The Devil’s Trill

I recently encountered an ever-so-slightly dated proposal by Robert Shiller to introduce equity into public finance.  The sales pitch begins:

Corporations raise money by issuing both debt and equity, the latter giving investors an implicit share in future profits. Governments should do something like this, too, and not just rely on debt.

Borrowing a concept from corporate finance, governments could sell a new type of security that commits them to paying shares in national “profit,” as measured by gross domestic product…

Each trill would represent one-trillionth of the country’s G.D.P. And each would pay in perpetuity, and in domestic currency, a quarterly dividend equal to a trillionth of the nation’s quarterly nominal G.D.P.

While a classic theorem in corporate finance posits that the mechanism of corporate finance – debt or equity – is irrelevant to its value (and by extension, its operations), subsequent work in governance economics has shown this to be not quite true.  Accordingly, Shiller observes – correctly, I think – that “Trills, even at an ultralow dividend yield, would seem more exciting as an inflation-protected prospect, because they represent a share in future economic growth” – which we expect to grow without bound.  Furthermore, governments offering trills as a mechanism for financing deficit spending would be immunized from default, since the dividends would be pegged to nominal GDP; as a country’s tax revenues declined, so too would its obligations, in contrast to debt.  Indeed, one of their primary advantages would be enabling countries to deleverage, replacing enormous debt burdens with relatively manageable dividend payments.  This would be particularly attractive to governments pursuing a Keynesian fiscal policy: when an economy slumps, its financing costs would fall, freeing up resources for programs like unemployment benefits.

I remain skeptical.  According to advocates for trills,

People who expect strong economic growth in a country would bid up the price of a claim on its G.D.P., creating a cheap source of funding for the issuing government. So a country with good investment prospects gets the resources at a low current cost.

But why can’t a country use debt?  After all, debt signifies an ability for a country to pay, too. Countries with strong growth expectations faced reduced borrowing costs because it is readily understood that a rapidly growing tax base can accommodate the taxation required to discharge the debt down the line.  Countries with weak economies, which supposedly benefit from this financial innovation most, would have to issue trills on the absolute worst terms, to reflect their poor prospects.  Such countries often face tremendous difficulty both in accounting for GDP and in actually collecting taxes, and the extremely low asset prices would require issuing trills in prodigious quantities.  These countries would simultaneously gain the least, and pay the most, thanks to the deadweight loss of taxation.  Framed in these terms, trills begin looking remarkably less attractive.

The most succinct critique is that Shiller appears to be viewing his proposal from the perspective of a public finance economist, rather than a governance economist.  Shiller’s entire pitch is based on the (correct) premise that debt and equity have different implications; while Shiller’s academic work is no doubt more sophisticated than his public writings, the enthusiasm with which he presents his proposal seems to betray an unwillingness to grapple with the governance implications of this type of finance, focusing heavily on the (financial) upsides without acknowledging the (governance) downsides.

We have a good working understanding of debt and equity from Oliver Williamson.  Among his key observations were that debt is suited to firms that use fairly redeployable capital.  Under these conditions, debt has relatively low risk, because the value of the assets it supports can be realized even if the firm issuing the debt is forced to liquidate.  Consequently, there is little need for costly oversight, and firms can tend to operate with a “market” governance structure, contracting out for their production inputs.

Equity, in contrast, is best suited toward firms with high capital specificity and a “hierarchy” governance structure that uses elements like vertical integration and authority (employment, as opposed to contractors).  The underlying assets can potentially operate at lower cost than more generalized technologies, but cannot be redeployed.  As such, debt has a relatively high risk, because liquidation would destroy much of the value of the underlying assets.

Why have debts been used, historically, while equity has not?  Clearly, they are much easier to manage as a contractual matter, and GDP estimation is relatively new in the course of human history, as are modern nation-states.  This is Shiller’s explanation.  But there is another candidate: debt is more suited to the kind of roles government assumes than equity.  Few operations of government are asset-specific; most government work is clerical or else entails contracting out services. (You didn’t think government actually builds roads, did you?)  Finally, financially-induced failure of government is less likely than of a corporation, owing to the ability to tax the population and/or raise taxes.  Investors thus sit relatively secure.

And equity serves more than merely compensating for the risk by providing higher returns.  Critically, it provides an oversight mechanism, which is absolutely necessary to the operation of the firm.

Under Shiller’s proposal, there is no real effective oversight mechanism.  Most people would not consider investor oversight of government policy desirable.  Indeed, it seems awfully like “selling democracy to the highest bidder”, in the words of campaign finance law enthusiasts.  Investors will presumably not gain the benefit of extra votes in elections, meaning they have very limited ability to implement the pro-growth policies they would naturally prefer (to maximize the returns on their investments).

Admittedly, there is an interesting best-case scenario in which institutional investors become the dominant holders of trills, and thereby gain an incentive to lobby for pro-growth policies rather than seeking rents for individual industries.  This would serve as an unprecedented counterbalance to rent-seekers and potentially improve policy outcomes from the perspective of the nation as a whole by creating an investor class whose interests and incentives are aligned with the public’s.  However, this still seems farfetched, unless the value and total holdings of trills are so substantial and so concentrated as to give it a dominant position in investor portfolios and thereby outweigh the concentrated-benefit/dispersed-cost aspect of rent-seeking.  But if this were the case, would taxpayers long tolerate being taxed in perpetuity for the benefit of a monolithic investment institution simply sitting on its assets?

The fact that taxation must be used to pay trills’ dividends reveals a series of other defects, chief among them that trills create incentives for government to be profit-maximizing.  In the ordinary situation of a corporation, this would be considered desirable as a reflection of efficient operations and resource allocation.  However, profit maximization can only be taken as a mark of efficiency when there are viable alternatives.  Governments have none.  They are a monopoly of the worst kind: monopolies on the legal use of force.  When you have taxation (i.e., guns and prisons), you no longer need to provide the best service at the best price.

Trills would create a permanent obligation of government to tax people.  In other words, investors would effectively be buying a right to other people’s money.  Admittedly, this problem also exists with debt, but there at least the obligation is a predetermined, fixed amount, rather than an indefinite one.

This perpetual obligation would be especially pernicious because the taxes needed to discharge it come with a deadweight loss, which one study put at two dollars per dollar raised.  Simply issuing trills dampens the growth that would make them valuable to both investors and the public, and this dampening effect would not merely propagate, but amplify, across time.

More philosophically, corporations exist to serve shareholders, by serving their customers.  They do not serve the public at large.  Citing corporate finance for insights into public finance, while intuitively appealing, may not be the best approach because the missions of the organizations are so different.  As a demonstration of this problem, consider that corporate equity provides returns on net profits: revenues minus costs.  Equity holders get nothing if the company runs at a loss.  But there is no real national analogue to this.  What is the “profit” of a nation?  To maintain the analogy, it would be taxation less spending.  The trill instead bases the payoff not even on gross revenue, but on GDP for the nation as a whole! This implies, essentially, a risk-free equity.  But that means, at its core, ownership with neither control nor accountability.  Even (perhaps especially) with trills at its disposal, there is no guarantee that governments will opt to be fiscally responsible.  Appealing though the prospect of deleveraging governments is, this hinges on the assumption that governments are committed to long-run balanced budgets.  Such a government defies the experience of human history.  And investors would not have the control necessary to obstruct bad policy, fiscal or otherwise.

(And why should we conflate a nation with its government, anyway?)

The most damning critique, however, comes from simple common sense: one should never go into debt to purchase something that isn’t productive.  Entertainment is a wonderful thing, but taking a loan to buy a TV is far from financial prudence.  Yet the majority of government spending consists of transfer payments.  To the extent government is financing activities that don’t actually lead to growth, it is mortgaging the country’s future, buying consumption goods today at the cost of indefinite lifetimes of labor in subsequent years.  This critique is not limited to trills, of course; it applies to debt just as well.  But it is truly sad that public finance experts would devote such creativity to the question of how we finance government spending, rather than to the question of how to contain and/or pay for it.

The proposal’s not all bad, though: to its credit, it would likely establish derivatives markets which could be used to allow people to place bets on the impact of policy and the overall course of a country’s development.  Such a market would create strong, low-latency signals to policymakers about the likely impacts of particular policy proposals, and that’s exactly the kind of information policymakers need more of.


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