Index Funds Help Curb Corporate Short-Termism

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Active money management has lost its luster. Since the Great Recession, investors have given up on expensive hedge funds and their mediocre returns, preferring far less flashy options like index funds. Even after years of loose monetary policies and low volatility, weary investors are hesitant to jump back into the fray of active investing. Passive investing in index funds is now the new normal for the stock market. If investors want to see companies return to innovation and long-term growth, they should hope it stays that way.

Passive investing holds promise as a key tool in the fight against an increasingly common issue: corporate short-termism. Measuring data for publicly traded companies from 2001 to 2015, a McKinsey report found a significant, upwards trend in short-term thinking by corporations. For public companies, short-termism typically takes the form of share buybacks. Rather than reinvesting profits in new projects, these companies use the money to buy shares from their investors to boost their stock prices. As a result, short-term companies invest less in innovation and, according to the same McKinsey report, experience lower earnings growth than companies with long-term strategies.

Company executives cite pressure from investors, arising from increased media coverage and lower trading costs, as one of the main reasons for their short-term thinking. Index funds offer insulation from these pressures, allowing corporate executives to worry less about volatile investor reactions and focus instead on long-term growth. Index fund investors focus on the performance of the fund as whole, and the diverse companies that make up these funds dilute the impact of any one company’s stock fluctuations. Because of this, missed quarterly earnings face less scrutiny when many investors are only looking at the performance of the index and not the individual stocks it is comprised of.

Furthermore, for the casual investor, index funds are typically part of a hands-off investing strategy, again offering more leeway for companies to pursue long-term growth. Individual investors increasingly recognize that neither day trading nor actively managed funds are likely to outperform stock indexes over the long term. In response, these investors rely more on diversified index funds, offering better returns and peace of mind. This means fewer stockholders scrutinizing the performance of individual companies, leaving fewer people to exacerbate price changes by jumping into the dangerous strategy of buying rising stocks and selling falling ones. Thus, index fund investors escape the dreaded “buy high, sell low” scenario that plagues traders of individual stocks, while corporations avoid the volatility that accompanies this positive feedback loop.

However, index funds do not erase volatility altogether, especially when one considers that not all index funds investors are so passive. In fact, trading data for a type of index fund known as an exchange-traded fund (ETF) indicates higher volatility for stocks making up ETFs due to the low trading costs of these funds. Importantly, though, this increased trading can largely be considered “noise,” not tied to market fundamentals of individual stocks. Because of this, individual companies’ actions have little effect on this volatility, still allowing executives to pursue long-term projects with less pressure from myopic investors.

By moderating investor pressure to meet short-term expectations, the popularity of index funds grants corporations more freedom to invest in innovation, even when these projects take time to turn a profit. Because most project expenses are immediate while resultant increases in revenue may take time to materialize, investments in innovation often fall prey to shortsighted expectations for a company’s bottom line. Other companies avoid investing in innovation due to the uncertainty of success, weighed against the investor backlash if they fail. If companies expect an outsized impact on their stock performance should a project prove unprofitable, otherwise-promising investment opportunities go unrealized. In either case, companies can invest more in innovation as more projects become worthwhile when given enough time to overcome the costs of the initial investment.  

Some critics of index funds charge that rather than promoting innovation, the popularity of index funds instead encourages monopolization and other anti-competitive practices. Supposedly, index fund managers use their large ownership stakes of companies within the same industries to discourage competition and raise prices. As a recent piece from The Atlantic highlighted, though, fund managers can only offer their low-cost index funds by avoiding costs of highly active management. Thus, the coordination required to design and enforce anticompetitive efforts on such a large scale would prove prohibitively expensive for these index fund managers.

Furthermore, in instances where index fund managers do exercise their voting power, they typically do so in ways that support long-term company performance. In August 2017, Vanguard voted against ExxonMobil’s management to require disclosure of climate change risks. In the long-term, this increased transparency will help the company, boosting its reputation for honesty and encouraging it to adapt to the climate risks it will face. For Blackrock, issues over executive compensation make up the largest proportion of its votes against management. Both of these asset managers are willing to exert their influence to encourage long-term thinking in the companies they hold, largely because it is long-term performance that index funds’ customers seek.

These criticisms do raise another valid concern over the rise of index funds. While freedom from excessive investor scrutiny can encourage companies to pursue innovative projects, it can also allow corporate executives to engage in dubious business practices with fewer repercussions. Investors play a key role in disciplining C-suite executives through company votes, but this threat is only credible if investors catch wrongdoing in the first place. As large shareholders, index fund managers should remain vigilant of wrongdoing, monitoring companies on their own or heeding the warnings of activist investors.

The popularity of index funds has eased some of the pressure restraining corporate investment in long-term growth, but it is still up to index fund managers to ensure company executives use this freedom to enrich their investors, not to line their own pockets.    

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The EU’s currency conundrum: Macron hits a nerve

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Following Emmanuel Macron’s victory in the recent French presidential election, a wave of relief washed over many supporters of the European Union. Macron’s pro-EU stance won out against his right-wing opponent, Marine Le Pen, a sign that the recent populist surge may be subsiding. With the release of exit poll results, the euro hit a six-month high, buoyed by increased confidence that the EU would remain intact under a Macron presidency.

However, celebration of the EU’s preservation may be premature. As France’s newest president, Macron hopes to reform the EU and its currency to reduce the financial strains of EU policies on poorer members. These changes would come at the detriment of Germany and other EU countries with stronger economies, who have benefitted in recent years from a euro weakened by underperforming members. Challenging this currency advantage as the gap in member states’ economic performances widens, France’s new president may only have granted the EU a stay of execution if it continues to resist reform.    

On the surface, Macron’s proposals seem more likely to draw the ire of the French workers rather than other countries in the EU. Aimed at reinvigorating the struggling French economy, his labor reforms seek to improve the competitiveness of French business by reducing labor unions’ power and cutting corporate taxes. Macron’s sees free-market policies as the path to success for the French economy, currently held back by restrictive policies that restrict the workweek to just 35 hours and make firing workers a costly process. French laborers, currently some of the most expensive workers in the EU, would become more competitive, easing France’s economic troubles in the process. Macron hopes these domestic policies will assuage the current discontent and fight the appeal of anti-EU sentiment among a French labor force struggling under scarce job opportunities and a 10 percent unemployment rate.

Critical of the EU’s use of austerity in previous years, he has also called for reforms to the EU, including a common Eurozone budget designed to promote investment in member states whose economies remain stagnant. Since his inauguration, though, Macron has taken a less aggressive stance on these proposals, no longer competing for the presidency against his populist opponent, Marine Le Pen. He announced that he will focus on domestic reforms and will not demand EU members to take on any of the debt of their weaker members. But while his EU policies may be not be a priority for now, the underlying issues with the Eurozone will not be going away anytime soon, nor will the populist elements throughout Europe let the EU’s problems be quietly swept under the rug.

After all, Macron’s EU reforms take aim at economic issues inexorably linked to a defining characteristic of the European Union: the euro. To enhance economic integration within the EU, most member states adopted the euro as their currency but lost a great deal of control over monetary policy in the process. The shortcomings of this shared currency became highly apparent in the wake of the Great Recession and Eurozone debt crisis as some EU members recovered quickly while others like Greece and Spain struggled to return to pre-crisis output levels.

Member states’ divergence in economic performance led to an unintended consequence for Eurozone countries. During the recovery of stronger economies like that of Germany, economic growth typically leads to currency appreciation, which hurts exports and tempers continued economic growth. However, the presence of weaker economies under the same currency reduces currency appreciation, helping German exports. On the flip side, this also means that the weaker economies will suffer from weaker exports, as their currency is not able to depreciate as much due to the growth of other, faster-recovering economies like Germany under the same currency. Thus, the Eurozone’s shared currency provides an extra boost to already-growing members, while weaker states find it increasingly difficult to expand exports and improve their stagnant economies.

Opposition to reforms of this currency problem unsurprisingly comes mostly from Germany, a result of its vested interest in maintaining the current EU’s currency policies to safeguard its record-high trade surplus of $270 billion. With the largest economy of any EU member, Germany also possesses significant economic and political influence to protect this position. German Chancellor Angela Merkel has reflected these realities in her meetings with Macron, agreeing only to small changes in trade policy and defense but resisting more substantial changes to the EU. Opponents to Macron’s reforms argue his proposals would require changes to the EU treaty, but the unspoken objection is still Germany’s potential loss of its currency advantage.         

Though the populist surge may have settled for now, Germany cannot maintain this unfair situation for much longer, unless it offers some form of compensation to the weaker Eurozone members. If Germany continues to fight even Macron’s modest reforms, it runs the risk of galvanizing anti-EU sentiment across the struggling member states. Europeans may have been more understanding of EU intransigence in the response to earlier, radical populist movements. However, now faced with Macron’s moderate proposals to help weaker members, the EU can no longer escape blame for its failure to address the economic malaise of many of its states. Unless changes are made, the EU’s struggling member states will continue to resent the implicit subsidies they give to stronger economies like Germany through their linked currencies. If reform does not take place soon, this resentment may well give way to renewed, widespread calls for exits in numerous member states. Should this occur, Germany may not be able to salvage the EU again, but this time it will only have itself to blame.

Filling the breach: Exploring China’s role in post-TPP Asia

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This month, U.S. Secretary of State Rex Tillerson met with top Chinese officials to pave the way for talks between the two countries’ leaders. Chinese economic policies in the Pacific will surely be discussed, especially as China exploits the demise of the Trans-Pacific Partnership (TPP) to assert itself as a powerful influence on trade policy in Asia. As the talks near, China’s new trade agreements with other Asian countries will offer valuable insight into how China has sought to expand its economic influence and upset Asia’s political landscape in the process. Amid rising tensions in Asia, the leaders of the United States and China must both recognize the futility of their attempts to use trade agreements as tools to dominate political developments in the Pacific region. Furthermore, while these two superpowers compete unsuccessfully for regional power, it will be the economic prosperity of other Pacific nations that suffers.

Discussions of Asia without the TPP may come as a surprise to some, especially considering the Obama administration’s strong support for the agreement. However, carried into office by the surging tide of populism, President Donald Trump has quickly acted to reverse any pro-globalization policies promoted by the previous administration. Without ratification from the United States, the TPP cannot go into effect, removing any possibility of the trade deal further integrating the economies of Asia and the United States. When President Trump put an end to the agreement, critics speculated that in response to U.S. actions, China would step in as the new economic leader in the Pacific region through trade deals excluding the United States. At the time of Trump’s withdrawal from the TPP, China had not yet enacted any such agreements, leaving its future role in the region unclear.

However, it did not take long for China to adjust to the United States’ withdrawal from the TPP and champion new international trade policy in the Pacific. After the TPP’s demise, many countries in Asia turned to the Regional Comprehensive Economic Partnership (RCEP) as the primary trade agreement, intended to promote freer trade between the many Pacific nations involved. Glaring differences between the RCEP and the TPP include the RCEP’s inclusion of China, as well as the absence of the United States despite its position as a major trading partner with many of the nations involved in the RCEP. Although negotiations among the 16 participating countries are ongoing, the RCEP agreement primarily focuses on lower tariffs, without any rules on environmental and labor protections. The trade deal will further integrate the economies of the participating countries, allowing for supply chains unhindered by expensive tariffs.

Cast in the role of outside observer to the RCEP because of its own political motivations, the United States loses out on a powerful tool for exerting its economic power to influence political and social issues in Asia. Under President Obama, the United States offered the economic benefits of lower tariffs to encourage developing nations in Asia to adopt stronger environmental and labor standards. Under the RCEP, it is unlikely that such protections would be enacted on the scale that the TPP proposed. After all, for many manufacturing-based economies in Asia, the lack of these safeguards allows their firms to produce at lower prices than many competitors can. Through the RCEP, China seeks to provide the Pacific region with the benefits of lower tariffs, without taking away the low-cost manufacturing advantage of these nations. In doing so, it hopes to assert itself as a powerful influence in the region and improve ties with other Asian countries, even as it pursues aggressive, expansionist policies in the South China Sea.

If China wishes to continue as the dominant economic force in Asia, however, it must also accept the detrimental economic effects of its politically motivated exclusion of the United States from the RCEP. Exports to the United States make up 18 percent of China’s total exports. As such, China would gain a great deal from free trade with the United States, though China would have to weigh this against regional influence lost to the United States. Furthermore, if China continues to exclude the United States from its trade agreements in the Pacific, increased tensions between the two countries could drive Trump to pursue protectionist policies. This would prove highly detrimental to the Chinese economy, threatening its ability to sell products abroad at lower prices than U.S. competitors can.

Most significantly, though, the politicized absence of the United States from Pacific trade agreements endangers the economic well-being of other Asian countries. Manufacturing-dependent economies like Malaysia and Vietnam looked to the TPP to provide access to U.S. markets like textiles, where these countries could sell their products at low prices. However, Chinese markets already have access to cheap manufactured goods produced domestically. Thus, trade deals with China would be unlikely to benefit other Asian economies to the degree that free access to U.S. markets would. Because of this, China would be less able to exert its economic leverage in pursuit of political influence in Asia, and developing economies in the region would suffer.

As talks between the leaders of the United States and China draw near, both countries must recognize the unintended consequences of trade policy as a tool for political influence. The allure of unfettered access to American markets will continue to divide the loyalties of Asian nations, even as China entices them with promises of freer trade within the region. As issues with the TPP and RCEP demonstrate, neither nation will secure uncontested political influence in the Pacific region through heavily politicized trade agreements. Instead, both the United States and China should focus on creating trade agreements to optimize economic growth in the numerous developing nations of the Pacific region through freer trade. If the United States and China cooperate on trade policy to achieve this goal, both they and many others in the Pacific region will benefit. Neither country should allow political machinations to stand in the way of economic progress.

Solving U.S. health care woes: a nonpartisan approach

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Earlier this month, Sens. Bernie Sanders and Ted Cruz engaged in a televised debate over the state of health care in the United States. While both politicians agreed with the assessment that health care as it stands now requires great reform, their solutions, not unexpectedly, fell along party lines. Americans were offered two, predictably partisan, options: Sanders called for more government involvement, while Cruz suggested cutting regulations as the key to reducing the burden of the costly system now in place. Implementing lasting reform in our broken health care system, however, will require a different approach—one guided by proper incentives and economic evidence rather than restrained by ideology.  

Both sides of the debate took an important first step when Sanders and Cruz rightly noted the shortcomings of the current system. Health care costs make up 17.1% of U.S. GDP, the highest in the world by a significant margin. Health outcomes, unfortunately, do not reflect this reality. Average life expectancy in the U.S. is only 78.7 years, ranking 26th relative to other countries in the world. Effectively, the United States is paying more for health care that does not deliver any significant improvement in health indicators. Americans are rightfully unhappy about this situation, but significant strides can be made to solve this problem in a manner that is largely nonpolitical.

In fact, many of the problems Sanders and Cruz recognized with the current system have solutions that do not fall squarely into any political ideology. Proposals like mandatory health savings accounts (HSAs) provide one instance of such policy fixes.

By ensuring citizens save money specifically for health care expenses, HSAs help eliminate financial roadblocks to health care access without limiting the ability of consumers to choose the health care provider and plan that best suits their needs. At the heart of nonpartisan improvements like this is the desired goal of a more effective, less expensive health care system, driven by the establishment of proper incentives guiding both corporations and consumers.

During the debate, for example, both politicians lamented the tragic results of unaffordable deductibles for patients with severe illnesses. However, ideologically polarized health care overhauls are not the only ways to solve this issue. One need only look at the structure of health care in a country like Singapore for a potential solution. On its face, Singapore’s policy to address the problem of unaffordable deductibles appears counterintuitive. Government funding for health care requires that no health service be provided for free.

In practice, this raises the cost of basic, day-to-day treatments like doctor visits for a mild illness, discouraging unnecessary use of medical care. This policy frees up medical resources to treat more life-threatening cases in a time-efficient and affordable manner.

Singapore also requires citizens to put money into tax-exempt health savings accounts in a program called Medisave, which has the result of discouraging spending on unnecessary medical procedures. The proper alignment of incentives for consumers in Singapore ensures that medical resources can be allocated to the most severe cases, rather than wasted on frivolous or overly expensive medical procedures.

The American health care system could also benefit from incentivising companies that provide medical services and insurance to cut unnecessary costs, without the need for heavy-handed government control. Again, the U.S. can look to the transparent system of Singapore, in which private health care providers are required to publish the prices of their policies.

By providing more information to consumers, this policy creates an environment that encourages health care providers to pursue more cost-effective policies without compromising health outcomes. This relatively light regulation of the industry can have outsized benefits, motivating cutbacks on expensive but ineffective medical procedures that contribute to the United States’ excessive spending on health care.

Another point of agreement between Sanders and Cruz was what they deemed to be the excessive costs of pharmaceuticals, a reality that prevents many Americans from receiving life-saving medicines. Sanders prescribed a greater use of the federal government’s market power as a large purchaser of drugs, while Cruz targeted excessive FDA regulation as the culprit behind high drug prices.

Rather than demonizing corporations as greedy evildoers or decrying safety regulations for drug approval as unnecessary, both parties should once again look to the establishment of proper incentives to craft policies that protect consumers without denying them affordable access to important drugs.

The Swiss system of approving pharmaceutical drugs provides one possible method to properly align incentives to benefit consumers, while still allowing companies to operate without excessive government control. In Switzerland, drug approval is contingent not only on meeting safety standards, but also on satisfying an objective calculation of cost-effectiveness for the new drug when eligible for reimbursement under health insurance plans. A system like this would discourage companies from creating overly expensive drugs, without requiring rigid price controls enacted by the government.

Out of current partisan stonewalling emerges a third, pragmatic path for health care reform in the United States: a focus on properly aligned incentives. Policies like the ones proposed here are driven not by ideology, but by economic evidence. Adopting these measures would be the first step toward the pursuit of a health care system that delivers better results at lower costs—an outcome that would be amenable to politicians and constituents across the political spectrum.

Clean energy to carry on under a Trump Presidency

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On the campaign trail, President-elect Donald Trump promised to prioritize America’s energy needs by ending restrictions on coal companies. To many environmentalists, there is an implicit threat in this commitment to U.S. energy dominance: clean energy sources will face their demise as government interest in supporting the industry wanes. Furthermore, there is fear that a lack of U.S. commitment to clean energy will have a contagion effect on other nations, encouraging other countries to abandon climate agreements like COP21. On the face of it, a Trump presidency seems to herald doom for the future of clean energy.

In reality, the fate of clean energy will likely be far from catastrophic. Rapid improvements in technology for renewables like wind and solar mean that most of these products will be cost competitive with traditional fuel sources by 2025 without subsidies, while solar and wind can already compete in some geographic areas. A pro-coal president is thus unlikely to be the killing blow for the clean energy industry. Alternative energy sources like solar and wind will continue to improve and eventually replace outdated, environmentally damaging energy sources. Concern should instead center around the environmental damage that will occur in industries like coal until such a substitution occurs.

The ongoing maturation of alternative energy has ensured it will be a mainstay in the global economy in the future. While still expanding, the clean energy industry has improved far beyond the first, inefficient attempts at harnessing fuel from environmentally friendly sources. The future profitability of this industry as a large-scale energy provider is under little doubt, especially as many renewable energy sectors have matured sufficiently to near-price competitiveness with “dirtier” energy sources.

In most cases, clean energy firms no longer face an uncertain future about their viability in a competitive energy market. As a result, these firms will not suffer the chronic underinvestment that plagues infant industries, making it probable that private investment will fill the void left by a reduction in subsidies. This benefit is especially likely for firms that have moved from research to development stages for their clean energy products, as the commercial viability of such products becomes more apparent and thus appealing to private investors.

Even if the increased quantity of private investment does not entirely replace the funds provided by subsidies, clean energy industries may still benefit from the improved innovative efficiency of private investment. While subsidies add to the total quantity of innovative expenditures made by receiving firms, innovative efficiency has been found to suffer with government subsidies in many cases. More efficient allocation of investment capital would spur improved innovation rates, further making up for any loss in public investment. This results in part from the greater flexibility of private investment, which is better able to keep up with changing market conditions like the entry of new firms compared to more cumbersome public subsidies.

Globally, clean energy will also likely maintain its potential as a replacement for dirtier energy sources, regardless of the direction American energy policy takes. The U.S. currently constitutes a significant share of global energy consumption (18% in 2013), but other large, developing nations like China and India are increasing their shares of energy consumption as they expand their economies. While many expect these countries to do so through dirty energy sources, the reality is that developing nations already make up over half of all renewable energy investment globally. These countries do so because it is the cheaper option, due in part to the lack of fossil fuel infrastructure already in place.

As these nations continue to expand their energy infrastructure in the coming years, demand for renewables and other clean fuel sources will only increase, ensuring a bright future for the clean energy industry outside the U.S.

All of these factors will ensure the clean energy industry’s continued rise toward becoming the primary producers of fuel in the world. The environmental implications of a Trump presidency are not entirely positive, though. Proposed cuts in regulation of the coal industry that would accompany a reduction in subsidies for cleaner sources will result in greater production of environmentally harmful energy as the coal-producing firms would no longer pay for their pollution costs. Thus, there remains valid concern over environmental damage as a result of Donald Trump’s policies for the coal industry. These fears, however, are far more limited in scope and severity so long as clean energy continues along its path of innovation and expansion throughout the world.

 

Beyond Populism: The Importance of Punishing White-Collar Crime

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Late last month, The Economist published an article, “Jail bait,” arguing that the increased pursuit of criminal charges against white-collar workers is merely a symptom of America’s populist desire to vilify the wealthy. The article further asserts that not only is charging individuals costlier than charging firms, but also that individuals should not be held liable for their actions due to a system that promotes white-collar crime. Finally, the article claims that heightened enforcement can prove detrimental to innovators like Uber and Steve Jobs, who often walk the line of legality and morality when creating new businesses in the face of outdated regulations.

These arguments fail to acknowledge the potential benefits stemming from the punishment of white-collar criminals. Through stronger enforcement, both consumers and businesses can gain from an economy in which individuals are held accountable for breaking laws. Improved consumer trust in sellers of financial products is more conducive to economic well-being than allowing white-collar workers to skirt laws without consequences.

Calls for the increased punishment of white-collar criminals should not be mischaracterized as seeking “punishment simply because they are rich and successful.” In fact, criminal punishment actually holds the potential to improve the economic well-being of white-collar workers. This results from greater trust and transparency in white-collar industries, as consumers believe that rules and regulations are being adequately enforced to ensure fair dealings. Consumers are willing to pay a premium for products they trust, increasing both the quantity they demand and the price they are willing to pay due to the obvious benefit of knowing that they will not be victims of fraud or other crimes.

Contrary to what the article suggests, the economy may in fact benefit from the increased enforcement of white-collar crime, as taxpayers would face lower costs. While the actual costs of enforcement would likely be higher due to the greater number of cases brought against individuals, deterrence should also be weighed in the decision of which method to employ. In my last article, I referenced a study from Cindy R. Alexander showing that criminal charges can be a stronger deterrent to illegal behavior than fines. As a result, the savings from avoiding the damaging impact that white-collar criminals can have on the economy may offset the greater costs of pursuing these punishments in court. For example, the recent financial crisis – due in part to misleading information on the riskiness of mortgage-backed securities – greatly hurt consumer demand and hampered economic growth for years to come. Therefore, deterring future white-collar crime and its potentially damaging economic consequences should be factored in when assessing the true costs of enforcement.

It is also a dubious claim that punishing white-collar criminals would deter innovators driven to violate obsolete regulations. Though it may be true that entrepreneurs like Steve Jobs and Bill Gates engaged in activities that brought them into conflict with enforcement agencies, this does not prove that these actions were necessary to the success of their societally beneficial companies. In fact, these anecdotes do not provide any causal evidence that punishing white-collar crime will stifle the innovations of the entrepreneurial process. It is reasonable to call for changing regulations when they are outdated and inhibit innovation, but this should be decided through proper legal channels.

Nor can the blame be shifted entirely to a corporate culture or business environment that promotes wrongdoing. Fiduciary duties hold corporate managers accountable to the best interests of shareholders and to the laws regulating the operations of their businesses. Thus, unlike the article suggests, corporate managers, not just firms, would be liable when in violation of these duties. To fail to punish white-collar criminals in these instances would enable those individuals to escape accountability to their fiduciary duties.

By reducing the trend of increased punishment for white-collar crime to a bitter, populist movement, The Economist’s article fails to acknowledge the potential benefits of such a policy. Ultimately, more studies should be conducted to analyze the impact of increased enforcement on rates of innovation to determine whether there is a causal link. Even if an impact is found, though, it merely suggests a need to update regulations with greater speed to account for changing economic conditions. To realize the potential economic gains from greater trust in financial firms, punishments for white-collar criminals must be adequately enforced. Such an effort extends beyond populism in its intent to improve the economic well-being of all parties, consumers and businesses alike.

Financial Crimes and Fines: A Misguided Approach

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In the wake of the Great Recession, populist opinion has responded approvingly to regulatory agencies’ stronger approach against wrongdoing by financial firms. Companies in the financial industry have increasingly found themselves subjected to fines as a result of this greater scrutiny. Yet, regulatory agencies are losing out on a superior alternative to fines. Criminal charges against individuals, including executive-level managers, should be employed as a more effective, targeted punishment that does not harm innocent employees and increase systemic risk in the process.

The U.S. Department of Justice’s recent charges against Deutsche Bank provide one example of the possible downsides of using fines as punishment. In September, the DOJ proposed a $14 billion fine against Deutsche Bank for selling mortgage-backed securities during the financial crisis without proper disclosure. The possibility of such a large fine sparked doubts in investors’ minds about the firm’s ability to pay, leading to a further decline in the already troubled firm’s share price. Fear of the ramifications of the fine was not limited solely to Deutsche Bank’s investors, either. Other financial firms became nervous at the precedent that the DOJ could set with this large fine. Some analysts were worried about the systemic risk Deutsche Bank could pose to the highly interconnected banking industry, should the fine significantly damage Deutsche Bank’s liquidity and endanger its ability to do business.

One of the main benefits of the use of criminal charges rather than general fines is that it allows regulatory agencies to avoid increasing systemic risk. Fines against a firm can reduce its liquidity, and if the fine is large enough, this reduction in liquidity could cost the firm more than the face value of the fine. In response to a liquidity shortage, the firm may have to engage in fire sales of assets, accepting lower prices to sell them quickly and damaging the value of similar assets held by other firms. Or, to fulfill regulatory capital ratios, the firm may have to issue additional equity, diluting current shareholder value. Thus, if enforcement agencies wish to avoid collateral damage to firms not implicated in a criminal investigation, then there is necessarily an upper limit as to how much they can fine guilty firms.

Criminal charges, on the other hand, hold the potential to lessen systemic risk by avoiding the more immediate losses in liquidity resulting from fines. Thus, criminal charges can limit harm to outside parties, as the replacement of even high-level executives is less likely to be as damaging to a firm as punitive fines. Furthermore, criminal punishments can be more effective deterrents to illegal behavior. In an analysis of data from 78 firms punished for financial crimes, Cindy R. Alexander finds that the “reputational penalties” firms pay are greater with criminal, rather than civil, sanctions. These reputational penalties, which take the form of lost customers or lower prices accepted by remaining customers, damage the punished firm’s profitability over time but avoid the larger, short-run costs that fines create.

However, there are some downsides to the greater use of criminal charges against firms. Alexander found that firms attempting to recover from reputational damage may shuffle employees and managers to regain reputation. This shuffling may be indiscriminate, resulting in employees not involved in criminal wrongdoing to lose their jobs. The deterrent effect of criminal charges, though, may counter this risk by discouraging firms from engaging in wrongdoing in the first place.

Historically, the use of criminal charges in response to financial firms’ misdeeds has been used sparingly by the DOJ and other enforcement agencies, especially against upper-level managers. Many were outraged when firms bailed out by the U.S. government during the financial crisis kept their executives without facing criminal charges. Regulatory authorities have, however, brought criminal charges against high-level traders in recent years. In July, the DOJ announced that it would charge two HSBC trading executives for manipulating currency prices. When firms are guilty of significant wrongdoing, as in the case of Deutsche Bank, enforcement agencies should ensure that senior executives face the same criminal charges that lower-level employees would face for their crimes, including possible jail time.

While many are happy to see regulatory agencies adopt a hardline approach with large fines like the one proposed against Deutsche Bank, such a method has unintended consequences that extend beyond just the guilty parties. On the contrary, the use of criminal charges against individuals, including high-level executives, offers an effective alternative that avoids many of the negative externalities created by fines. In a global economy that is increasingly interconnected, it is important that regulatory agencies punish wrongdoing with strong deterrents like criminal charges that do not cause wider economic harm.