The great drama of our time is the rise of the 1 percent. Thomas Piketty has done more than anyone else to put this question on the public agenda. But while his book Capital in the Twenty-First Century documents the growth of inequality, he does not offer much of an explanation or a solution. He thinks that capitalism naturally favors investors over workers, and proposes as a remedy a global wealth tax, which no one thinks is feasible. Yet recent work by a brilliant young economist suggests that the problem is not capitalism per se, but the way our financial system is organized. The key to the problem—and to the solution—is the rise of the institutional investor.
Institutional investors are companies that own other companies. A familiar example is the mutual fund. A mutual fund owns shares of dozens or hundreds of companies. Many mutual funds pursue specific investment strategies; others just try to mimic the market or certain segments of the market. When you invest in a mutual fund, you indirectly invest in companies that supply goods and services, and obtain the benefits of diversification of investments without having to bother to manage your own portfolio. Other types of institutional investors include pension funds and hedge funds.
Mutual funds have a benign reputation. They make life easier for ordinary people who don’t have the time, resources, or expertise to pick stocks. They are also thought to improve corporate governance. They have the resources to monitor the companies they own shares in, and they can put pressure on them if managers overpay themselves or engage in other bad behavior. And they are familiar: Nearly everyone with a 401(k) owns shares of a mutual fund.
Yet mutual funds have a dark side. José Azar, an economist now at Charles Rivers Associates, argued in his ingenious dissertation that mutual funds can reduce market competition and raise prices for consumers. The idea behind this argument dates to the late 19th century, another period of rapidly growing inequality. Back then, economists argued that firms can reduce competition in markets by buying up the firms that operate within them. At the time, the firms that bought up other firms were called “trusts” to conceal their monopolistic goals. They were broken up by progressive reformers after Congress passed the first major antitrust law, the Sherman Antitrust Act of 1890. Azar’s insight—drawing on some other recent work by economists—was that modern institutional investors such as mutual funds are trusts in sheep’s clothing.
In a new paper, Azar and co-authors Martin C. Schmalz and Isabel Tecu have uncovered a smoking gun. To test the hypothesis that institutional investors gain market power that results in higher prices, they examine airline routes. Although we think of airlines as independent companies, they are actually mostly owned by a small group of institutional investors. For example, United’s top five shareholders—all institutional investors—own 49.5 percent of the firm. Most of United’s largest shareholders also are the largest shareholders of Southwest, Delta, and other airlines. The authors show that airline prices are 3 percent to 11 percent higher than they would be if common ownership did not exist. That is money that goes from the pockets of consumers to the pockets of investors.
How exactly might this work? It may be that managers of institutional investors put pressure on the managers of the companies that they own, demanding that they don’t try to undercut the prices of their competitors. If a mutual fund owns shares of United and Delta, and United and Delta are the only competitors on certain routes, then the mutual fund benefits if United and Delta refrain from price competition. The managers of United and Delta have no reason to resist such demands, as they, too, as shareholders of their own companies, benefit from the higher profits from price-squeezed passengers. Indeed, it is possible that managers of corporations don’t need to be told explicitly to overcharge passengers because they already know that it’s in their bosses’ interest, and hence their own. Institutional investors can also get the outcomes they want by structuring the compensation of managers in subtle ways. For example, they can reward managers based on the stock price of their own firms—rather than benchmarking pay against how well they perform compared with industry rivals—which discourages managers from competing with the rivals.
Competition among mutual funds cannot substitute for competition among corporations. Consider two mutual funds, A and B, each of which owns substantial stakes in the airlines. Both A and B benefit when the airlines fail to compete because they share the airlines’ above-market profits. The managers of A and B don’t need to meet in a smoke-filled room in order to hatch a conspiracy. All they need to do is reward the airline managers if those managers make large profits.
One might argue that none of this matters. After all, a large fraction of ordinary households own shares of mutual funds, so they benefit from the bonanza. They pay higher airline prices out of one pocket, but their share of the above-market stock returns goes into the other. However, high-income people put much more of their money in mutual funds and stocks than ordinary people, who use most of their money to buy goods and services. So the profits mainly accrue to the rich, while the costs are paid by the middle class and poor. Moreover, the high prices lead to waste, as people who are able to pay market prices but not monopoly prices are deprived of goods and services. The institutional investors shrink the size of the market while giving the rich a larger share of what’s left.
While Azar and his co-authors studied only the airline industry, there is good reason to think that their findings apply more broadly. As they point out, the investment management company BlackRock is the top shareholder of the three largest banks in the United States; BlackRock is also the largest shareholder of Apple and Microsoft. The companies that are the top five shareholders of CVS are also the top five shareholders of Walgreens. (And yes, one of them is BlackRock.) Institutional investors dominate the economy.
And this brings us back to Piketty. His famous U-shaped curve showed that inequality was high in the 19th century, fell during the middle of the 20th century, and then rose again over the last 40 years. The rise of the institutional investor coincides with this 40-year growth. The share of the stock market owned by institutional investors rose from about 5 percent after World War II to about 67 percent at the end of 2010. Thus, the two periods of high inequality correspond to the dominance of trusts at the end of the 19th century and the dominance of institutional investors toward the end of the 20th and beginning of the 21st centuries. We see the two as substitutes. Trusts and institutional investors are both devices for capitalists to monopolize the market at the expense of workers and consumers.
If all this is true, can anything be done about it? Absolutely. One question is whether the managers of institutional firms are directing the managers of the firms they own not to compete over price. If so, this is a violation of the antitrust laws, and the Department of Justice should investigate. But we suspect that nothing so obvious is going on. When all the people with the power over pricing share a common interest in raising prices, they don’t need to enter conspiracies or even talk to one another.
Another approach would be for Congress to pass a law that restricts the holdings of mutual funds and other institutional investors. The law would be very simple. Currently, employees and employers get tax advantages when employers set up retirement accounts for employees. The government regulates the types of funds that employers may offer to their employees. The government should direct employers to offer only mutual funds that do not own a significant number of shares of more than one firm in a specific industry. In other words, mutual funds would be allowed to own shares of only a single firm in any specific industry, but could invest in as many industries as they wanted.
For example, a mutual fund could own shares in United or Delta or Southwest, but not more than one airline. The same mutual fund could also own shares in GM or Ford or Tesla, but not more than one car manufacturer. By owning shares in different industries, mutual funds could continue to offer the diversification benefits that investors value them for. But because mutual funds would not be allowed to own shares of firms in the same industry, they would have no incentive to encourage firms not to compete on price.
While our proposal might seem radical since it would indirectly require the mutual fund industry to reorganize itself, it should produce huge benefits for society. By reducing the monopolization of markets, it should lower prices for everyone. The returns to investors would decline, but their losses would be much less than the gains to society from the price reductions. And because low-income people are more sensitive to prices than rich people are, the proposal would help alleviate the high level of inequality. Just like the trust busters of the 19th century, we seek to save markets from themselves.