Allen Ferrell on income inequality, financial crises, Corporate Social Responsibility, and securities legislation

January 2018. GrowthPolicy’s Devjani Roy interviewed Professor Allen Ferrell, Greenfield Professor of Securities Law at Harvard Law School, on income inequality, financial crises, Corporate Social Responsibility, and securities legislation. | Click here for more interviews like this one.

Links: Allen Ferrell’s Harvard Law School faculty page

For questions about this interview, contact Devjani Roy.

Growthpolicy.org. What should we do about income inequality?

Allen Ferrell: Based on the economic research to date, the low-hanging fruit in this area seems clear: the pressing need to reduce regulatory barriers (zoning restrictions, city approvals) to the development of high-density housing in desirable urban areas, such as San Francisco, Boston, Los Angeles, and New York. These barriers have made it incredibly, often prohibitively, expensive to increase the supply of housing. Consider the astonishing fact that San Francisco’s population has grown by just 4,000 people (roughly speaking) per year from 1980 to 2010, despite the tremendous wealth creation in the Bay Area during this same time period.

The increasing returns to housing (i.e., imputed rental income) in highly desirable but difficult-to-build-in urban areas has largely driven the increasing returns enjoyed by capital, which in turn has contributed to income inequality. Perhaps most importantly, the high cost of housing has reduced the economic opportunities available to those that cannot afford the housing costs in desirable areas. As economic research has shown, these economic opportunities exist not just for high-skill labor but for low-skill labor as well. Moreover, the children of individuals that live in desirable communities often do better over their lifetimes than those that are not as fortunate. And, incidentally, high-density housing is far more environmentally friendly than urban sprawl along a variety of dimensions including pollution and energy consumption.

I called this low-hanging fruit for two reasons. First, there appears to be a clear cause and effect between these regulatory barriers and the supply of housing, a relationship that is not surprising. Second, the removal of excessive regulatory barriers would enlist rather than suppress market forces to address some of the concerns raised by income inequality by allowing the market to create more housing in response to increased demand. It entails neither top-down mandates as to what people must or must not do, nor does it rely on distortionary taxes.

Growthpolicy.org. How do we prevent the next financial crisis?

Allen Ferrell: I wish I knew! As a believer in the efficient market hypothesis, my presumption is that the risk of a financial crisis is already reflected in current market pricing in a way that I could never beat in terms of prediction. That being said (and actually entirely consistent with the prior statement), it is also true that forcing financial institutions to have significantly more equity capital is the appropriate regulatory focus. The arguments that high levels of equity capital would impair economic activity, such as fewer loans, are weak and unconvincing. Also, increasing equity capital is far more straightforward and doable (putting aside political economy problems) than alternative regulatory strategies.  Increased equity capital—which has thankfully happened for U.S. banks since the financial crisis—should be paired with reduced federal guarantees (implicit and explicit) of financial institution debt, including that of the government-sponsored entities. The latter has unfortunately not happened on the scale that it should.

On a different note, while I am not a monetary economist, there does appear to be a strong argument that excessively tight monetary policy in 2008—which took the form (in part) of the Federal Reserve paying interest on reserves at this time—was a major contributor to the financial crisis.  I suppose there is no bulwark against monetary policy mistakes.

Growthpolicy.org. Where do you stand on the role of corporate social responsibility (CSR) and shareholder value? What are the pros and cons of a high CSR performance?

Allen Ferrell: There is now a substantial academic literature on the role of CSR and shareholder value. To be fair, there are papers on both sides of the issue: papers that argue for and papers that argue against the proposition that CSR is consistent with shareholder wealth maximization.  I wrote a paper published in the Journal of Financial Economics (with Hao Liang and Luc Renneboog) analyzing data for firms around the world. We show in that paper that, on average, firms that engage in CSR tend to have fewer agency problems (with an agency problem being a divergence between managers’ and shareholder interests) than firms that don’t. In other words, firms that engage in CSR tend to be run consistent with shareholder wealth maximization. This is, however, very much a topic of ongoing research.

Growthpolicy.org. What are your current thoughts on the connections, if any, between the Efficient-Market Hypothesis and securities legislation?

Allen Ferrell: Efficient market hypothesis has been foundational to modern securities class action litigation. Most securities class action (not all) relies on the presumption that the market in the firm’s security is “efficient” in the semi-strong sense. The reason is that this presumption enables plaintiffs to argue that if the firm made a public material misstatement, then the market, given that it is efficient, would ensure that the public material misstatement was reflected in the security’s price. Suppose the firm lied and said profits were higher than they really were. If the firm’s stock price is “efficient,” presumably the stock price would be higher than it would have been if the firm had told the truth. The fact that the security’s price has been impacted enables class certification because all purchasers of the stock are arguably similarly situated in the sense that they all purchased at too high a price. The Supreme Court has, broadly speaking, endorsed this line of reason in its 1988 decision in Basic v. Levinson and reaffirmed in its 2014 decision in Halliburton II.

The efficient market hypothesis has also been incredibly important in shaping public firms’ disclosure obligations. Essentially, the Securities and Exchange Commission, over the years, has backed off of forcing firms in various contexts to disclose information that was previously disclosed to the market. The idea is simply that the efficient market would price the previous disclosures and any further repetitive disclosure would play no further role in an efficient market. Efficient markets react when there is unanticipated, new information, not already known information.

Growthpolicy.org. Your 2009 paper “What Matters in Corporate Governance?” (with Lucian Bebchuk and Alma Cohen) is among the most cited in the research literature. How have your views evolved, or changed, over the last decade, especially as pertaining to the role of indices of good corporate governance? 

Allen Ferrell: It is clear, and was clear at the time, that while the use of indices enjoys some important benefits (such as standardization in the literature, availability of indices for a very large sample of firms), there are also limitations. Obviously, collapsing corporate governance into one number results in the loss of information. Moreover, the use of more particularized measurements might enable, in some contexts, better identification, a key goal of the empirical literature. In short, indices are one important tool, but there are other important approaches. Given the complexity of the issue, the more approaches the better.