Contagion effect of corruption

Vijay K. Mathur

Published in Standard-Examiner, August 11, 2013, Ogden, Utah

The Corruption Perception Index (CPI) of Transparency International (TI) measures perceived level of public corruption in countries around the world from the perspective of businesses and country experts. The rankings are from least to most corrupt. In 2012, Denmark was the least corrupt while Somalia was the most corrupt among 174 countries. In 2012, the U.S. ranked 19 as compared to 22 in 2010, not a significant change. On the Bribery Payers Index of TI for 28 countries, Netherland ranked 1 with the least bribery, the U.S. ranked 10th, and the most bribery prone country is Russia. The Global Corruption Index of TI surveys 114,000 people around 107 countries. In 2013, 64 percent of the respondents thought that just a few big interests run the U.S. government.

Corruption implies dishonesty, bribery, fraud, cheating and perversion of integrity. On different indices, it seems that U.S. standing on corruption is very poor among the nations of the world. It has also infected the private sector as we witnessed fraudulent practices in the banking and financial investment industry, including hedge funds, derivatives and mortgage finance, in the recent Great Recession. These practices still continue. As recently as July 25, SAC Capital Advisors, a hedge fund, was indicted in New York for “rampant insider trading” and charged that the firm had a culture of pervasive cheating.

  

Utah is no exception, as evidenced by cases of affinity fraud in which investment fraud is committed by using church connections, securities fraud, as well as fraud cases in other sectors. Public officials are also not immune to fraudulent activity. Utah Attorney General John Swallow is facing scrutiny for accepting bribes from an imprisoned businessman. Creeping corruption corrodes moral and ethical standards, fair play in public policy and in the conduct of business. It also undermines trust in public officials and in the market place.

Corruption diverts resources from productive activities, discourages entrepreneurship and encourages rent seeking behavior, where rewards flow to those who have inside connections within business world and/or with public officials and politicians. Hence, it results in efficiency loss that is detrimental to growth and prosperity for all the people. The 1999 report by the European Bank for Reconstruction and Development provides evidence on deleterious effects of corruption on growth in many countries.

The worst part of corruption is its contagion effect, like a contagious disease. There is a cascading effect of corruption, when the corruption is top down at any level of government or in private sector. A contagious disease spreads from one person to another by mere exposure to the diseased person. The spread of the disease of corruption requires a certain minimum level of corruption before it spreads to others and becomes the social norm. However, it is hard to pinpoint the minimum threshold because it is influenced by cultural traditions, lack of monitoring and accountability, lack of transparency and an incentive system that includes rules, regulations and laws.

Economists C.J. Waller, T.Verdier and R.Gardner, Economic Inquiry, October 2002, theorize that centralized corruption (top down corruption) of public officials (as in Russia) results in less efficiency loss than bottom up corruption (as in India). The U.S. is closer to the centralized corruption regime.

The experimental work, reported by economists Robert Innes and Arnab Mitra (IM), Economic Inquiry, January 2013, at U.S. universities and at a university in India shows that dishonesty is contagious. An Indian experiment found that if a large proportion of the subjects were dishonest, other individuals were also dishonest with greater frequency. In the U.S.,  “... individual propensities for honesty evaporate when peers are thought to be dishonest.”

  

The above evidence is remarkable in the sense that it does not matter if the country is more corrupt, like India (ranking 94 on CPI in 2012) or China (ranking 80 on CPI in 2012), or less corrupt like the U.S. IM argue that their findings also provide some hope that corruption can be reduced, if there are significant number of honest peers to establish the social norm of honesty, integrity and truthfulness.

Chrystia Freeland, in her book “Plutocrats,” refers to a study in a book by Daron Acemoglu and James Robinson (AR) that analyses rise and downfall of nations. AR argue that the difference between failed states and successful states is “whether their governing institutions are inclusive or extractive.” In extractive states, ruling elites exercise control. 

The ruling elite’s aim is to acquire power and maximum amount of wealth from the rest of the society.

Concentration of power and wealth breeds corruption, and after a point it plagues the rest of the society. Inclusive states enable everyone to take part in the governance of institutions and society and provide access to economic opportunity for all. 

Leaders in the U.S. should be alarmed by the growing concentration of wealth, increasing corruption in business and among public officials, declining growth rate, high unemployment and under employment, declining wages and the gradual decline of the middle class.

Mathur is former chairman and professor of economics and now professor emeritus, Department of Economics, Cleveland State University, Cleveland, Ohio.   He also writes blogs for the Standard-Examiner at http://blogs.standard.net/economics,etc.

Is productive entrepreneurship in decline in the U.S.?

Vijay K. Mathur

Published in Standard-Examiner, July 19, 2013, Ogden, Utah

In a recent investigative article on risk-taking and entrepreneurship in the June 20 Wall Street Journal, Ben Casselman finds that Americans have become more risk-averse.  This decline of risk-taking and entrepreneurship is manifested in the decline of new business formations, start-up rates, new job creation, and fewer adults changing jobs. It is creating less churn and dynamism in the economy, important characteristics of a growing economy.

   

Coincidently, this decline in risk-taking and entrepreneurship is accompanied by increasing income and wealth inequality, shrinking of middle class, decrease in employer businesses, and big business with market and/or asset concentration.  Middle-income class provides the reservoir of entrepreneurship, a resource whose allocation into different activities determines the well-being of a capitalistic market economy. 

In “A History of Economic Theory and Method,” Robert Ekelund, Jr. and Robert Herbert, state that the earliest discussion on the role of an entrepreneur in an economy is found in Richard Cantillon’s 18th century work. He was an economist, Paris banker and a London merchant. For Cantillon, entrepreneurs either work with capital in their enterprises or without capital for uncertain wages, as opposed to other workers who work for certain wages. He even considered robbers and beggars as entrepreneurs.

However, 19th century economist Joseph Schumpeter crystallized the concept and considered entrepreneurs crucial for economic development in a capitalistic society. For Schumpeter, an entrepreneur sees and grabs opportunities for new products, processes, markets, organizations, resources, and any innovation to start and build an enterprise. He need not be a capitalist, businessman, manager or inventor. The common assumption that an entrepreneur is an inventor and always promotes growth and development is faulty.

A nation must design rules, regulations, laws and an incentive system that produce productive entrepreneurs who make positive contributions to the national economy. Political indecisions and corruption create uncertainty in the design and implementation of laws and regulations that encourage entrepreneurship. 

Professor William Baumol, in his paper in the October 1990 Journal of Political Economy, further advances Cantillon’s idea. Baumol argues that an entrepreneur is like any other resource. Rules, regulations, laws and incentive system can influence the allocation of entrepreneurial resources into productive or unproductive and even damaging activities (e.g., drug cartels) deleterious to the nation.

He states, “If entrepreneurs are defined, simply, to be persons who are ingenious and creative in finding ways that add to their own wealth, power, and prestige, then it is to be expected that not all of them will be overly concerned with whether an activity that achieves these goals adds much or little to the social product.” 

For Baumol, a Schumpeterian list for entrepreneurial activities should also include economic rent-seeking innovations, the type of innovations we witnessed in the financial bubble of 2007-08 that eventually led to the Great Recession. In general, rent-seeking behavior implies keeping and/or acquiring claims on resources to earn excess profits. Maintaining the ethanol subsidy by corn producers is an example.

  

Baumol argues that in ancient Rome and China, despite many innovations, productive entrepreneurship in commerce and industry was discouraged by rules, regulations, reward systems, prestige and general attitude of rulers. Rules of the game were stacked against wealth accumulation in economically productive enterprises. Courts encouraged entrepreneurship that engaged in rent-seeking behavior through political favors.

The Great Recession of 2007 showed us how non-enforcement and/or non-existence of government rules and regulations and loopholes in laws led to the emergence of some entrepreneurs who implemented financial innovations that were not only unproductive but contributed to the serious recession. The emergence of such entrepreneurs was encouraged not only by non-enforcement of rules and regulations, but also by tacit approval of rent-seeking by relevant authorities to accumulate wealth by many, at the cost of the Great Recession. FBI reports show that mortgage fraud, as measured by Suspicious Activity Reports, increased 573 percent during 2003-2007. Only 7 percent of SARs filed during FY2007 led to losses of more than $813 million. 

In addition to a 4 percent decline in GDP and 10.1 percent unemployment rates from December 2007 and June 2009, economist Scott Shane of the Cleveland Fed reports in The Economic Commentary, March 24, 2011, that entrepreneurship, measured by employer firms, decreased by 146,000 firms. Perhaps rules, regulations and incentives facing many relatively small employer firms are so archaic and cumbersome that it is discouraging many in the dwindling middle class to be risk-takers in productive activities.

  

The rewards for small-employer firms, who face stiff competition from big and concentrated businesses with outsourced profits, may be skewed towards activities that are shadier, border on corrupt practices and rent-seeking through political favors. The Supreme Court decision on Citizens United has further encouraged rent-seeking behavior.

  

If the U.S. wishes to regain its momentum for innovations and entrepreneurship, it must implement rules, regulations, laws and an incentive system that encourage productive entrepreneurship that contributes to economic growth and well-being for all Americans.

Mathur is former chairmen and professor of economics and now professor emeritus, Department of Economics, Cleveland State University, Cleveland, Ohio.  He also writes blogs for the Standard-Examiner at http://blogs.standard.net/economics,etc.

Medical care cost control requires both demand and supply management

Vijay K. Mathur

Published in Standard-Examiner, April 14, 2013, Ogden, Utah

It is well known that the price people pay for medical care either directly or indirectly is increasing at a rapid rate. In 2011 the national expenditure for health care was $2.7 trillion, a 92 percent increase since 2000. If the medical care market is competitive, the interaction of demand and supply would determine its price, and that price will be efficient and welfare maximizing.  However, despite the usual rhetoric of politicians and free market ideologues, the medical care market suffers from what economists call market failure. Competition in the medical care market, for example, requires a large number of buyers and independent providers of services, a relatively small size of providers to avoid dominance, full information about quality and prices of services.

On the demand side, competition works when consumers are well informed about the quality of medical care services and prices actually paid by them so that they can shop for services. Usually though, patients depend upon their doctors for information about medical procedures, need for those procedures, drugs, and hospitals’ quality.

Physicians are the agents who look after patients’ interests. However, when doctors are either employed by hospitals or have privileges in using hospital services, their loyalty is split between patients and hospitals.

Doctors have incentive to overuse medical services, because their own compensation is based upon the amount billed to insurance companies and/or to government programs such as Medicare and Medicaid. Third-party payment systems encourage doctors to create demand for hospitalization and/or medical services.  For example, a Rand Corporation study, “ Health Insurance Experiment” in 1982, found that when patients shared in the cost of medical care in an HMO, their use of all medical services was much less than those who had free care, without affecting quality of care and health outcomes.

Most of the discussion about medical care costs centers around demand and not much attention is paid to the supply side (cost). There is no doubt that something has to be done on the demand side, such as, increasing means tested and capped co-pays as a percent of the total bill of services as opposed to flat amounts. This will make consumers aware of their costs in relation to prices charged.  In 2011, those 65 years old and over constituted 13 percent of the total population while federal spending on Medicare and Medicaid was 30 percent of the total health care spending. Per capita spending on older people in 2011 was close to $14,000.

On the supply side, hospitals operate in a non-competitive market. The March 4, issue of Time magazine presents an in-depth investigation by Steven Brill on hospitals’ pricing strategy. He finds that hospital pricing cannot be explained by costs of medical services and procedures. It resembles monopolistic pricing strategy, in which hospitals dictate prices as opposed to being subjected to market prices. Steven Brill states, “ No hospital’s Chargemaster prices are consistent with those of any other hospital, nor do they seem to be based on anything objective — like cost — that any hospital executive spoke with was able to explain.” Chargemaster prices are prices most hospitals use in their billings, however they are discounted for insurance companies and Medicare. Even with discounts hospitals earn abnormal profits, unlike other businesses.

Contrary to other industries, improved technology in medical care, has led to an increase in costs. This is partly due to more ease in conducting various tests, fee for service pricing and efforts to ward off complaints.  The evidence does show increase in costly tests and medical procedures, a result of lack of attention to preventive care. 

Tests have increased by extending the population group, e.g., screening younger groups for breast cancer (extensive margin), and by increasing the number of tests on the same population group, e.g., more frequent colonoscopies (intensive margin). This has increased cost as well as profits of hospitals and physicians’ compensation.

Since evidence-based tests and treatments have not been extensively implemented either in hospitals or physicians’ clinics, we find a great variation in tests, procedures and hence, cost of medical care. In addition, since physicians are not sole agents of patients, they have no incentive to shop around for best prices on behalf of their patients. Also, control of prices due to monopoly power puts no pressure on hospitals to restrain abnormal compensation packages for administrators, physicians and other personnel, hence escalating total costs of care.

It is ironic that we regulate gas and electricity prices but not prices of medical care services, even though this market is monopolistic. It is only through Medicare, Medicaid and to a certain extent through insurance system that the cost of medical care for most consumers is kept below Chargemaster price level. The Affordable Care Act also contains provisions to contain costs of medical services (e.g., payments based on treatment outcomes) and insurance premiums.  However, a single-payer Medicare system for all, with a means tested increase in Medicare tax and supplemented by private insurance system, would be more cost effective than the mish-mash system we have now.

Mathur is former chairman and professor of economics and now professor emeritus, Department of Economics, Cleveland State University, Cleveland, Ohio. His articles also appear in mathursblogonomics.blogs.com. He also writes a blog for the Standard-Examiner at http://blogs.standard.net/economics,etc.

Misunderstanding on budget deficits and debts

Vijay K. Mathur

Published in Standard-Examiner, February 10, 2013, Ogden, Utah

Many Americans, including politicians and media pundits, are not well informed about federal budget deficits and debt and their role in fiscal policy. Most equate it with consumer debt. They also believe that state and local governments and consumers balance their budgets, and hence by implication have no debts. They assume that debt is burdensome on our children, without realizing that children also inherit substantial federal assets. However, the view that federal government should follow the example of states and consumers to balance its budget and reduce debt is not based on sound economic reasoning.

  

Budget deficit occurs when consumers’ spending exceeds income received in any given year. Borrowing, on credit cards or from other sources, must finance budget deficits. Debt in any given year is accumulated deficits over a period of time. Data shows that consumers in general are not debt-free in any given year, as many tend to assume. For example, New York Fed reports that in September 2012, total consumer debt, including mortgage debt, was $11.31 trillion, almost the same as federal debt held by the public in 2012. Consumers willingly tolerate debt if they have enough disposable income to service their debt. However, as opposed to governments at all levels, consumers do not have the power to tax or issue securities to finance their obligations. Individually, they also do not have the power to regulate business cycles or promote economic growth and development.

State and local governments also have debts in any given year. According to state government finances, total debt (excluding pension obligations) across all states was $1.132 trillion in 2011, and Utah was no exception. Federal government, as opposed to state and local governments, uses deficits and debt as a tool of fiscal policy to fine-tune the economy and build and accumulate national assets. In addition, the federal government has the constitutional obligation to provide national security against enemies and may have to incur deficits and debt to finance those obligations. 

In recessions, private consumption spending and private investment tend to decline. If exports are not increasing to offset imports, as is the case for the U.S. since 1976, the only component that can increase gross domestic product (GDP), a measure of a nation’s income, is to increase federal spending and hence deficits. In recessions tax revenues also decline. However increasing taxes, on all Americans at all income levels, in recessions is counter productive. Therefore, the only option to finance budget deficits is to issue Treasury securities (debt obligations). In 2011 the deficit was $1.3 trillion (8.7 percent of the GDP), decreasing 0.11 trillion from its recessionary peak in 2009.

No one is forced to buy Treasury securities. Individuals, businesses, foreign governments, pension funds and other investors and institutions buy these securities as a safe investment. As long as the federal government is able to service its debt and meet its obligations given its capacity to pay, the problem of default does not arise. Note, there is a distinction between “total debt” ($14.7 trillion in 2011) and “debt held by the public” ($10.1 trillion in 2011). In addition to “debt held by the public,” “total debt” includes obligations for entitlements such as Social Security, Medicare and other intra-government debt obligations. However, a significant part of “total debt” burden can be ameliorated, while at the same time assuring future benefits, by increasing income limit for Social Security and Medicare tax on higher income people. 

“Debt held by the public” includes debt to domestic and international investors, state and local governments and the Federal Reserve. The Congressional Budget Office (CBO) estimates that this debt was 77.8 percent with net interest cost of only 1.4 percent of the GDP in 2012; it is expected to decline to 58.5 percent of the GDP in 2022 with slight increase in interest cost. Federal debt poses no threat to inflation and crowding out private investment, since interest rates and inflation rates have been so low for quite some time. 

Americans should also know that total foreign debt is close to 48 percent of the “debt held by the public” and mainland China holds only 10 percent of our debt obligations in 2012-Q3. Moreover, no one is forcing China to buy U.S. Treasury securities. Given the economic conditions elsewhere in the world and China’s stake in the U.S. as an export market, it considers our securities a safe investment. Moreover, debt to foreigners should be viewed in terms of their substantial debt to us.

   

It should be understood that we cannot keep on piling up debt beyond our capacity to service and meet other debt obligations, but recessions are not the time for spending cuts. 

Taxes and spending should be tailored to stimulate investment in research and development, private and public physical capital, and human capital. All eyes should be focused on policies that stimulate growth now, and on deficit and debt reductions when the economy picks up robust growth.

Mathur is former chair and professor of economics and now professor emeritus, Department of Economics, Cleveland State University, Cleveland, Ohio. He also writes blogs for the Standard-Examiner at http://blogs.standard.net/economics,etc.

Incentivizing poor and low-income persons to work and save more

Vijay K. Mathur

Published in Standard-Examiner, October 28, 2012, Ogden, Utah

Means-tested anti-poverty programs determine eligibility based on income and assets. If benefits to able-bodied low income and poor persons are cut in larger proportions of their increasing earnings and assets, it provides a disincentive to earn and save more. Benefit cuts are like a tax on work earnings.

The study by John Karl Scholz, Robert Moffitt and Benjamin Cowan (SMC), Discussion Paper no. 1350-08, September 2008 (www.irp.wisc.edu), cites a study of low-wage single-parent families in New York where benefit cuts were such that their extra dollar earnings, from working between 8 to 35 hours per week, would increase their take home by only 15 cents per dollar earned (a 85 percent cut in income). However, there is also an upside of anti-poverty programs. SMC study investigates the role of social insurance programs and means-tested transfers, including entitlements, in reducing poverty. Assuming no behavioral response, they show these programs do reduce percentage of poor across different family types between 35 percent to 86 percent. The investigators did not want to confound the effect of anti-poverty programs on poverty rates by including behavioral responses. Even though anti-poverty programs have substantially reduced poverty rates, there is still a significant fraction of poor people in the country.

It appears that a large proportion of post transfers residual poverty rates must be due to behavioral responses to programs’ benefit policies. Program benefit cuts are an increasingly larger proportion of increasing earnings and assets, as the above study for New York shows. In addition, more benefits are guided to single parent as opposed to two parent families, thus encouraging formation of single parent families and/or encouraging divorces. The data show that single parent families headed by females have a much higher poverty rate than two parent families.

Since benefits and Earned Income Tax Credit (EITC) increase with family size, they tend to encourage more children in a single-parent family. Large family size is another source of hardship for poor families. However EITC, one of the fastest growing means tested program after Medicaid, is a pro-work program. Mr. Romney once remarked that the 47 percent of Americans who do not pay federal income taxes claim victimhood and expect the government to provide these transfers. It includes all those low-income people and poor who receive EITC. The credit provides incentive to work. Therefore, if the credit is taken away, poverty roles will further increase. In fact all means tested poverty programs for able-bodied persons, including food stamps, TANF (Temporary Assistance to Needy Families), housing subsidies and supplemental nutrition program (WIC), should be tailored around the theme of work incentives.

If we are serious about reducing poverty, benefits should increase when able-bodied poor and low-income families earn and save more, until income reaches a threshold level equal to "Basic Needs Budget" (BNB) proposed by National Center for Children in Poverty (NCCP) at Columbia University (www. Nccp.org). NCCP’s budget based income thresholds are higher than the poverty income thresholds defined by the Census Bureau, and vary from high-cost to low-cost cities and types of families. For example, Kinsey Dinan of NCCP (March, 2009) proposed annual income need of $41,000 for a single-parent family with two children in moderate-cost city, Des Moines, Iowa. It is 233 percent of the federal poverty level.

There is another beneficial side effect of pro-work EITC. The study by Gordon Dahl and Lance Lochner (DL), American Economic Review, August 2012, investigates scholastic achievement of children five years old and over due to EITC. They use a data set of 4,500 children from the National Longitudinal Survey of Youth and sample period (1987-2000) and measure family income as total net income, including EITC net of federal and state taxes and transfers. Test scores on PIAT (Peabody Individual Achievement Tests) measure scholastic performance of children. These standardized scores measure ability in mathematics, oral reading, reading comprehension and ability to derive meaning from printed words.

They find that increase in current income due to EITC significantly increases a child’s math and reading scores. Increase in scores is larger for younger children growing up in poor disadvantaged families, such as unmarried households, minority families, families with low-educated mothers. The effects are also more pronounced for boys. These findings are predictive of a better future for poor children and economic well-being of poor families.

Evidence indicates that means tested anti-poverty programs would provide incentives for work if a smaller proportion of benefits were reduced with increase in earned income. Census Bureau’s measures of poverty income are inadequate and hence should be modified along the lines of BNB. Also, benefits should promote education and skills and asset accumulation to put poor families on a sustainable path to economic self-sufficiency and replace programs that subsidize employers such as Work Opportunity Tax Credit. These subsidies do not help fill the skill gap emerging in the labor market due to the changing structure of the economy.

This is the second part of a two-column series by Mathur, who wrote on Oct. 21 about a renewed focus on poverty and entitlements. Mathur is former chair and professor of economics and now professor emeritus, Department of Economics, Cleveland State University, Cleveland, Ohio. He also writes blogs for the Standard-Examiner at http://blogs.standard.net/economics,etc.