Yes, the Earth is Round

[Dellerman@worldbank.org]

This is in response to several EMs, one from Michael Harrington on 8/10 and a
brief one on 10/14, and to an intervening one from Shann Turnbull on10/13.

1. I am abit puzzled by the continuing criticism of orthodox economics that they
don't understand the "productivity of capital"!  This is one of the kooky
aspects of Kelsoian economics--the idea that capitalist economists don't know
about the productivity of capital because of the journalistic emphasis on the
statistic of "labor productivity" which is sometimes shortened to
"productivity".  Please crack any text and read about capital theory.  I am just
baffled how anyone could really think capitalist economists have fallen down on
their job to emphasize the productivity of capital.

Perhaps the logic is like this.  Kelsoians discover that the earth is round and
then after some bizarre reasoning conclude that the moon is made of green
cheese.  When others deny that the moon is made of green cheese, the Kelsonians
accuse them of not realizing that the earth is round.  Let me assure all
Kelsonians within earshot that conventional economists really do understand that
capital is productive.  The disagreement must lie somewhere else!

Anyway on to substantive issues.

2. One of the issues about ESOPs is who ends up paying for ESOP shares?  MH
dodged the issue by modeling it as a case of borrowing money to buy equity and
then paying off the loan with the proceeds from the equity.  MH is trying to
model the ESOP on the limiting case of a 100% leveraged buyout where the ESOP
trust, in effect, plays the role of the acquisition shell.  But ESOPs work for
any percent of ownership, and the general result I referred to is that without
any productivity effect on workers or changing wage demands and things of that
sort, then the value of the shares that end up in the workers hands comes from
dilution and tax breaks. In the near 100% or 100% buyout case, there are no
other shareholders to dilute so the LBO enterprises often ended up having to
partially decapitalized to make the payments for the loans that financed the
LBOs (remember the 80s?)--sort of a self-dilution.  Alot of the hoopla in the
80s was about all the productivity improvements that the new management was
going to make to be able to pay off the loans without decapitalizing the
companies.  I will submit my paper on "Who Pays for ESOP Shares?" to the
discussion list.  It gives a derivation of these results.

In general, ESOP loans are hardly paid for out of dividends (as I pointed out).
If they were, then indeed it would be a trivial transaction to analyze, namely
borrowing to buy equity and paying the debt off strictly from that equity.

To better see the problem, perhaps one should focus on the shell game involved
in the two descriptions of the ESOP transaction.

ESOP descriptions often involve a type of "shell game" of switching between two
quite different interpretations of the transaction.  The front-end is described
as an equity injection?a purchase of shares at full market value.  And the
back-end of the transaction is described as paying off a loan with pretax
dollars.   But if the front-end is described as shares being purchased with
money borrowed by another party (the ESOP), then it should be added that the
corporation itself pays off the other party's loan with the ESOP contributions
[the corporation and ESOP can only be identified in the 100% case].  And if the
back-end of the transaction is described by paying off a loan with pretax
dollars, then it should be added that the company has already "paid for" the
cash injection (the loan) with the transfer of shares to the ESOP.   But ESOP
descriptions often focus on either the front-end equity injection or the
back-end tax-favored loan payments without giving the effect of the whole
transaction.

In fact, the company pays twice for the money it receives in an ESOP loan, once
with the new shares issued to the ESOP (a quid pro quo transaction) and the
second time with the loan payback.  The tax break on the loan payback reduces
the 100% dilution of the second time the funds are paid for to whatever is left
after the tax break.  If the company is in a 40% bracket, then 40% of the ESOP
shares value is paid by the tax break and the remaining 60% is dilution.  This
is all shown rigorously in the aforementioned paper.

If the ESOP loan buys say 10% of the shares, then the company (which is 90%
different from the workers) is paying off the loan which means less value to the
equity (90% owned by others) and that is dilution.  But the company gets the tax
break to pay off the loan that way, so the dilution is less than it would
otherwise be due to the tax break.  One has to carry through this analysis to
see why the stuff about "self-liquidating loans" was intellectual fog to cover
up the dilution.

MH's attempt to use CAPM-style arguments is a non-starter since one can go
through the whole analysis of dilution & tax breaks under conditions of
certainty (so clearly the risk premium on equity is not the essence of the
argument).  Suppose a model has characteristics A and B, with A presented as the
cause of B.  But then one takes another model without A and finds that B is
still there, so A (worker risk-bearing) was apparently not the cause of B (value
of shares ending up in worker hands).

Naturally one should also be cautious about attributing the CAPM risk premium to
some special productivity of capital since it derives from the assumed
risk-averse nature of the economic agents, not from a characteristic of the
capital goods or financial capital.


Let me move on now to Shann's EM of 10/14.  He starts off with saying that
according to his interpretation of my Chapter 6, I don't understand "that
productive assets provide a source of greater productivity, income and growth."
Many thanks, Shann, for pointing that out.  I guess I must have missed that.
[You see Vic, I am learning already from this debate so it isn't totally
stupid.]

Shann goes on to say that the dilution argument is possible only because
"bankers" don't enforce "ownership sharing" where the latter I think means
Shann's form of expiring (dynamic) property rights in capital (like the expiring
property rights in intellectual capital).  Perhaps this would be a good place to
comment on that idea.  There already are examples of essentially such property
rights, namely ownership of rental properties in rent-controlled districts.
With no de facto or de jure subletting, then the people living in those
apartments are in effect getting part of the rental (being allowed to not pay it
to the property owner) so the rental control has the (well-known) effect of
attenuating the property right.  This does not model the time-change in Shann's
expiring equity rights but it does model the attenuation and that is the source
of the problems.  There is firstly a problem with the switchover.  The owner of
the property might have bought it for full price so the imposition of the
attenuated-right scheme amounts to a partial expropriation which may cause a
political problem to more people than "bankers."  Secondly, there are well-known
supply effects.  Given a choice, no one would build rental properties in rental
controlled areas.  Or to be more precise, if the rent controls took away say
half the return, then one would only build super profitable properties so that
the attenuated rate of return to invested capital would be normal.  Thus the
effect of this suggestion would be to cut down on the production of the capital
to which the attenuated property rights apply, a funny suggestion from one who
is accusing others of not appreciating the productivity of capital.

Anyway, moving on, Shann goes on to say that the chapter shows that "Ellerman
believes that economic development is created by the productivity of labor
rather than the productivity of productive assets..."  In other words, Ellerman
must not realize that the earth is round since he does not buy our conclusions
that the moon is made of green cheese.

The next few paragraphs talk about Harold Moulton's notion of "procreative
assets" which are "a special class of productive assets which over their useful
life create more value than the cost of their establishment and operations
before the transfer of any value in the form of interest payments and taxes.
That is, all procreative assets must by definition become self-financing.  It
would seem that modern economists no longer use the concept of procreative
assets and so have lost an intellectual tool to ..."  Shann, you really have to
take a peek at any economics or corporate finance text.  That is simply the
ordinary notion of a capital asset which might yield a profit after the
subtraction of all costs of acquisition and operation.  That is perfectly
ordinary capital theory in Samuelson's or any other text.  How could you
possibly think that is some sort of discovery??

I don't think I will be long for this debate if I am called upon to explain that
capitalist economists really do understand the notion of capital goods that are
profitable to buy and operate.  If that is supposed to be the discovery that
Kelsoians have made, then I think we have a clue why economists don't take
Kelsoians seriously.  Actually, Kelso discovered something much more important
which I spelled out in the chapter but which could be rephrased as a way to
dilute absentee shareholders in favor of workers all under a verbal smokescreen
about the wonders of "capital."  Now that really is an accomplishment!

The dilution + tax break argument is still the starting point to understand the
key point of who pays for ESOP shares, and, so far, the commentators have not
engaged the argument.  Ranting that others don't appreciate one's discovery of
the round earth will not do.

Instead of wasting your and our time with such a banality from Moulton, the
first president of the Brookings Institution, why don't you read Brookings
himself?  He suggested


     to  require  that  [interstate]  corporations  should reincorporate under a
     federal  incorporation  act;  which  act,  while securing to capital a fair
     return  at  a  fixed rate of interest and dividends, risk considered, would
     divide  all  additional  profit  or  accretions in the form of labor shares
     between  the  employees  (management  and  labor)  in  the  ratio  of their
     individual  contribution,  probably  as  recorded  by  their wage or salary
     compensation.  [Brookings,  Robert  S.  1932,   The Way Forward.  New York:
     MacMillan, 17-18]


     This  reform  would consist largely in the rental of capital by the workers
     and  management,  stabilizing a fair rental return for it while leaving the
     workers  and  management  as their remuneration all the profits. [Brookings
     1932,  The Way Forward.  New York: MacMillan, 73-74]





_______________________________
David Ellerman
Economic Advisor to the Chief Economist
World Bank, Room MC4-335
1818 H St., NW
Washington, DC 20433
Ph: 202-473-6368
Fx: 202-522-1158