion: profitability. Those firms which can grow most profitably by using invested capital most efficiently should be termed “winners.” The more a subsidy program channels capital to such firms, that is, the more efficiently its subsidies are used, the better the results for the economy as a whole.
What do the advocates of industrial policy find objectionable about the market’s method of picking winners? To show that private capital markets allocate capital efficiently, it must be shown that: (1) efficiency is enhanced when firms seeking investment capital maximize their own profits, (2) private investors can effectively pursue their own self-interest, and (3) the market effectively links points (1) and (2), that is, that investors’ pursuit of their own gain channels capital to those firms that can use it most profitably.
Advocates of industrial policy seem, by and large, to accept points (1) and (2). As I understand it, their principal concern is that the market is a flawed mechanism for translating investors’ pursuit of gain into the most efficient use of capital by investees.
Much of this concern may stem from simple ignorance of how the market functions. Therefore, this article will first describe how the market picks winners. Then it will discuss how a government agency that is optimally structured to achieve its objective might undertake the same task.
A variation on the debate over socialist economic calculation. This discussion is based in part on the insight developed by Ludwig von Mises[2] and Freidrich Hayek[3] that economic calculation is impossible under socialism. In 1920,
Mises first presented his now-famous challenge to socialism. He argued that, since the socialist state would own all means of production, there could be no market on which the prices of the myriad productive inputs would be established. Without such prices, which operate as “aids to the mind” by conveying information in a highly condensed form, the managers of the socialist economy would have no way to allocate capital efficiently.
Eventually, socialist economists regrouped around “market socialism,” under which managers of socialist firms would be instructed to operate as if they were profit-maximizing corporate managers buying and selling productive inputs. Mises and Hayek counterattacked with a variety of arguments, the most basic of which focused on the role of the central planning board, which would select firm managers and allocate capital among the competing firms.
The prescribed role of the socialists’ central planning board is strikingly similar to that which industrial policy advocates wish to confer on a subsidy-granting agency. The only difference is that the former would have a monopoly on its function, while the latter would attempt to operate as an alternative to an already-existing private capital market.
The special form of uncertainty faced by investors. No system can guarantee that its selection of future winners and losers is correct at any given time. But that is inherent in the situation faced by investors in any economy, whether they be private investors, a subsidy-granting agency of the sort envisioned by industrial policy advocates, or the market socialists’ central planning board. As Victor Borge once put it, “Forecasts are very difficult, particularly about the future.”
Uncertainty about the future is a fact of life for all participants in an economy. But the uncertainty facing investors is magnified by the nature of competition among investees. No in-vestee walks around with the word “winner” stamped on his forehead, waiting to be discovered by investors. Rather, winners emerge from an often unpredictable evolutionary process, a process of struggle which may impel a firm which everyone thought to be a “loser” to develop a decisive innovation in technology, marketing, manufacturing, or some other field. Such a firm may in turn be overtaken by others whose innovations once again help to remake the economy.
Economic progress is utterly dependent on this unpredictable process of rivalrous competition among investees. A society seeking a method of allocating capital among investees can face this fact in one of two ways: (1) it can cover up the problem by squelching competition among investees, with stagnation as the result, or (2) it can select a capital allocation procedure that adjusts to change as rapidly as possible. Such a procedure must provide incentives for the rapid communication and use of information, and for the formation of realistic expectations in the face of risk and uncertainty.
How the Market Picks Winners
Advocates of industrial policy often decry the lack of information about how “we” should allocate “our” capital. According to Representative Start Lundine, “We don’t even have credible information on which to base our decisions,” and “You have to get down to the ball bearing industry; you can’t just talk about industry in general.”[4]
Such statements seem to assume that information doesn’t exist unless it resides in written form in a central location. This assumption causes industrial policy advocates to overlook the market’s largely non-written, decentralized method of storing and communicating information. Sitting in the midst of the most sophisticated capital market in the world, U.S. advocates of industrial policy fail to grasp how that market picks winners because they don’t understand the signals continually transmitted among investors and investees.
How the market stores and communicates information. The market stores information in the form of prices, in this case, the prices of corporate equity securities.[5] The price of each corporation’s shares tends to encapsulate the information about the corporation and its relative prospects which is widely dispersed among investors. No single investor possesses all the information extant about a particular firm, much less an industry or the entire economy. Yet the market as a whole possesses such information because it is able to draw on the knowledge and judgment of millions of investors.
For example, if a new industrial process is developed which increases demand for ball bearings, those investors who first spot the change in data and correctly evaluate its effect on the earnings of ball beating makers will profit by buying the shares of such firms, thus driving their prices up. Sparked by the profit-seeking behavior of investors, this process of adjustment continues rapidly until the share prices of ball bearing makers fully incorporate the new data.
The crucial point is that this adjustment process operates without most investors having to learn about the new industrial process or its effect on ball bearing usage. The market gains the use of this information by, in effect, paying for it. The profit received by those who first come into possession of the information is their payment for transmitting it to other market participants.[6]
What information is reflected in security prices? Investors tend to bid each firm’s shares to a price equal to the sum of expected future after-tax returns thereon (in the form of capital appreciation and dividends), discounted by current and anticipated interest rates, and adjusted for the investment’s perceived risk.
The ability of the market to price securities correctly has led a number of academic economists to formulate the “efficient market theory,” which Paul Samuelson describes as follows:
If intelligent people are constantly shopping around for good value, selling those stocks they think will turn out to be overvalued and buying those they expect are now undervalued, the result of this action by intelligent investors will be to have existing stock prices already have discounted in them an allowance for their future prospects. Hence, to the passive investor, who does not himself search out undervalued and overvalued situations, there will be presented a pattern of stock prices that makes one stock about as good or bad a buy as another. To that passive investor, chance alone would be as good a method of selection as anything else.[7]
Since Samuelson’s statement, some of the more enthusiastic efficient market theorists seem to have gotten carded away with the allegedly automatic, instantaneous character of market adjustment. The vital role of active investors in bringing about such adjustment is described as follows by Arlene Hershman in the October 1984 Dun’s Business Month:
. . . academics are reexamining the role of information in an efficient market. Some economists believe that information isn’t free, that it has a price that is paid for in time, money and effort; they assert, further, that market participants who dig out new information will be paid for it in stock market profits. . . . Some money managers, who also are efficient market adherents, believe that it has sectors of inefficiency and that they can outperform the market by searching out ideas that are strikingly new or different.
Market prices as a means of communication among investors. Samuelson’s statement focuses on what market prices communicate to the passive investor, while Hershman’s focuses on what they communicate to the active investor. Integrating these statements, we can see what the market, through its particular constellation of security prices, is telling each investor and potential investor at every moment: “Here, in the highly condensed form of security prices, is the sum total of all that everyone else knows and expects about the firms with shares outstanding. If you have something positive to contribute, in the form of new information or understanding, the market will tend to compensate you with profits. If you don’t, you are nevertheless protected to a large degree by the fact that other, more active, investors have bid stock prices to levels which reflect their knowledge and understanding.”[8]
Just as a scientist stands on the shoulders of all those who have gone before him, each investor stands on the shoulders of the market as a whole. Both the scientist and the investor are presented with an immense amount of information generated by others; both must be exceptionally good to improve on what they receive.
The movement of security prices through time also communicates information to each investor. The investor’s profit or loss on each investment provides him with feedback on his investment decisions, and to some degree allows him to learn from his past successes and failures.
Market prices as a means of communication by investors to investees. So far we have focused on security prices as a means by which investors communicate with each other. Security prices are also a means by which investors communicate with companies with securities outstanding. The higher investors bid up a firm’s share price in relation to its book value (invested and reinvested capital per share), the more efficiently they expect the firm to use its capital. That is, the more the market expects the firm to be a “winner.”
The higher a firm’s share price, the more cheaply it can raise additional capital; that is, the smaller the percentage of the company’s fu-rare earnings that must be given up by its existing shareholders to raise a given amount of cash. Since management tends to act in the interest of existing shareholders (for reasons explained below), management is encouraged to issue more shares when investors bid up the company’s share price. In effect, such investors are pre-buying the company’s next stock issue.
The more cheaply a firm can raise additional capital, the greater its incentive to expand its operations. Conversely, the lower a firm’s share price, the more it costs to raise new capital and expand.
In sum, relative security prices are the way millions of investors tell companies whether to expand or contract, to continue what they are doing or make changes. The market “picks winners” (and losers) every day.
Market prices as a means of communication by investees to investors. The communication described so far—among investors and from investors to investees—would go for naught if in-vestees wasted new capital. How do investors know that investees will use newly raised capital productively?
Since management tends to act in the interest of existing shareholders, it will attempt to offer securities on the market at the highest price that clears the market, that is, at a price which gives investors an expected rate of return equal to or just above the market rate (adjusted for risk). For the same reason, management will offer securities which provide such a return only if it believes it can use the invested funds to generate a greater return for the business.
By “stepping up to bat” in the securities market, management is telling investors that it believes such returns are achievable. Just as active investors adjust stock prices in a manner that tends to allow the passive investor to earn nearly a market rate of return with a minimum of investigation, the incentives faced by corporate managers tend to decrease the need of investors to investigate the expected returns on a corporation’s proposed investments. Prices convey information in a condensed form.
“The problem of economic calculation is a problem which arises in an economy which is perpetually subject to change, an economy which every day is confronted with new problems which have to be solved. Now in order to solve such problems it is above all necessary that capital should be withdrawn from particular lines of production, from particular undertakings and concerns and should be applied in other lines of production, in other undertakings and concerns. This is not a matter for the managers of joint stock companies, it is essentially a matter for the capitalists—the capitalists who buy and sell stocks and shares, who make loans and recover them, who make deposits in the banks and draw them out of the banks again, who speculate in all kinds of commodities.”
—Ludwig von Mises, Socialism
The role of selection and incentives. The market’s ability rapidly to communicate meaningful information and to put it to good use is only as good. as the incentives facing market participants. So far, we have assumed that investors seek profits and corporate managers tend to serve the interest of existing shareholders. But the capital market consists of more than individual investors and ultimate investees. Capital often flows through long chains of intermediaries, each of which is subject to incentives that enhance the rapid flow and use of information. To fully understand why the market will pick winners better than a subsidy-granting agency, we must explain the incentives facing each type of market participant.
• Individual investors—The desire for profit gives investors a strong incentive to act competently. In addition, the market tends to select in favor of more competent investors and against the less competent by reshuffling assets from the latter to the former.
• Managers of investees—Corporate managers have an incentive to act in the interest of existing shareholders because their compensation tends to be tied to their company’s stock price (the market has selected in favor of firms which compensate their managers in this way); because a lower stock price reduces a corporation’s ability to expand, giving the manager a smaller organization to govern; and because a low stock price encourages tender offers to oust incumbent managers.
• Managers of intermediaries—Mutual funds, pension funds, banks, insurance companies, brokerage firms, and other intermediaries are managed by people who face similar incentives to those described above (although some intermediaries are not subject to tender often). Often their compensation is tied to their firm’s investment performance or to the dollar value of assets managed (again, because the market has selected in favor of firms which compensate their managers in this way).
• Managers of tender offerers and other acquirers—Corporations which are not usually thought of as intermediaries can play that role when they buy or sell other companies, either through negotiated transactions or hostile tender offers. The managers of such firms have exactly the same incentive to keep their stock price high as do other corporate managers.
• Employees of intermediaries—Most intermediaries are too large for their managers to select and monitor investments personally, so they must hire others as portfolio managers, investment analysis, researchers, etc. Because managers are affected by their subordinates’ performance, they have a strong incentive to select and reward competent employees.
This brief description presents a pattern. In each case; (1) a party (let’s call him “A”) en-trusting funds to another (“B”) is directly affected by B’s performance, (2) B’s performance can be measured by monitoring investment results, and (3) A has the power to replace B or affect B’s remuneration. As we shall see below, the breaking of this pattern, this chain of accountability and control, underlies much of the explanation of why a government-created agency could not’ pick winners as well as the market.
How a “Non-Political” Government, Agency Would Pick Winners
It is sometimes argued that, while industrial policy works in other countries, it could not work in the United States because our political culture is different.[9] Jobs in government planning agencies are insufficiently “prestigious,” such agencies are not given the requisite “flexibility” and are subject to too much political pressure from special interests, and so forth.
To see whether such factors are all that stand between the American people and a successful industrial policy, let’s imagine how an agency could be structured to maximize its ability to pick winners. Let us assume:
• Congress creates the agency with competent, independent directors, as little Congressional oversight as constitutionally permissible, and a large enough initial appropriation that it need never return to Capitol Hill for more funds;
• the agency is able to hire the most competent staffers with large salaries and performance-based bonuses, and can terminate and promote staffers without regard to civil service rules;
• the agency can spend as much as it desires on research; and
• the agency can make its investment/ subsidy decisions on any basis it desires, free of any requirement to treat applicants on an equal or rational basis.
In short, the agency could be structured to look and act like a first-rate investment fund, with just two exceptions that go to its very nature and purpose:
(1) Let us recall that advocates of industrial policy seem not to contest the idea that private investors can effectively pursue their own self-interest, but rather argue that the market cannot effectively translate investors’ pursuit of gain into the most efficient allocation of capital among investees. Therefore, if our hypothetical agency were to operate as a nationalized mutual fund, trying to maximize its own profit like any private investor, it would not be addressing the problem it was created to solve. Since the agency must assume the market is not allocating enough capital to winners, it would have to channel more capital to such firms than its own profit expectations could justify, thus acting at least in part for the firms’ benefit. The agency must operate on the basis that the full return on its “investments” can be calculated only by including the benefits it confers on its “investees.” In summary, the only way the agency could attempt to improve on the performance of the market as an institution is to operate as an alternative institution which grants subsidies to those it perceives as winners.
(2) Since the agency would be created by Congress for a public purpose, it could not be operated for the private profit of its appointed directors or anyone else to whom they would be accountable. Whatever the proponents of industrial policy want, it is clear they do not advocate conferring on any private party the economic benefit that could flow from the power to disburse billions in public funds.
The agency would underperform the market in picking winners for four reasons, the first three of which arise from exception number (1) and the fourth of which arises from exception number (2).
Why the Agency Would Underperform the Market
Inability to use information communicated by other investors. As noted earlier, the market prices of equity securities serve as a highly efficient form of communication among investors, telling each investor what everyone else knows and expects about investees. Since our agency is premised on the idea that the market’s selection of winners via stock prices is flawed, the agency has no choice but to disregard such prices and all the information they convey. Instead, it would have to rely entirely on the non-price information gathered by its own research department.
To pick winners better than the market, the agency’s research department would have to outperform the market in quickly acquiring, evaluating, and using information. Let us assume that the agency would be able to hire “enough” researchers and that it could properly structure their incentives. The agency would still face an insurmountable problem: the larger its research department, the more its internal communications would become overloaded by the sheer mass of verbal and numerical (non-price) data. Like any intelligence agency, its problem would lie not so much in gathering data, but in getting it to the right people, integrating it, and evaluating it. By contrast, the problem of “internal” communication within the market is handled primarily by the price mechanism, with the system’s participants paid (in the form of profits) for ensuring that the in formation encapsulated in prices is as accurate and current as possible.
It might be objected that the task faced by the agency’s research department is the same as that performed every day by investment analysts and researchers for intermediaries such as mutual funds, namely, attempting to obtain information not already reflected in stock prices. This objection misconceives the role of such re-search efforts. Such research uses current stock prices as benchmarks, continually attempting to determine whether a stock is overpriced or underpriced compared to other stocks in light of new data. By using stock prices in this way, investment analysts stand on the shoulders of the market. By contrast, the agency would be attempting to see farther by getting down from the market’s shoulders and standing on its own feet.
It might also be objected that, if the agency makes favorable loans or outright grants to its “investees,” its research would be comparable to that of other lenders. After all, lenders seldom make their credit decisions based on a prospective borrower’s stock price. The problem with this objection is that lenders also do not pick winners; that function is performed by the equity markets. Therefore, the relevant comparison is between the respective information-gathering methods of the agency and the market for equity securities.
Since the agency would be making its “investments” on the basis of less complete, less current information than the market, a higher proportion of the agency’s funds would be real-invested. The agency would probably earn less than passive investors, who tend to be saved from malinvestments by the price-adjusting behavior of more active investors. The agency’s information-gathering handicap relative to the market would be greatest with respect to the most rapidly changing segments of the economy, which happen to be those segments dis- proportionately inhabited by “winners.”
Unreliability of information communicated by investees. As discussed above, investees communicate information to investors whenever they issue securities. New securities can be only issued if the offering price gives investors an expected rate of return (adjusted for investor-perceived risk) at least equal to the market rate. By offering securities at that price, the managers of investees communicate their expectation that the proceeds can generate greater returns for the business. This process forces corporate managers to realistically evaluate the risks of alternative strategies and investments. As anyone familiar with corporate planning could attest, projects presented to management with a stated return of 20 per cent or 25 per cent are a dime a dozen; the real trick is for managers to reject those projects which are too risky in light of the firm’s cost of capital.
Since our hypothetical agency must seek to outperform the market by subsidizing investees it perceives as winners, it must require investees to project above-market returns on its funds, while its own returns must be below-market. What happens when a corporate manager is faced with the prospect of obtaining a subsidized investment of this sort? Obviously, the manager is given the incentive (1) to seek the agency’s funds for any investment which he expects to earn more than the agency’s below-market rate of return, and (2) to overstate the expected return on such investments, in effect underplaying their risk.
By altering the corporate manager’s incentives, the agency’s investment process would reduce the reliability of information communicated by investees about their own expectations. By eschewing information contained in stock prices, the agency would be forced to substitute largely futile after-the-fact efforts to determine the investee’s actual rate of return on invested funds.[10] The more the agency grants subsidies rather than seeking its own profit, the less it could rely on information communicated by investees, and the lower the total return on its investments is likely to be.
Inability to calculate the return on its investments. So far, we have focused on two factors which suggest that, for investments made any given time, T1, the agency is likely to underperform the market: (1) it would always be two steps behind the market in gathering information because it could not use information transmitted by other investors, and (2) the information obtained on investee expectations at T, would be less reliable than the information such investees transmit to the market.
The agency would also underperform the market because it could not calculate the return on its investments from time T1 to any subsequent time T2. Unlike a profit-seeking investor who can compare stock prices at T1 and T2 and add in dividends, our agency must attempt to measure its performance by factoring in the benefit it confers on its investees.
This task would be virtually impossible. The agency could not determine whether its investees are winners by comparing the performance of their stocks against the market’s. To the extent an “investment” by the agency contains a subsidy element, the subsidy constitutes found money for the shareholders of the subsidized firm and would of course raise the firm’s share price. By this standard, the agency could turn a corporate “dog” into a winner by giving it a large enough subsidy.
Nor could the agency determine whether it has selected winners by reference to the return on investment of subsidized firms. A firm which has a high return can always use its next investment dollar on a low-return or high-risk project (as the agency’s subsidies would encourage it to do). The agency could measure its returns only by attempting to monitor the actual returns its subsidies generate for investees, a process which, as noted above, would be fraught with error and uncertainty.
The agency’s inability to measure its performance would block its access to the self-correcting mechanisms that operate in the market, in effect severing its feedback loop. Unlike a profit-seeking investor, the agency could not learn from its past successes and failures.
And unlike other intermediaries, its managers could not measure the performance of staffers hired to make or recommend investments, and those ultimately in charge of the agency could not measure the performance of its managers. As a result, agency personnel could not be compensated, promoted, or fired based on performance. Even if the agency were to start with the “best and brightest,” its ability to motivate its personnel and to select in favor of the most competent and against the least competent would be substantially impaired.
Lack of incentive. The fourth and final mason the agency would underperform the market in picking winners arises from the fact that it could not be operated for the private profit of those ultimately in charge of the agency. As noted earlier, the managers of investment intermediaries have a strong incentive to operate in the interests of their investors because (1) such investors can capture the benefits and detriments of the managers’ performance and (2) such investors have the power to replace the managers or affect their remuneration. The merciless judgment of investors is the means by which external reality impinges on managers, forcing them to be alert to opportunities for profit and to resist the natural tendency of organizations to become “fat” and to operate in set routines.[11]
By contrast, no one in a position to influence the agency’s actions could capture the resulting benefits or detriments. Therefore, even if the performance of the agency’s managers could be measured, no one would have a strong incentive to select and reward such managers based on their performance. As a result, even if all of the other objections to the agency could be overcome, its managers would have less incentive than private managers to ensure that it operates efficiently and alertly. Given enough time, our creative, high-powered agency would take on the appearance of any other government bureaucracy.
Bringing Politics Back into the Picture
In order to focus on the economics of industrial policy, we have temporarily assumed that our hypothetical agency could be operated free of political influence. Now this assumption can be relaxed.
In fact, eliminating political considerations would be impossible, if for no other reason than that Congress would retain the power to abolish or rein in the agency if its activities become politically unacceptable. On this point, the allegedly independent Federal Reserve System’s continual accommodation of political pressure is instructive. A non-political government-created agency is a bit like a square circle.
Once it becomes apparent that the politicians would function as the owners of the agency, all sorts of things fall into place. The politicians, even those who might have opposed creation of the agency, can capture the benefits of its activities by influencing it to subsidize favored constituents, receiving payment in the currency of politics: votes, contributions, and favors. The effect on the agency’s already modest ability to channel funds to winners ought to be readily apparent.
While the agency could not succeed by the market’s criteria, it could succeed admirably by the very simple criterion of politics: is the result visible to the voters ? As long as a politician can point to a government- subsidized project and say “this created (or saved) X jobs,” the project’s political benefits would probably out weigh its political costs. Why this is so—that is, why the political process weighs costs and ben-e fits so much more crudely than the market—is an important and difficult subject, one that is beyond the scope of this article.
Nevertheless, the sharp divergence between political and economic criteria of success shows the principal danger of industrial policy. Once a subsidy granting agency becomes established, it will appear to be a success even as it draws resources from productive to unproductive uses, making us all poorer as a result. []
1. “States Back Risky Ventures In Effort to Create New Jobs,” New York Times, June 23, 1986.2. Ludwig von Mises. Socialism: An Economic and Sociological Analysis (London: Jonathan Cape. 1951), pp. 111-222 and especially pp. 137-142.
3. Friedrich A. Hayek, Individualism and Economic Order (Chic, ago: Henry Regnery Company, 1948). pp, 119-208.
4. National Journal, May 21, 1983.
5. This discussion focuses on equity securities rather than debt securities because it is by pricing the former that the market picks winners. Equity securities are residual claims against a business which can be realized only after all contractual claims, such as the obligation to pay principal and interest on debt securities, are satisfied. Because debt securities are partly insulated from the corporation’s performance by a “cushion” of higher-risk equity securities, the market prices of its debt securities depend primarily on market-wide interest rates and only partly on the corporation’s “downside” potential, that is, the likelihood of its default. By contrast, the price of a corporation’s shares depends less on interest rates and more on expectations about its “upside” as well as “downside” potential. It is the ability of equity securities to capture the “upside” potential that makes them the market’s vehicle for picking winners.
6. See Thomas Sowell. Knowledge & Decisions (New York: Basic Books, Inc., 1980). pp. 1034.
7. Burton Malkiel, A Random Walk Down Wall Street (New York; W.W. Norton & Company, Inc., 1973), pp. 167-8.
8. There are really three broad categories of investors—active, passive, and what might be termed “pseudo- active.” The third group engages in a great deal of trading activity, often on the basis of charts, but does little, if anything, to adjust prices to new information or more perceptive analysis. The third group probably creates short-term distortions in security prices which are then connected by “true” active investors scathing for profit opportunities.
9. Joseph L. Badaraceo, Jr. And David B- Yoffe, ‘”Industrial Policy’: It Can’t Happen Here,” Harvard Business Review, November-December 1983.
10. This task would be fraught with error and uncertainty. The prOjects funded by the agency would not necessarily be the ones so designated by the investee, but would be those which, in management’s mind. would not have been undertaken but for the subsidy.
11. See Mises, Bureaucracy (New Rochelle. NY.: Arlington House, 1969).
The market’s ability rapidly to communicate meaningful information and to put it to good use is only as good. as the incentives facing market participants. So far, we have assumed that investors seek profits and corporate managers tend to serve the interest of existing shareholders. But the capital market consists of more than individual investors and ultimate investees. Capital often flows through long chains of intermediaries, each of which is subject to incentives that enhance the rapid flow and use of information. To fully understand why the market will pick winners better than a subsidy-granting agency, we must explain the incentives facing each type of market participant. —The desire for profit gives investors a strong incentive to act competently. In addition, the market tends to select in favor of more competent investors and against the less competent by reshuffling assets from the latter to the former. —Corporate managers have an incentive to act in the interest of existing shareholders because their compensation tends to be tied to their company’s stock price (the market has selected in favor of firms which compensate their managers in this way); because a lower stock price reduces a corporation’s ability to expand, giving the manager a smaller organization to govern; and because a low stock price encourages tender offers to oust incumbent managers. —Mutual funds, pension funds, banks, insurance companies, brokerage firms, and other intermediaries are managed by people who face similar incentives to those described above (although some intermediaries are not subject to tender often). Often their compensation is tied to their firm’s investment performance or to the dollar value of assets managed (again, because the market has selected in favor of firms which compensate their managers in this way). —Corporations which are not usually thought of as intermediaries can play that role when they buy or sell other companies, either through negotiated transactions or hostile tender offers. The managers of such firms have exactly the same incentive to keep their stock price high as do other corporate managers. —Most intermediaries are too large for their managers to select and monitor investments personally, so they must hire others as portfolio managers, investment analysis, researchers, etc. Because managers are affected by their subordinates’ performance, they have a strong incentive to select and reward competent employees. This brief description presents a pattern. In each case; (1) a party (let’s call him “A”) en-trusting funds to another (“B”) is directly affected by B’s performance, (2) B’s performance can be measured by monitoring investment results, and (3) A has the power to replace B or affect B’s remuneration. As we shall see below, the breaking of this pattern, this chain of accountability and control, underlies much of the explanation of why a government-created agency could not’ pick winners as well as the market. It is sometimes argued that, while industrial policy works in other countries, it could not work in the United States because our political culture is different. Jobs in government planning agencies are insufficiently “prestigious,” such agencies are not given the requisite “flexibility” and are subject to too much political pressure from special interests, and so forth. To see whether such factors are all that stand between the American people and a successful industrial policy, let’s imagine how an agency could be structured to maximize its ability to pick winners. Let us assume: • Congress creates the agency with competent, independent directors, as little Congressional oversight as constitutionally permissible, and a large enough initial appropriation that it need never return to Capitol Hill for more funds; • the agency is able to hire the most competent staffers with large salaries and performance-based bonuses, and can terminate and promote staffers without regard to civil service rules; • the agency can spend as much as it desires on research; and • the agency can make its investment/ subsidy decisions on any basis it desires, free of any requirement to treat applicants on an equal or rational basis. In short, the agency could be structured to look and act like a first-rate investment fund, with just two exceptions that go to its very nature and purpose: (1) Let us recall that advocates of industrial policy seem not to contest the idea that private investors can effectively pursue their own self-interest, but rather argue that the market cannot effectively translate investors’ pursuit of gain into the most efficient allocation of capital among investees. Therefore, if our hypothetical agency were to operate as a nationalized mutual fund, trying to maximize its own profit like any private investor, it would not be addressing the problem it was created to solve. Since the agency must assume the market is not allocating enough capital to winners, it would have to channel more capital to such firms than its own profit expectations could justify, thus acting at least in part for the firms’ benefit. The agency must operate on the basis that the full return on its “investments” can be calculated only by including the benefits it confers on its “investees.” In summary, the only way the agency could attempt to improve on the performance of the market as an institution is to operate as an alternative institution which grants subsidies to those it perceives as winners. (2) Since the agency would be created by Congress for a public purpose, it could not be operated for the private profit of its appointed directors or anyone else to whom they would be accountable. Whatever the proponents of industrial policy want, it is clear they do not advocate conferring on any private party the economic benefit that could flow from the power to disburse billions in public funds. The agency would underperform the market in picking winners for four reasons, the first three of which arise from exception number (1) and the fourth of which arises from exception number (2). As noted earlier, the market prices of equity securities serve as a highly efficient form of communication among investors, telling each investor what everyone else knows and expects about investees. Since our agency is premised on the idea that the market’s selection of winners via stock prices is flawed, the agency has no choice but to disregard such prices and all the information they convey. Instead, it would have to rely entirely on the non-price information gathered by its own research department. To pick winners better than the market, the agency’s research department would have to outperform the market in quickly acquiring, evaluating, and using information. Let us assume that the agency would be able to hire “enough” researchers and that it could properly structure their incentives. The agency would still face an insurmountable problem: the larger its research department, the more its internal communications would become overloaded by the sheer mass of verbal and numerical (non-price) data. Like any intelligence agency, its problem would lie not so much in gathering data, but in getting it to the right people, integrating it, and evaluating it. By contrast, the problem of “internal” communication within the market is handled primarily by the price mechanism, with the system’s participants paid (in the form of profits) for ensuring that the in formation encapsulated in prices is as accurate and current as possible. It might be objected that the task faced by the agency’s research department is the same as that performed every day by investment analysts and researchers for intermediaries such as mutual funds, namely, attempting
to obtain information not already reflected in stock prices. This objection misconceives the role of such re-search efforts. Such research uses current stock prices as benchmarks, continually attempting to determine whether a stock is overpriced or underpriced compared to other stocks in light of new data. By using stock prices in this way, investment analysts stand on the shoulders of the market. By contrast, the agency would be attempting to see farther by getting down from the market’s shoulders and standing on its own feet. It might also be objected that, if the agency makes favorable loans or outright grants to its “investees,” its research would be comparable to that of other lenders. After all, lenders seldom make their credit decisions based on a prospective borrower’s stock price. The problem with this objection is that lenders also do not pick winners; that function is performed by the markets. Therefore, the relevant comparison is between the respective information-gathering methods of the agency and the market for equity securities. Since the agency would be making its “investments” on the basis of less complete, less current information than the market, a higher proportion of the agency’s funds would be real-invested. The agency would probably earn less than passive investors, who tend to be saved from malinvestments by the price-adjusting behavior of more active investors. The agency’s information-gathering handicap relative to the market would be greatest with respect to the most rapidly changing segments of the economy, which happen to be those segments dis- proportionately inhabited by “winners.” As discussed above, investees communicate information to investors whenever they issue securities. New securities can be only issued if the offering price gives investors an expected rate of return (adjusted for investor-perceived risk) at least equal to the market rate. By offering securities at that price, the managers of investees communicate their expectation that the proceeds can generate greater returns for the business. This process forces corporate managers to realistically evaluate the risks of alternative strategies and investments. As anyone familiar with corporate planning could attest, projects presented to management with a stated return of 20 per cent or 25 per cent are a dime a dozen; the real trick is for managers to reject those projects which are too risky in light of the firm’s cost of capital. Since our hypothetical agency must seek to outperform the market by subsidizing investees it perceives as winners, it must require investees to project above-market returns on its funds, while its own returns must be below-market. What happens when a corporate manager is faced with the prospect of obtaining a subsidized investment of this sort? Obviously, the manager is given the incentive (1) to seek the agency’s funds for any investment which he expects to earn more than the agency’s below-market rate of return, and (2) to overstate the expected return on such investments, in effect underplaying their risk. By altering the corporate manager’s incentives, the agency’s investment process would reduce the reliability of information communicated by investees about their own expectations. By eschewing information contained in stock prices, the agency would be forced to substitute largely futile after-the-fact efforts to determine the investee’s actual rate of return on invested funds. The more the agency grants subsidies rather than seeking its own profit, the less it could rely on information communicated by investees, and the lower the total return on its investments is likely to be. So far, we have focused on two factors which suggest that, for investments made any given time, T1, the agency is likely to underperform the market: (1) it would always be two steps behind the market in gathering information because it could not use information transmitted by other investors, and (2) the information obtained on investee expectations at T, would be less reliable than the information such investees transmit to the market. The agency would also underperform the market because it could not calculate the return on its investments from time T1 to any subsequent time T2. Unlike a profit-seeking investor who can compare stock prices at T1 and T2 and add in dividends, our agency must attempt to measure its performance by factoring in the benefit it confers on its investees. This task would be virtually impossible. The agency could not determine whether its investees are winners by comparing the performance of their stocks against the market’s. To the extent an “investment” by the agency contains a subsidy element, the subsidy constitutes found money for the shareholders of the subsidized firm and would of course raise the firm’s share price. By this standard, the agency could turn a corporate “dog” into a winner by giving it a large enough subsidy. Nor could the agency determine whether it has selected winners by reference to the return on investment of subsidized firms. A firm which has a high return can always use its next investment dollar on a low-return or high-risk project (as the agency’s subsidies would encourage it to do). The agency could measure its returns only by attempting to monitor the actual returns its subsidies generate for investees, a process which, as noted above, would be fraught with error and uncertainty. The agency’s inability to measure its performance would block its access to the self-correcting mechanisms that operate in the market, in effect severing its feedback loop. Unlike a profit-seeking investor, the agency could not learn from its past successes and failures. And unlike other intermediaries, its managers could not measure the performance of staffers hired to make or recommend investments, and those ultimately in charge of the agency could not measure the performance of its managers. As a result, agency personnel could not be compensated, promoted, or fired based on performance. Even if the agency were to start with the “best and brightest,” its ability to motivate its personnel and to select in favor of the most competent and against the least competent would be substantially impaired. The fourth and final mason the agency would underperform the market in picking winners arises from the fact that it could not be operated for the private profit of those ultimately in charge of the agency. As noted earlier, the managers of investment intermediaries have a strong incentive to operate in the interests of their investors because (1) such investors can capture the benefits and detriments of the managers’ performance and (2) such investors have the power to replace the managers or affect their remuneration. The merciless judgment of investors is the means by which external reality impinges on managers, forcing them to be alert to opportunities for profit and to resist the natural tendency of organizations to become “fat” and to operate in set routines. By contrast, no one in a position to influence the agency’s actions could capture the resulting benefits or detriments. Therefore, even if the performance of the agency’s managers could be measured, no one would have a strong incentive to select and reward such managers based on their performance. As a result, even if all of the other objections to the agency could be overcome, its managers would have less incentive than private managers to ensure that it operates efficiently and alertly. Given enough time, our creative, high-powered agency would take on the appearance of any other government bureaucracy. In order to focus on the economics of industrial policy, we have temporarily assumed that our hypothetical agency could be operated free of political influence. Now this assumption can be relaxed. In fact, eliminating political considerations would be impossible, if for no other reason than that Congress would retain the power to abolish or rein in the agency if its
activities become politically unacceptable. On this point, the allegedly independent Federal Reserve System’s continual accommodation of political pressure is instructive. A non-political government-created agency is a bit like a square circle. Once it becomes apparent that the politicians would function as the owners of the agency, all sorts of things fall into place. The politicians, even those who might have opposed creation of the agency, can capture the benefits of its activities by influencing it to subsidize favored constituents, receiving payment in the currency of politics: votes, contributions, and favors. The effect on the agency’s already modest ability to channel funds to winners ought to be readily apparent. While the agency could not succeed by the market’s criteria, it could succeed admirably by the very simple criterion of politics: As long as a politician can point to a government- subsidized project and say “this created (or saved) X jobs,” the project’s political benefits would probably out weigh its political costs. Why this is so—that is, why the political process weighs costs and ben-e fits so much more crudely than the market—is an important and difficult subject, one that is beyond the scope of this article. Nevertheless, the sharp divergence between political and economic criteria of success shows the principal danger of industrial policy. Once a subsidy granting agency becomes established, it will appear to be a success even as it draws resources from productive to unproductive uses, making us all poorer as a result. [] 1. “States Back Risky Ventures In Effort to Create New Jobs,” 23, 1986. 2. Ludwig von Mises. (London: Jonathan Cape. 1951), pp. 111-222 and especially pp. 137-142. 3. Friedrich A. Hayek, (Chic, ago: Henry Regnery Company, 1948). pp, 119-208. 4. May 21, 1983. 5. This discussion focuses on equity securities rather than debt securities because it is by pricing the former that the market picks winners. Equity securities are residual claims against a business which can be realized only after all contractual claims, such as the obligation to pay principal and interest on debt securities, are satisfied. Because debt securities are partly insulated from the corporation’s performance by a “cushion” of higher-risk equity securities, the market prices of its debt securities depend primarily on market-wide interest rates and only partly on the corporation’s “downside” potential, that is, the likelihood of its default. By contrast, the price of a corporation’s shares depends less on interest rates and more on expectations about its “upside” as well as “downside” potential. It is the ability of equity securities to capture the “upside” potential that makes them the market’s vehicle for picking winners. 6. Thomas Sowell. (New York: Basic Books, Inc., 1980). pp. 1034. 7. Burton Malkiel, (New York; W.W. Norton & Company, Inc., 1973), pp. 167-8. 8. There are really three broad categories of investors—active, passive, and what might be termed “pseudo- active.” The third group engages in a great deal of trading activity, often on the basis of charts, but does little, if anything, to adjust prices to new information or more perceptive analysis. The third group probably creates short-term distortions in security prices which are then connected by “true” active investors scathing for profit opportunities. 9. Joseph L. Badaraceo, Jr. And David B- Yoffe, ‘”Industrial Policy’: It Can’t Happen Here,” November-December 1983. 10. This task would be fraught with error and uncertainty. The prOjects funded by the agency would not necessarily be the ones so designated by the investee, but would be those which, in management’s mind. would not have been undertaken but for the subsidy. 11. Mises, (New Rochelle. NY.: Arlington House, 1969).