Elizabeth Warren’s Socialist Dogwhistle
2018-08-25 · Guest: Richard Epstein (Professor of Law at NYU and University of Chicago) · 51:01
Elizabeth Warren Accountable Capitalism Act and Corporate Governance
Bob Zadek and Professor Richard Epstein discuss Senator Elizabeth Warren’s “Accountable Capitalism Act,” which proposes a radical shift from shareholder-focused corporate governance to a “stakeholder” model. They critique the plan’s reliance on federal charters, its potential to compromise trade secrets, and the economic dangers of politicizing corporate boards.
Topics: Corporate Governance, Elizabeth Warren, Richard Epstein, Accountable Capitalism Act, Fiduciary Duty, Shareholder Value, Stakeholder Model, Federalism, Drug Pricing, Corporate Philanthropy
Speakers: Bob Zadek, Richard Epstein, Caller (Nick)
Introduction to the Accountable Capitalism Act [00:18]
Bob Zadek: Hello everyone, welcome to the Bob Zadek Show, the longest-running live libertarian talk radio show in all of America, perhaps the world, but I haven’t checked. Thanks so much for listening this Sunday summer morning.
In the past week, Senator, perhaps soon-to-be presidential candidate, Elizabeth Warren from Massachusetts, former Harvard Law professor, published an article, an opinion piece in the Wall Street Journal entitled “The Accountable Capitalism Act.” Right out of Atlas Shrugged. “Accountable Capitalism Act.” In that opinion piece which she wrote, she offered a proposal basically to redo, or some might say eliminate, capitalism in America. To rejiggle everything, how we do business, how we organize business affairs in America.
It received a lot of attention from thinkers both on the left and on the right, including this morning’s guest. I’m happy to welcome back to the show Professor Richard Epstein. Professor Epstein teaches law at NYU and is also at the University of Chicago, the economics school. Richard has written a bunch of books, all of which I’m proud to say I have read, some more than once. Richard published in Defining Ideas, his weekly blog, an opposition or a response to Senator Warren’s piece, and we’re here to discuss the Accountable Capitalism Act.
Why are we discussing it? Why have I selected this as the topic for this morning’s show? Because it is so gosh-darn scary. The fact that a law professor, a United States Senator, could actually, and probably with a straight face—but I don’t know how you write with a straight face, but perhaps with a straight face—she might even believe what she wrote makes sense. And because it comes from a United States Senator, because it comes from somebody who is certainly being discussed as a presidential candidate in 2020, it is worthy of at least an hour of time to study both the piece itself and what it tells us about those people on the political left and how they look at business life in America. Richard, welcome to the show this morning.
Richard Epstein: Glad to be here.
Bob Zadek: Now Richard, tell us the bullet points—because there weren’t that many, at least the headlines—of what Senator Warren is proposing. There’s only four or five major bullet points. What is she proposing to do in the management of American business, or large business?
Shareholders vs. Stakeholders [03:27]
Richard Epstein: Essentially, what happens is she wishes to convert the American corporation from a shareholder-run operation to a stakeholder-run operation. Now, these two terms are a little bit elusive, at least the second one, so let me explain the way in which this works.
The traditional American corporation, and here I’m speaking of the public corporation, is an organization which is owned by shareholders, which creates a board of directors, which in turn appoints a CEO. And the way in which corporations are organized, the three groups each have a distinct set of responsibilities and opportunities. So shareholders at some level can sell their entire things out to somebody else in the takeover market. Each of them individually is entitled to sell their shares in a trading market, and all of them have the right to vote with respect to the selection of the board of trustees, or the board of directors.
The directors in turn are charged with general oversight of the corporation, and they in a sense then appoint the CEO to run the thing on a day-to-day basis, subject to the general direction that they give. And so what you do is you have these three layers of corporate situation. And the focus of each and every one of them is to make sure that the corporation will maximize the rate of return that it gets on its investment, consistent with its legal obligations to the state and to the party with whom they enter into contract.
And the key feature and the key word to describe what happens to the board of trustees and the CEO is each of them have fiduciary duties. And fiduciary duties essentially mean when they start to make decisions, they don’t make them in their own interest. Their own interest is taken care of by the pay that they receive for the job. But they’re supposed to look at the class of shareholders and essentially try to do what in their good judgment is the best long-term operation for the company at large.
The Business Judgment Rule and Fiduciary Duty [05:27]
Richard Epstein: And so essentially what happens is the entire law rests on the following kinds of propositions. There is first a business judgment rule, which says that if you’re running these corporations and you are trying to maximize the value of your shareholders, you will not be held responsible if it turns out that the guesses that you made do not turn out particularly well. What happens essentially is that people make good choices and bad choices, and in the long run, if you’ve got a decent board of directors, the good choices will outdo the bad choices. And the last thing you want is to allow individual shareholders to snipe at the bad outcomes while keeping all the gains from the good outcome. “Heads I win, tails you lose” essentially is a recipe for closing down the corporation because the board gets all the downside and the shareholders get all the upside. Not viable.
The exception to that rule is in cases of self-dealing, whether by members of the board or the CEO. And if you enter into a transaction with a buddy or a friend, the rule now switches. We no longer think of you as acting as a fiduciary agent for the shareholders. We think of you as trying to deal for your own benefit. So if you look at these transactions, it’s not that you invalidate them per se, although many corporations have very stringent restrictions on what officers and directors can do by way of transaction, but you subject them to something known as the fair value test, which means that this transaction only goes through if the value which is received by the corporation is as great or greater than the value of the assets that they surrender.
So you put this situation together, and essentially what happens is everybody is focused on the same thing. In order to make this work in a public corporation, you tend to have by and large only single classes of shareholders. And the reason you do that is the moment you start introducing preferred shareholders and common shareholders, there are going to be lots of choices where if they’re safe, they’ll benefit the preferred shareholders, and if they’re risky, they’ll benefit the common shareholders. And you don’t want these people to start figuring out, well, which class of shareholders do we wish to prefer and why? So the single class of shareholder means that everybody is, to the extent that the law can create it, in an identical position. So if you maximize the welfare of one shareholder, at least as a first approximation, you’ve done it for all.
Now, how do you then deal with the rest of the world? Well, the rest of the world is not owed a fiduciary duty because if it were owed a fiduciary duty, you would get conflicts even much more intense than those that you have with respect to the difference between a preferred and a common shareholder. So all of these arrangements are done in one of two ways. If you’re talking about externalities and harms to individuals who don’t trade with the corporation, you have such things as environmental protection laws, which sort of limit emissions and things of that sort, and the fiduciary duty requires you to comply as best you can with the external obligation.
If you’re dealing with trading partners, starting with bondholders, employees, suppliers, customers, and so forth, in those particular circumstances, each of them know that you owe a fiduciary duty to your own shareholders. So what you do is you bargain at arm’s length for transactions that will be mutually beneficial. And in some cases, there’s going to be a contest as to how this ought to work. Do we have unionized corporations? Do we have contracts at will with lenders? What kind of covenants can they put in to foreclosures and so forth? But the whole model is: they will take care of themselves, we will take care of ourselves, the fiduciary duties create win-win arrangements inside the corporation, and if you’re doing voluntary transactions, you then get win-win on the other side.
So it’s not that there aren’t stakeholders, i.e., people who are interested in the affairs of the corporation, but we have a very clear way in which they defend themselves. What Elizabeth Warren wants to do, and it’s mindless as far as I’m concerned, is to say that the fiduciary duty model, which applies to shareholders, also requires you to have fiduciary duties with respect to all of these outside stakeholders, employees, and everybody else.
Now, if you’re going to do that, then the question is, how do you discharge that? And she comes to the right conclusion—I use the word “right” in quotation marks—that if you only have a board represented and chosen by the shareholders, how is it going to act as a fiduciary to people who are non-shareholders? So what she wants to do is to have a federal agency call in every charter that has been issued to every corporation by every state, which means virtually all corporations—a massive move—and tell them that they will get their federal charter, which they are now required to do (you must come to us), only if you agree to put on your board individuals who represent these other stakeholder groups.
So essentially now what happens is you’ve got this mess of trying to figure out how this particular corporation board is supposed to work. And remember, you have to raise new capital. How are you going to raise equity capital if the guys who are getting it are sworn to make sure that other people can divert it to their own interest? If you’re a lender, how are you going to lend to a corporation if you know in effect what they can do is divert the proceeds from the operations of the business to some collateral venture so there’s nothing left there for you to take it back?
This is essentially an effort to nationalize all corporations by changing the control mechanism. And if in fact the federal government is there and you’ve got no exit, whatever conditions they can impose upon you, you’re going to have to respect, which means that foreign capital will never come here and American corporations will never essentially stay here. And any small business which gets over a billion dollars with respect to net asset value is now going to find as it gets larger, all the flexibility that it needs as a startup is going to be taken from it because the board of directors is going to be passed into alien hands. This puts aside all the crazy difficulties as to who these people are, how they’re going to be compensated, how long their terms of office is going to be, who is going to select them. So what it is is this is a scheme which is essentially designed to nationalize every piece of American business in the name of saving capitalism. And why does she want to do this? Well, her motivation is she thinks there’s some inequality in the way in which various markets work. Let’s suppose she’s right about that. There are other mechanisms like welfare benefits or progressive taxation that you could use to handle these kinds of situations. And for the most part, she’s wrong about that because what happens is if you run an economy in which you heavily regulate corporations, the boards that respond to them, knowing that labor contracts are going to be regulated in a way that are often unacceptable, they will shift to overseas operations, they will shift to greater capital intensity in terms of their situation. So what’s so crazy about all of this is the difficulties that she perceives is essentially a direct product of the kind of legislation that she typically transfers, ignorant I think in her case of the way this thing works. I mean, I know she was a Harvard professor. The truth about the matter is her work there was never any good, and this stuff is simply off the wall. And I think most people who know anything about American business quake in their boots at the thought that somebody as positive, this confident, and this uninformed could put forward a proposal like this, which would shake American business to its root and leave everybody subject to massive dislocations in pension funds, wages, dividends, and everything else. Short answer.
The Danger of Competing Board Interests [13:00]
Bob Zadek: Short answer. The principle that jumped off the page, if you will, in Richard’s presentation is when he described how corporate governance works and the fiduciary duty. The word Richard didn’t mention, but was clearly there in almost every paragraph, is accountability. Where you have shareholders elect directors who hire officers who know their job, everybody knows to whom they owe a duty, a fiduciary duty, which is the highest level of duty one can owe to another under our system of law. Fiduciary duty is a very high duty.
But now when you show up at work and you’re an officer, you know your job. The board requires you to maximize the wealth and the well-being of the corporation, maximize the financial well-being of the shareholders. The board knows they are accountable to the shareholders. The officers are accountable to the shareholders. Everybody knows their job.
Just imagine sitting at—it’s like dinner with a dysfunctional family. You’re sitting in the boardroom and you have all of these competing interests, all of whom now you owe an equal duty. And you have neighbors, and it’s not just environmental issues according to Elizabeth Warren, you owe a duty to neighbors, to people who are in the state where you operate, to employees as Richard said, to shareholders, to creditors. And how in the world, how in the world could anybody balance and go home from a day at the board meeting and say, “I did a good job today”? It is absolutely impossible, which means everybody’s got a target on their back because whatever you did, it’s highly subjective, and unless there are regulations, you have no idea if you’ve done anything right. It makes it impossible to govern a corporation. It’s a lottery. It’s just God knows if we’re doing the right thing, and here we go.
Richard Epstein: Bob, you’re so optimistic. It’s even worse than that. Or let me mention some of the things that I didn’t mention in the paper that I wrote, which was short. One of the things, of course, that boards of trustees have—not only do they have fiduciary duties, they have strong duties—
Bob Zadek: Board of directors. It’s board of directors.
Confidentiality and Trade Secrets [15:13]
Richard Epstein: Board of directors. I’m a university guy. These boards of directors, they have very powerful duties of confidentiality. So if you’re running a major corporation, one of the things that you have, of course, are a parcel of trade secrets. These concern secret processes, they concern marketing plans, they concern research and development and so forth. And every member of this particular operation knows full well that when those information come to you, it stops with you. How these things are operated is very complicated, but there are some trade secrets that are so sensitive that what happens is you’re not even allowed to take the document. What you have to do is you have to go into a room, you go through an inspection, you don’t have any pencil and paper, and it’s for eyes only, and you get the one or two things that you need in order to do this. So if you take a formula like the formula for Coca-Cola and so forth, there’s nobody who knows the whole formula. There are people who know all the bits and pieces.
Now what you’re going to do is you’re going to put on the board people who by definition are stakeholders and therefore have obligations to other individuals. Are they duty-bound now to release the secrets that they get from the corporation to the people whom they represent? Can you really expect that they’re going to keep their duties of confidentiality even if they swear to it? One of the things that happens is once a trade secret gets out, it doesn’t bear a pedigree of who managed to leak this thing. So what you can do is get somebody who sits on a board meeting, works for a union, it turns out to be antagonistic to the company he happens to be on the board of, releases information about trade secrets that a billion dollars in potential income starts to disappear and to go away. There’s absolutely nothing that—when you start looking at these duties, you cannot have multiple masters and hope to discharge any and all of them. You send directors to school for a very long time to figure out exactly what they can and cannot do, how they interact, which corporations they could work on, what you do with respect to conflicts of interest, all of which is designed to give you structural protections so that when the fiduciary duties come, everybody knows where they stand.
Milton Friedman and Corporate Philanthropy [17:30]
Richard Epstein: Now, one thing we didn’t mention and unless you want, I’d like to mention it now, is the question of: does this mean that corporations are selfish? And of course, the reliable bogeyman for somebody like Elizabeth Warren is Milton Friedman, who in 1970, do you remember Bob, he wrote this article about, you know, the duty of corporations is to maximize profits for their shareholders and published it in the New York Times. Now, Milton is no fool.
Bob Zadek: To say the least. To say the least.
Richard Epstein: To say—of somebody who’s a fourth-rate mind like Elizabeth Warren sort of trying to pull her inter-credential credentials on somebody like Milton Friedman, who dead knows more than she does when she’s alive. And so, what did Milton want to say? Well, the first thing he said is, “I’m not against charity.” And in fact, virtually every free marketeer is in favor of charity. The University of Chicago was founded by John D. Rockefeller. Harvard was founded by, remember, John Harvard. Yale by Elihu Yale. I mean, you take the names of great American universities: Carnegie Mellon, Johns Hopkins, Stanford, and so forth. These are all people who essentially amassed fortunes and then realized that consumption was not their dominant goal after a point, and so what they did is they created these massive institutions of huge wealth for the benefit of the rest of the world.
Laissez-faire has always believed in strong what they call imperfect obligations of charity, which go to help the poor, to advance medical and scientific research, and to create and to advance the institutions of culture and higher learning. But what Milton wanted to say is: if you’re a corporation, to which of these particular charities do you give and why? His attitude was, this is a classic opportunity, if you’re not very, very careful, for self-dealing, in which the head of the board of trustees will give to his favorite charity. And that is not what corporations are supposed to do.
So the answer that he had was twofold. One part was: when you want to have the charitable stuff, you’ve got your own shares. You can deed some of them over to the charity that you want. Or if you want to hold the shares, well, what you can do is make a pledge of money from the dividends or from the value of the shares that you sell. And if you do that at the shareholder level, you manage to eliminate all the conflicts of interest which would arise. So the CEO owns a parcel of shares, and if he and his spouse want to give to a symphony orchestra, they can use that share as a source of value there without having to implicate the entire corporation. So that’s the first point. And essentially that means that you get much more powerful giving because it’s focused and donors actually watch over what’s going to happen.
The other thing is corporations have to maximize goodwill. And this is a very tricky situation. But imagine a corporation who went to the world, lived in a particular community, and decided that it has a bunch of excess equipment that it doesn’t need, and then puts a funeral pyre outside and burns the whole thing. People are going to look around and say, “Why did you do that?” So what a corporation typically does is, in order to advance its goodwill and with doing something which virtually all shareholders agree with, they will make a gift of that obsolete equipment to a private or a public school or a neighborhood center and so forth. They will then encourage members of their staff if they wanted to work in these organizations as a volunteer and may take that into account in the way in which they think about salaries and promotions and so forth. So there is a certain very sensible limited function of, quote-unquote, benevolence to a corporation, but it’s always understood that you give to those organizations such that the image of the corporation will be improved, such that by virtue of your superior reputation, you’ll be able to sell more goods, which will allow you to expand your charitable activities, create more positive reputations and so forth.
Now, it’s very tricky because suppose it turns out that you’re a corporation, do you really want to get involved with certain kinds of issues? So if you’re the head of a corporation, do you want to start giving to gay rights groups? Do you want to give to, say, traditional marriage groups? Essentially what happens with corporations, notwithstanding Citizens United, is they have quickly learned that when you start making public political pronouncements unrelated to your work or gifts to organizations that have strong ideological stands—
Bob Zadek: We’ve just lost Richard. We’re going to reconnect with Richard. We’re going to go to break now. We’ll be back in one short minute and Richard will have an opportunity to finish his sentence and spend another full half hour with us. Please stay tuned, we’ll be back in 60 really short seconds.
[Sponsor break omitted]
Bob Zadek: Welcome back to the Bob Zadek Show, the longest-running live libertarian talk radio show in all of radio. We’re still working on getting Richard back, he’ll be back in one second. Before we went to break, Richard was explaining the very delicate decision that boards of directors have to make in terms of charitable giving. Should they give money to charities and if so, to whom?
I’ve always been of the belief that corporations should think long and hard before giving even one penny to charity. Because after all, once a corporation sees its role in society as being that to benefit society as a whole, then we lose that accountability that I spoke about earlier. Accountability that is: the directors now are no longer simply accountable to shareholders to maximize the value of the shares, and the officers are no longer accountable to the board to do a good job at maximizing the value of the shares. But now they see themselves as having a duty to society as a whole, a duty which is impossible to define and impossible to quantify. Therefore, as an investor—all of us are investors in one way or another—as an investor, I’d be quite circumspect about investing in a corporation which was somewhat generous in its charitable giving. Generous, of course, is highly subjective. But I would not want the corporation to be giving away my money. In part, it is my money; I own a pro-rata share. I wouldn’t want the corporation giving away my money to a charity that perhaps I wouldn’t support. If I was going to support a charity, please corporation, give me back some of my money by dividend or stock repurchase, whatever they might do, and I will give it to the charity that I wish. Thank you very much.
So the area of charitable giving, and Elizabeth Warren in her proposal seeks to invite charities and all and the public at large as the, quote, “stakeholders”—a key defined term in her piece—she wishes to invite them to the table so they will be sitting around the boardroom yelling and screaming and lobbying for their fair share. Oh, how we hate that word, “fair share.” They will be lobbying for their fair share, leaving an impossible decision for directors and for officers. It will be impossible for them to have gotten it right.
So the area of charitable giving is a tricky one at that. Another concept in Elizabeth Warren’s piece, as Richard explained, which is to require corporations with over a billion dollars in assets to have a federal charter, that of course is reverse federalism. That is devolving power once again from the states. States now issue corporate charters, and we’re now going to move those charters—ah, very good. Richard is back. Good news, Richard. We hope you’re okay. You survived the disconnect. And Richard—
Richard Epstein: You hear me?
Bob Zadek: I’m sorry, Richard? Yes, I can hear you now.
Richard Epstein: Okay, I’m on—do you want me on speaker or off speaker?
Bob Zadek: Well, right now we can hear you fine. Yeah, I can hear you fine.
Reverse Federalism and the Delaware Model [26:00]
Richard Epstein: I’m not changing anything. So let me answer the question. I mean, this is an extremely important issue. One of my good friends, Jim Copeland at the Manhattan Institute, wrote a blog which simply said “federalism issue.” And it turns out there’s a very important thing here. The traditional argument with respect to corporations had the following issue. And the issue was whether or not when you have competition among states to issue corporate charters, whether this was a race to the bottom or a race to the top. And the theory of the critics, of which Elizabeth Warren would be one, is it’s always a race to the bottom. That people will start to go to those jurisdictions in which they can get the best deals for themselves as operators and to hell with the shareholders and anybody else who runs inside the business.
But the answer on the other side is much more powerful. It says if you go to one of these places, sure, you can pick the place to incorporate which is going to give to the insiders all the advantages that you could possibly hope for. But there’s one little hitch in that argument, which is you still have to find a way in which what you can do is to make sure that you’re going to be able to sell those shares to somebody else. What happens when there’s a competition in this market, so long as there are buyers, is going to happen is that the company’s going to go to that particular jurisdiction where the charter terms are going to be optimal in terms of the total value that it generates, and then you will jigger the terms of the shareholders to figure out what the respective portions of that value will be to the founders of the corporation on the one hand and to the public people working in these kinds of arrangements on the other.
And so to give the most famous illustration of this, you have to ask the question: why do we have so many Delaware corporations today? And the answer goes back to another progressive, Woodrow Wilson, who was governor of the state of New Jersey around the turn of the century, a little bit after, and this is before he becomes president in 1913. And what he does in effect is New Jersey is the pioneer in corporate law, and in good progressive style, what he decided to do is to essentially change the way in which corporations are going to operate inside the state, how they’re going to be taxed and how they’re going to be regulated and so forth. And this turned out to be so intolerable that all of these corporations marched en masse over to Delaware, that is quite literally across the river, because the terms at which they got there were going to be much better.
And Delaware has been able to maintain its dominance in corporate law, notwithstanding the fact that it’s a tiny little state. And the reason it’s done so is that it has a system of rules on the one hand and a system of courts on the other hand which are exquisitely attuned to the basic problem of how it is that you maintain the proper balance between shareholders, management, and inside on the corporate governance issues so that people are confident when they go there, A, that the legislative rules are going to be pretty good, B, the regulations under them are going to be pretty good, and C, the judges that interpret them are going to be pretty good.
Once you put all of these people into the federal government, then everything starts to become almost insane because now you’ve got only one set of guys, and if it turns out that they are politically chosen with a span of responsibility so broad they can’t possibly discharge it, you’ve got no place to go. And so what happens is the reason we like federalism is because the competition. Is there reasons why we don’t like federalism? And the answer to that question is yes, but they’re very different situations. So starting in the late 19th century when railroads became very powerful, these are network industries, and the only way in which you can effectively operate is to make sure that you can ship your goods from San Francisco to New York by going through 15 states. And what you’re very worried about under those circumstances is that each state will try to be opportunistic and block the free movement of goods back and forth across state lines, at which point federalism, instead of creating competition, now creates blockades. And it was for exactly those reasons that a form of federal regulation, embodied originally in the Interstate Commerce Act of 1886-87, was in fact the way in which this thing started. So the federalism point you have to get it right. Like everything else in the world, federalism is a mixed good and a mixed bad, but if you get wrong the distribution of powers as Ms. Warren always seems to do, it could be a catastrophe to nationalize. On the other hand, if you have the blockade issue, then absolute devolution to the states is going to be a big mistake. And in fact, if you go back and look at the original Constitution, one of its chief aims was to make sure that states could not barricade trade across state lines in order to create a national market for goods and services. And they did a pretty darn good job of that. And the Supreme Court, although it gives much too much power to the federal government to nationalize charters, for example, has done a very good job under the dormant commerce clause to make sure that no state can impose burdens upon other individuals in ways that will make it impossible to have the free shipment of goods and services across state lines. Okay?
Bob Zadek: One observation, Richard. Elizabeth Warren and others worry about the phrase you used, which is a “race to the bottom.” That phrase, in my opinion, doesn’t really apply. It’s not the bottom. It’s the top. Because if states don’t have good corporate governance statutes, they will lose the business. So a “race to the bottom” is a politically motivated phrase designed to prove your point when it really doesn’t do that at all.
Richard Epstein: Amen.
Bob Zadek: Thank you. Now Richard, we have a caller. We have Nick on the line. Nick, good morning. What’s on your mind?
Drug Development and the Knowledge Problem [32:15]
Caller (Nick): Here’s my question. I’m a drug development scientist, and I’ve kind of come to this conclusion over the last 20 years. In my opinion, I think that drugs are essentially gifts to society. There is no possible way I will ever recoup the amount of money I’ve lost in the nine out of ten failures that happened before it, which everybody seems to forget about when I talk to them about it. But they always remember the billion dollars that I made off the one drug that did succeed, right? And I can see these costs spiraling as we continue to drill down and drill down into the cell and as we approach the genetic level, that the costs are going to go higher and higher. If it’s true that we should not donate money to charities, essentially isn’t my development company just nothing more than a charity then? To me, that’s all it is because essentially they’re gifts to society. That’s how I feel about drug development now at this stage. And I’ll listen to what you have to say about that. And y’all take care of yourselves.
Bob Zadek: Thank you, Nick. Richard, the reception’s a little bit spotty, but I think the question he’s asking is: if you’re a company, a pharmaceutical company, and you invest in drugs, when you have a win, you have to recover for all the dry holes that you put out there. And so when you start to see the pricing, what you have to do is to understand the full picture under which things take place. This is in fact related to our problem, to the problem that we talked about above, but only in a tangential way. What happens is if in fact you start talking about populists, what happens is they are so confident in their own judgment as to what is and is not a just price that they just look at the way in which the thing sort of spread out on the table and they don’t take into account all the complexities that are there.
So when you start to talk about drugs, it turns out the dry hole problem is very, very serious. The patent delay problem is very serious, so that if in fact you have a drug, you will not go through clinical testing until you are able to secure your patent because otherwise, if the patent isn’t secured, your clinical testing will be a public good and will make you, as Nick says, into some kind of a charity. So you have to get the patent. Then the processes that you get these through, this is through federal regulation, have elongated themselves very much since 1984 when the Hatch-Waxman Act was passed, which was designed to give an extra term to patent holders to reflect the time when they had the exclusive right to vend under the patent law but were prohibited from vending under the FDA rules.
So that’s one kind of a problem and you have to start getting greater rates of return. The other thing that is so clear about drug pricing is what we call the marginal cost problem. To make that first drug is going to cost you two billion dollars, let’s say. This is a perfectly sensible estimate. And to make the second pill is going to cost you, say, five dollars. Well, if you do marginal cost, the first person pays two billion dollars for the first pill and everybody else pays five dollars. But since the first pill is never going to be sold, the others won’t be sold either. So the way drug pricing works is you have to backload the fixed cost of getting the thing in there, and there’s no unique formula by which that can be done.
So what this does is it leads to a kind of a funny game in which everybody is willing to pay their own marginal cost, which is trivial, but they want to push the cost of the fixed cost onto everybody else and you create this very, very difficult situation. And drug companies have figured out what is known as Ramsey pricing, that is a situation where you put the bulk of the cost on the people who have inelastic demands, that is people who cannot reduce very much the amount that they consume because of a price rise, because if you do that, you’re going to be able to recover them and then when you’ll be able to recover them, you’ll be able to make the drug to begin with. So this leads to some strange situations where retail pharmacists who have to stock every line pay more per unit drug than do specialty firms which can pick one company and decide to give it an exclusive. These markets therefore are extremely complicated. And what happens is if we don’t understand how they operate, when you’re a populist, it’s very easy to give a one-sentence denunciation of the arbitrary prices in drugs and it’s very difficult to come up with an explanation as to what should happen.
Here’s another version of the same problem having to do with generic drugs, which has always been the situation. The theory used to be that once something was off patent, anybody who can prove that they could make a bioequivalent of the standard drug was allowed to enter into the market. So you would then get competition after the original patent period. This meant that the original guy had chance to recover his fixed cost and then consumers get the benefit of lower prices for drugs, as for everything else in the face of the universe that goes off patent. But what’s happened in the United States is we now have very powerful restrictions against getting generic drugs onto the market. Often it can take two or three years or four years to do so, which perpetuates the original monopoly and creates all sorts of anomalies. And so what one has to do is to re-engineer that particular system, and that gets you into such wonderful things as the “Orange Book,” which is the question of the book of permissible therapeutics. Can a company which has already marketed one drug take its drug off the Orange Book after a period of patent expiration because it has a new substitute? It’s a mistake to allow that to happen, but this just tells you how quickly you have to get into the details to do this.
And the thing to mention about Ms. Warren and virtually everybody like her is a kind of intellectual impatience. They’re so sure they’re right that they don’t try to understand anything before they figure out why it ought to be condemned in the most categorical terms. And that’s the way in which it is. Just think of it in this way. Ms. Warren has never been on a corporation, doesn’t know anything about how to put together a business plan, who is a politician down to her fingertips, is going to tell every single corporate name in the United States, filled with experts and people who spent lifetime knowing the business generally and their own particular industry, “You don’t know what you’re talking about, ladies and gentlemen. I’m going to tell you how every corporation in America should run because it turns out I was once a professor.” It’s a kind of an arrogance. The thing about it is you can be very confident, as I am in many issues, about the fact that I don’t want to tell people how to run their own businesses. But it’s a different kind of confidence to say, “I’m so confident that I can tell everybody else that they’re wrong in the way in which they’ve run their businesses when you’ve created the greatest profit-making and social welfare machine in the history of the world.” It is just mind-boggling that you would ignore all these successes in every relevant dimension: life expectancy, product safety, medical practices, in virtually anything that you wish to look at. If you go over, say, the last 40 years, the downside in terms of safety and environmental risk that you’re talking about, these things are all down by 75, 80, 90 percent. And at the same time that you get these massive improvements, what you do is you attack the system that managed to generate them. I simply do not understand why that makes sense.
Bob Zadek: And what’s to me the fatal flaw in Liz—well, one of many fatal flaws—is society operates today where you have lots of organizations, each of which are specialists in what they do. The police are specialists in controlling crime. The SEC is a specialist on what it does. Businesses are specialists in one thing: taking capital and making more capital on that existing capital so that investors are induced to give that capital creator more money. Therefore, if I want to make money, I will give money to a corporation because I like the history and how well they’ve done. If I want to build a house, I’ll hire an architect. If I want police protection, I will hope the police will do it. When you start to blur the lines, when you give the corporation the job of looking after the environment, enforcing the laws, protecting labor laws, looking after workers, managing some kind of artificial minimum wage laws, everybody has every job. Look what happened in the educational system once we expand the task of the schools to be now nannies, to be job teachers, to teach morality, all of the assignments we give to schools because other elements of society have failed at the task. Schools don’t have enough resources and they don’t do a good job at any of them. So Elizabeth Warren takes corporations, why? Because they are there and have lots of money. And she appoints them to be the guardians of the rules of society that government has selected as the rules. It blurs everybody’s assignment. So nobody knows which way is up. And that to me is the scariest part of Liz Warren’s proposal.
The Amazon Effect and Income Ratios [41:00]
Richard Epstein: Yeah. Well, one of the things that you’ve done is you’ve sort of restated the Hayekian issue about the diffusion of knowledge throughout society. What happens is if you have centers that pick their own areas of expertise and so forth and then are allowed to trade, is that you solve the knowledge problem by assigning the high risks to the people who have the greatest knowledge of what’s going to happen. And so if you want to buy a good from a corporation, you don’t have to know anything about how it manufactures that good, procures its stuff. What you do is you look at the final product, you see that it’s got a warranty with it, you can inspect it, you pay a price, and you can make your decisions without going internal. The moment you start having this collective situation and you have these great corporations, it’s going to be much more difficult for you to do those things if in fact there’s always going to be an administrative process which is going to challenge the way in which the corporation has decided to put these things together.
Now, in terms of these things, I do disagree with you on one thing. American corporations, Bob, have been able to survive amazingly well, notwithstanding the fact that they’re burdened by various kinds of labor law. I’m against all of them. I agree with you that a free market in labor is as good as a free market in capital or in goods of any particular sort. But the incredible thing is notwithstanding that we have very bad rules dealing with labor, whether they’re minimum wage rules, overtime rules, family leave rules, anti-discrimination rules, these corporations are so adroit that they actually can, given their fiduciary duties and their expertise, minimize the risk associated with internal regulation.
This is an incredible achievement, and I think one can say that if you were to remove all of these things, corporations would again instantly adjust and what you would do is you’d see higher levels of productivity, which in turn would lead to higher wages. Donald Trump is attacked for many things, and of course Liz Warren is one of the people who hates him most. And I certainly disagree with him violently, I would say, on any issue in which he’s against sort of free trade and voluntary exchange, which has to do of course with the international trade markets and his penchant for trade wars. But on the domestic front, the willingness to lower taxes and to back off on the existence of new regulation and on the enforcement of old regulation has created a huge upward draft in the stock market. Those stocks are owned by lots of people, including many pension funds and so forth, university endowments and all this, it makes life easier by expanding the particular pie. And if it turns out that the rich get more money in the short run, they give more money away, they hire more people and do all sorts of things.
So essentially when you’re doing general public policy, you should always spend your time initially worrying about maximizing the size of the pie rather than trying to figure out what the size should be for each particular slice. And the Warren approach is exactly the opposite. Without any basis whatsoever, she knows what ought to be done and what not to be done. Let me give you one example. It’s called the so-called Amazon effect. You know, Amazon essentially hires large numbers of relatively low-wage workers to work in filling orders, shipping goods, and all the rest of that stuff. And so what happens is the company is quite different from Apple, where all its employees tend to be high-tech types. Well, if you in fact hire another 100,000 who had no jobs whatsoever and pay them, say, $35,000 a year, as opposed to what Bezos gets, which is several billion, the ratio between his salary and that of his average employee is going to go up and you say, “Oh my god, this guy is an exploiter.” But that’s exactly what you want. Somebody who’s willing and is able to create thousands of jobs for thousands of people who had no jobs whatsoever. He’s a hero. The ratio is utterly unimportant between how much he earns and how much they earn. What you’re trying to do is to have American capitalism bring people with marginal skills back into the workforce. And interestingly enough, with the decline in corporate taxes and the sort of softening of regulation, all of a sudden youth employment is up far beyond the old levels, blacks are coming back into the market, people with criminal records are now able to get jobs whereas before they were never able to do so. You expand that pie, and sure enough, in order to make yourself rich, you will, in market transactions, try to make somebody else richer than they were.
And one of the things we should do is as follows. Suppose you have two people, Bob. One who has, say, $10 in income and the other who has $100. And now what we do is we give a little change and the guy from $100 goes to $200 and the guy from $10 goes to $20. Well, you could say, “Oh my god, what you’ve done is you’ve expanded the difference.” But it’s a Pareto improvement. And then what you have to do is remember in a corporate world, there’s not just one guy getting going from $10 to $20 as the rich guy goes from $100 to $200. You’ve got a thousand people in that group who are going from $10 to $20. So that it turns out that most of the gain goes to people at the bottom end of the income distribution, even though the percentage gain for the one guy at the top is larger than everybody else’s. You don’t want to kill that kind of motion by saying to the guy at the top, “You’ve got a billion dollars, now we’re going to basically kneecap your business by giving you a series of board members, all of whom are antagonistic to everything that you want to do.”
Corporate Greed and Property Rights [49:00]
Bob Zadek: One comment as we’re running out of time, as we always do, Richard. Your comment about Milton Friedman and corporate greed, I would just refer our listeners to a wonderful YouTube series of videos. Donahue was interviewing Milton Friedman, and Milton Friedman had a wonderful discussion of corporate greed. And Richard, when you mentioned corporations being greedy as part of the rap that those on the left say, I did a show about 10 years ago on corporate greed. And since greed is an emotion, I wondered how a corporation can experience an emotion. I then speculated that a wonderful job opportunity for psychiatrists, since corporations can now have emotion, is to be a psychiatrist for corporations. Since they experience emotion, they might be depressed also, and maybe fearful, and maybe insecure, and there might be a future for psychiatrists. So corporations cannot be greedy. Plus the fact everybody in America is greedy in the sense that everybody wants to, unless they are self-destructive, they want to do the best they can for themselves, financially and otherwise. So greed is something which drives the engine of American business, and it should be encouraged and praised. People who talk about greed are really talking about the manner of acquiring wealth, the style and the mores of acquiring wealth, not the fact of it. Everybody wants stuff, most people do. It’s how you get it that makes it praiseworthy or not, not the fact that you want stuff.
Richard Epstein: Yes, no, look, the word “greedy” is very funny, but it’s corporations are not greedy in the sense that we say of ordinary individuals that they’re greedy. So let me give you a case of greediness which is not the corporation. Richard, we have one minute, so just a warning, we have one minute till John Phillips Sousa joins us. Yes, I understand that. So you have a bunch of people sitting around the table, and the greedy person is the person who goes first and takes more than his proportionate share, leaving less for everybody else. What’s the source of greediness? It’s indefinite property rights which you get with a common. The reason that corporations are successful and greed is effectively eliminated is these roles are so heavily specified that you’re not allowed to say that the property rights are indefinite and just simply take your largest share. And so I don’t think that it’s wrong to say that people are greedy, but I think it’s wrong to say that the institutional arrangements that corporations put into effect are not very powerful counterweights to the kind of greediness that ordinary people engage in in their ordinary lives.
Bob Zadek: Richard, thank you so much for giving us an hour of your vacation time. We always appreciate your thoughts. Please follow Richard’s writing at the Hoover Institute in Defining Ideas. Richard’s podcast is available as well as his writing. This is Bob Zadek thanking Richard Epstein for joining us for a third time to share his wisdom. I’ll be back again next Sunday for another one hour of ideas, not attitude. Thanks so much for listening. So long for now.