Price Gouging

“Price Gouging in a Pandemic,” by Christopher Buccafusco, Daniel Hemel, and Eric Talley. SSRN Working Paper no. 3758620, January 2021.

When negative supply shocks occur, debate immediately arises about the appropriate role of price changes as an acceptable allocation method. The conventional wisdom is that only economists favor large price changes to reduce demand and create incentives for increased supply to remedy the negative supply shock. Everyone else supposedly prefers quantity limits on consumption.

This conventional wisdom was first presented academically by Daniel Kahneman, Jack L. Knetsch, and Richard Thaler in their 1986 American Economic Review article “Fairness as a Constraint on Profit Seeking: Entitlements in the Market.” They surveyed Canadians in Toronto and Vancouver about a scenario in which a hardware store raised the price of snow shovels from $15 to $20 after a large snowstorm. They reported that more than 82% of respondents characterized the price increase as unfair.

The COVID-19 pandemic has provided an opportunity to test whether this view is held by today’s Americans. In this paper, Christopher Buccafusco (Cardozo School of Law), Daniel Hemel (University of Chicago Law School), and Eric Talley (Columbia University School of Law) surveyed 656 U.S. residents in May 2020 about a scenario in which a supermarket raised the price of a bottle of hand sanitizer after the onset of COVID-19 by the same 33% that Kahneman et al. used in their paper. Just 46.6% of respondents deemed the increase to be unfair. The survey also asked about potato chips (a nonessential item) and snow shovels (to replicate the Kahneman et al. question exactly) and found similar results.

Buccafusco et al. also asked participants how government should respond to a supermarket that raises the price of hand sanitizer by 33% after the onset of the COVID-19 crisis. Approximately three-fifths of respondents said the government should do nothing. This finding is particularly striking given that, in many states, a price increase of that magnitude in an emergency would be prima facie illegal and, in many cases, punishable as a misdemeanor. The price-gouging thresholds most states use — typically a 10–25% increase over normal prices — are significantly lower than the 33% increase that generates consistent acceptance from survey participants. — Peter Van Doren

Securities Regulation

“Gamestonk: What Happened and What to Do about It,” by James Angel. SSRN Working Paper no. 3782195, February 2021.

Speculative activity surrounding the stock of the video game retailer GameStop has been in the news. The firm’s share price exploded from $18.84 at the end of 2020 to a high of $483 on January 28, 2021, before collapsing to under $60 in early February.

Gamestops are found in traditional shopping malls, which means high lease costs for a retailer that faces growing competition from internet-distributed games. Institutional investors, including prominent hedge fund Melvin Capital, shorted GameStop because they concluded the future of such a business is doomed and that its stock price was overvalued. Shorting stock (borrowing shares and selling them now in the belief that they can be purchased for less in the future when they need to be returned) is a useful and important activity that appropriately disciplines stock market optimism.

According to media accounts, GameStop stock was involved in what is termed a “short squeeze.” Retail investors using venues that do not charge commissions, like E‑Trade and Robinhood, purchased GameStop shares in a David-versus-Goliath battle against the institutional shorts. The squeeze results from the fact that those who short the stock must eventually buy it to return the borrowed shares to their original owners. If enough investors buy shares, the shorts must compete against them to buy stock at an increased price to return the borrowed shares. Melvin Capital had to raise $2.75 billion to close out its failed short bet on GameStop.

This paper, by Georgetown finance professor James Angel, examines possible reforms of Securities and Exchange Commission rules regulating the shorting of securities in light of the GameStop events.

The manner in which the Internal Revenue Service treats the realization of capital gains from shorting inefficiently prolongs the time period over which stock shorting occurs. The IRS generally taxes stock trades when a position is closed out and the profit or loss is realized. This makes sense when cash is received when a stock is sold. In a successful short sale, however, the short seller has received the cash long before the position is closed out as a result of the daily collateral adjustment that occurs in the stock lending market. The current tax treatment induces those who short never to close out the position, and thus short sellers have incentive to spread negative information about the future of the shorted firm forever. The solution is to tax short positions like futures and mark to market at the end of each year.

Retail investors who want to short a stock face obstacles not encountered by institutional investors, so the supply is unnecessarily constrained. The 2010 Dodd–Frank Act explicitly ordered the SEC to enact new rules to improve transparency in the stock lending market within two years. The SEC failed to do so, and currently short interest in each stock is disclosed only twice a month, with a lag of several days. The short market needs a real-time “ticker tape” that resembles the information on stock purchases.

Retail investors also face rules that unnecessarily restrict their ability to loan shares to be shorted. If a customer borrows money from a broker in a brokerage margin account, the broker can lend out shares from that account worth up to 140% of the amount borrowed. If the shares are fully owned with no borrowed money, the broker must navigate a more complicated set of rules. The result is that most brokers don’t allow such shares to be loaned for shorting. Fully owned shares and shares bought on margin should be treated similarly.

Some stock trades are not fulfilled. Prior to the 2008 financial crisis, the United States was very lax about stock delivery. Some short sellers “who were too cheap to pay to borrow shares in the proper fashion took advantage of the system,” Angel explains. During the October 2008 financial meltdown, the SEC implemented a rule that required shares be delivered on settlement day. This knife-edge delivery requirement assists those who engineer short squeezes like what occurred with GameStop. Those who must buy stock at any price to then return shares to their original owners exacerbate the increase in the price of a stock. Evidence consistent with this argument is that there were relatively few failures to deliver GameStop on January 27, when its price reached $348. Failures to deliver fell dramatically on January 27, from 1,032,986 shares the day before to 138,179, suggesting the high price was the result of shorts buying GameStop to return shares to those from whom they had borrowed.

Short interest in a stock is disclosed only twice a month, with a lag of several days. The short market needs a real-time “ticker tape” like what exists for stock purchases.

Angel recommends that the SEC abandon the required share delivery rule and instead adopt what is used in the U.S. Treasury bond market: a late-fee system. The fees would escalate with the length of the delivery delay and be large enough that market participants will only delay delivery in exceptional circumstances.

Robinhood restricted trading in GameStop because it could not raise collateral quickly enough to cover the trades of its retail investors. Collateral requirements are the result of the two-day settlement period for stock trades that was developed when stock certificates were paper. On the day after a stock trade, money must be deposited with the settlement corporation to cover the cost of the trade in case the broker goes bankrupt before settlement occurs on the second day. During the GameStop episode, total industry collateral requirements jumped overnight from $26 billion to $33.5 billion on January 28. Brokers such as Robinhood scrambled to raise additional capital. The scramble was exacerbated by the SEC’s Customer Protection Rule, which requires brokerage firms to segregate customer assets from those of the firm. Even for stocks purchased with cash, the firm is not permitted to use the proceeds to post as collateral the day after the trade. — P.V.D.

Social Welfare Policy

“Lessons from Denmark about Inequality and Social Mobility,” by James J. Heckman and Rasmus Landersø. NBER Working Paper no. 28543, March 2021.

President Biden’s American Families Plan includes taxpayer-funded universal pre-kindergarten and community college. Such proposals are always accompanied by the obligatory observation that “the United States is an outlier compared to almost every industrialized country” regarding the provision of universal social safety net benefits.

Supporters of such programs assume that their effects are progressive. That is, they improve the welfare of those with fewer resources relative to those with more. The earlier quote about the United States being an outlier suggests an obvious research strategy before we enact such policies: what have the effects been in Europe?

Previous Working Papers columns (Summer 2014 and Summer 2018) have examined papers by University of California, San Diego economist Gordon Dahl, who has devoted much of his career to examining the efficiency and distributional effects of social welfare policies in Europe. The Summer 2014 column summarized his analysis of expansion of maternal-leave benefits in Norway. Dahl and his co-authors concluded that the program had no effect on a wide variety of desired outcomes and instead redistributed income to the affluent. The Summer 2018 column examined the long-term effects of reductions in disability benefits in the Netherlands between 1993 and 1996. The reductions applied to younger cohorts, while older cohorts were exempted from the new rules. Younger workers who were pushed out of disability insurance or had their benefits reduced are now, a generation later, 11% less likely to receive disability benefits than their parents’ generation (with no increased use of other government safety net programs). Further, they earn 2% more in the labor market as adults. The reduction in benefits aided taxpayers as well as program participants.

Nobel economics laureate James Heckman, working with Rasmus Landersø of the Rockwool Foundation Research Unit in Denmark, continues the tradition of examining social welfare policies in Europe by examining Denmark. For many American policy analysts, Denmark is a model welfare state with low levels of income inequality and high levels of social mobility in income across generations. It has free college tuition, universal access to high-quality health care, equality of per-pupil expenditures across all neighborhoods, universal high-quality pre‑K, and generous childcare and maternity leave policy.

The paper demonstrates that Denmark achieves reduced inequality not by the provision of universal public services that augment human capital, but through tax-and-transfer policies. Intergenerational mobility in educational attainment declined when Denmark moved away from targeted programs that aided the least advantaged (mostly rural) groups and instituted universal education policies such as free college tuition and universal daycare. Current educational mobility in Denmark and the United States are similar and associations between test scores and family background are also strikingly similar. The relationship between cognitive test scores and parental income are remarkably similar in Denmark and the United States and haven’t really changed over time in Denmark despite the large expansion of universal welfare state programs. — P.V.D.

Proxy Advisers

“Proxy Advisors and Market Power: A Review of Institutional Investor Robovoting,” by Paul Rose. Manhattan Institute, April 2021.

Investment management is a hyper-competitive business whose practitioners work dreadful hours trying to gain an edge in the market. They don’t want to waste time or energy on tasks that are largely irrelevant to their attempts to divine the future performance of publicly traded companies.

One undesirable task they nonetheless have to undertake is voting their proxy shares. The Securities and Exchange Commission requires investment managers to vote their proxies for each company whose shares they own. Because the majority of these votes are rote and inconsequential (shareholders must vote for a slate of directors each year and consider any proposal put forth by a shareholder owning more than $2,000 in shares), most investment managers turn the task over to a proxy adviser.

However, in the last few years an increasing number of proxy proposals have dealt with issues that could potentially affect a firm’s long-run performance. After the 2016 presidential election, many activists engaged public corporations on a variety of political issues that the activists were unable to get traction on in Congress or with the Trump administration, mostly pertaining to environmental, social, or governance (ESG) issues. Some of their proposals had the potential to reduce firms’ long-run profits, thereby reducing stock values.

However, most investment advisers do not personally vote their proxies for the companies whose stock they own. Because they own stock in hundreds of companies and by law must vote each proxy, most of them foist that task onto a proxy advisory firm.

Even small reductions in an asset’s rate of return can have a big effect on the amount of money that a retiree accumulates over a lifetime of savings.

Two firms, Glass Lewis and Institutional Shareholder Services (ISS), dominate the proxy advising market and are not indifferent to political issues. Perhaps surprisingly, their perspectives often align with the activists who submit such proposals. As a result, activists have begun to win some proxy votes, especially on those related to climate change.

The SEC professed concern with investment managers completely abdicating the task of proxy voting to an outside entity — sometimes referred to as “robo-voting” — because the practice may reduce clients’ returns, suggesting that robo-voting is not in the best interest of investors. In 2020 the SEC completed a rule that put in place a system to allow firm managers to respond to proxy advisory recommendations and requires proxy advisers to distribute those responses to their clients.

The SEC also issued guidance telling asset managers that to fulfill their fiduciary duty to their clients, they have a responsibility to review the proxy adviser’s recommendation, along with management’s response to that recommendation, to show that they are performing their due diligence and attempting to vote in accordance with their clients’ interests.

Paul Rose, a professor at Ohio State University’s Moritz College of Law, looked at the extent to which investment managers have conformed to the new rule thus far. The SEC’s rule does not fully take effect until the 2022 proxy season, so compliance in 2020 and 2021 is largely voluntary. He suggests that the prevalence of early compliance would indicate the degree of enthusiasm that the profession has for the rule and — perhaps — how likely it is for the rule to remain in place through the next four years. The Biden SEC has already taken several steps toward enhancing the role that ESG–focused investing has in financial markets.

Rose finds that the practice of robo-voting declined only modestly in 2020: 6% fewer asset managers appeared to turn over their votes to their proxy advisers, and this group only accounted for about 3.6% of assets under management for those affected by the rule.

Besides increasing the cost (and hassle) of administering proxy votes, Rose observes that another reason for the relative lack of enthusiasm may be that investment managers care about their relative investment performance and not their absolute performance. If proxy advisers were to have success in nudging all companies to take positions that would reduce their returns, investment managers may not care because there is no reason to think that it would cost them any clients — or fees.

Nearly a decade ago, the Obama administration moved to strengthen the fiduciary rule because, it noted, even small reductions in an asset’s rate of return can have a big effect on the amount of money that a retiree accumulates over a lifetime of saving. That rationale supports this rule as well. — Ike Brannon