Capitalisn't

Episodes


Are stock buybacks evil? A lot of politicians seem to think so. Senators Bernie Sanders and Chuck Schumer wrote an op-ed in the New York Times this year calling for a limit on corporate buybacks. On this episode, Kate and Luigi break down what stock buybacks really are, how long they've been around, and whether we should ban them.

If you've been paying attention to Andrew Yang's Democratic presidential campaign, you're probably familiar with the concept of universal basic income. On this episode, Kate and Luigi give the economic outlook on how a UBI might work, or not work, and investigate how automation and techno-anxiety are driving the conversation.

With Democratic presidential candidates making the student debt crisis one of the central issues of the 2020 race, Kate and Luigi give an in-depth economics look at the ideas of free college tuition and debt forgiveness, explain the history of how we got to into this student debt crisis, and debate some solutions for how to get out of it.

Last episode, Kate and Luigi discussed how the patent system creates a temporary monopoly designed to make the incentives to innovate. But the real question is does the patent system, and our entire system of intellectual property for that matter, actually accomplish that goal? We start to answer that question by investigating one of the most powerful figures in intellectual property...Mickey Mouse.

Luigi: Last week, we discussed how the patent system works. Essentially, it’s a temporary monopoly designed to create incentives to innovate. The logic is very simple. A patent grants an inventor an exclusive right to produce. Being without any competitors for a while, an inventor can earn extra profits. These extra profits act as a reward to innovation and motivate companies to invest billions in R&D.

Kate: But the real question is, does the patent system, and our entire system of intellectual property, for that matter, accomplish these goals? There are some economists who say, not really, and a few who say that we should actually have no patent system at all.

Luigi: From the University of Chicago, I’m Luigi Zingales.

Kate: And from Georgetown University, I’m Kate Waldock. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, more importantly, what isn’t.

Kate: On this episode, patents and our patent system. Is this a capital-is or a capitalisn’t?

Luigi: To really understand how our current system of intellectual property rights interacts with capitalism, we need to also understand copyright. So, first of all, what is copyright? It’s a form of intellectual property that grants the creator of an original work an exclusive legal right to determine whether and under what conditions this original work may be copied or used by others, usually for a limited period of time. When it comes to copyright, there is one person who is more powerful and influential than anybody else.

Kate: I think I have an idea of who this might be.

Luigi: Mickey Mouse, of course.

Kate: So, before we get into the story of Mickey Mouse, I think we owe a shout-out to one of our listeners, Francisco Higareda, who actually suggested that we do an episode on this topic. Thanks for the tip, Francisco.

I don’t know if you knew this, Luigi, Mickey Mouse came to be, in some sense, because of copyright law, but actually it was the failure of another character that Walt Disney had been working on. Unfortunately, he was working on this character under the auspices of Universal Studios and sort of ended up getting screwed out of some money, because he didn’t have the rights to this rabbit that he was putting time and energy into. So, he was like, “You know what? I’m going to create my own character. I’m going to get my own copyright, and I’m going to get all the royalties this time.” So that was the genesis of the idea for Mickey Mouse. And to this day, even though that was back in 1928, Disney still has a copyright on the Mickey Mouse universe.

Luigi: That is fascinating and shows how important these rights are in pushing people to create new characters. I think that we would be stuck with the rabbit if it wasn’t for copyright law, but the interesting fact is that this copyright law gives, generally, a time period under which you have these monopoly rights of your production. And this period has been increasing constantly since the birth of the republic. In fact, it’s interesting to know that the first copyright law was introduced by George Washington himself in 1790. And at the time, it only lasted for 14 years with an option to renew for another 14.

Kate: I think it’s also important to mention here that copyright law and intellectual property law overall are in the Constitution. It’s in Article 8, Section 1 that says Congress has the right and obligation to protect or create incentives for this sort of innovation, both in science and in art.

Luigi: And that’s the reason why they introduced it right away. But then they kept increasing the period. So, in 1831, and again in 1909, the period of monopoly was extended, eventually settling for 28 years with an option to renew for another 28. The copyright for Mickey Mouse, which was created under the 1909 law, was supposed to expire in 1984. Guess what? Shortly before its expiration in 1976, a new law was created, and the period of copyright was as long as the author’s life, plus 50 years for individual work and 75 years for all work for hire, so that the Mickey Mouse expiration extended to 2003. But shortly before it was about to expire, guess what happened?

Kate: OK. I guess it was extended.

Luigi: It was. And how long? It was extended for another 20 years, from ‘75 to ‘95. Now what is interesting is the Mickey Mouse copyright is set to expire in 2023. So, wait to see what is going to happen, because my bet is it’s going to be extended again.

Kate: I don’t know. I’m not sure if I would take that bet. I mean, first of all, the first set of laws that extended Disney’s copyright on Mickey Mouse until 2003, those laws were not really lobbied for by Disney. That was just part of an international harmonization effort to standardize copyright law across a bunch of countries. Because you can imagine that if one country has copyright laws that protect an inventor for 50 years, and then another country has them for only 10 years, then you might have people stealing different ideas and different ideas moving to different countries that have the better protections. And so it makes sense that these should be standardized internationally. Now, there’s the open question of whether you can actually protect international copyright, but the idea for harmonization makes sense. And so that was the impetus for the first law change. The second law change, I admit, that was fully lobbied for 1,000 percent by Disney. In fact, so much so that people often call that bill the Mickey Mouse Protection Act.

Luigi: And what is particularly obscene about that extension is that it was retroactive. There’s a discussion in economics about what is the optimal length of a patent or a copyright. On the one hand, you want to extend the length so that you create more incentives to innovate. On the other hand, you don’t want to extend this length too much, because it perpetuates a monopoly. The only reason why you might want to increase the length is because there are some incentive effects. Now, clearly this incentive effect cannot have any role for authors who are dead, like Walt Disney. So, the fact that the 1998 law extended the copyright by 20 years for Mickey Mouse was entirely designed to give more power and more money to Walt Disney. There was no incentive effect. It was purely a redistribution, and it is what I would like to call a Nottingham Sheriff Tax.

Kate: Can you explain that?

Luigi: Yes. That’s the opposite of Robin Hood. You know the Nottingham Sheriff and Robin Hood. Generally, you think about Robin Hood as redistributing from the rich to the poor. The Sheriff of Nottingham was actively redistributing from the poor to the rich. The copyright on Mickey Mouse is taxing the little kids who want a T-shirt and a balloon with Mickey Mouse on it. That balloon costs more because the only one who can produce that balloon is Walt Disney, and they will demand a fee for producing that balloon. So, think about copyright and patents as a tax on all of us. But the tax’s revenues don’t go to fund public services. They go partly to the shareholders of Disney, but partly to the managers of Disney. Michael Eisner, who was the CEO at the time, left the company with $400 million worth of stock.

Kate: Yeah. So, ironically, I am not terribly familiar with the Robin Hood story, and I think it’s because that’s a story that at one point, in the 1920s, was in the public domain. And then once Disney realized that they could turn all of these public-domain stories into cartoons and then get copyrights on those cartoons and take them out of the public domain, then Disney became the sole publisher of that sort of material. And so, I guess I’m vaguely aware of Robin Hood, but I’d forgotten about the Sheriff of Nottingham.

Luigi: So, you have not seen the Walt Disney movie Robin Hood?

Kate: I don’t think so.

Luigi: It’s this . . . It’s a very funny movie. But the point that you make is excellent, because it is true that on the one hand, Disney made a fortune by using public-domain stories. Most of the fabulous stories, from Pinocchio to Cinderella, from Snow White to Aladdin, were all stories in the public domain, and they use them without paying any copyright, but they don’t let other people do the same.

But the problem is not just Disney, in a sense. The Disney story is particularly outrageous. But I think that the problem is a more general problem. It is to what extent granting a monopoly really spurs innovation and to what extent it actually prevents innovation.

Kate: Just to recap, the issues with monopoly, once again, are that prices tend to be higher than under a pure competition, and fewer people are able to afford a good that they otherwise would have been able to afford if prices had been lower. So, there is this utility loss by these potential, or wannabe consumers, and that’s what economists call the deadweight loss associated with monopolies. It’s not just a transfer. It’s important to understand that this is a net loss for society. So, extending monopoly power either through patents or through copyright law for too long, that’s going to increase this distortion, this deadweight loss, and might only lead to minor benefits in terms of more incentives for innovation. So, ideally, the right duration for a patent or a copyright is going to be the perfect balance between the benefits you get from a boost in innovation, a boost in creativity, versus those losses, the deadweight losses associated with monopoly prices.

Luigi: There are some economists who think that patents should be abolished so that, in other words, that length should be zero. There is an entire book written by two economists, Boldrin and Levine, who argue very passionately about the abolition of all forms of intellectual monopolies.

Kate: Well, I don’t think that they’re anti-economic theory, but they do raise an important point, which is that there is another sort of hidden cost that we don’t think of. Let’s say you want to innovate on top of an innovation that’s already been made. So, let’s say there’s some piece of software. Software is actually a pretty bad example, because now a lot of software is open source. And so, the whole idea is that everyone can build on top of it. But let’s say there’s an important piece of software that a company has a patent on. If you want to innovate on top of that software, then you might have to pay royalty fees or licensing fees every time you use that software or sell any product associated with the original patent. And so, that might actually discourage follow-on innovation.

Luigi: But actually, you brought up an excellent point. I don’t think that software is a bad example. Software is a fantastic example, because, in a sense, the innovation brought by open source is giving up on monopoly rights, and it is done precisely because you want to build on the existing code. And if you had to contract for licensing every time you want to build on a piece of code, the cost would be enormous, and innovation in software would be much lower. And, in fact, people tell me that since the diffusion of open source, the speed of innovation in software has increased tremendously. So, in a sense, that is a strong argument for the abolition of intellectual monopolies, because open source has done that.

Kate: Yeah, so you bring up a good point, which is kind of a tough question to answer. What fundamentally spurs innovation? Is it the profit motive? Is it the desire for fame and glory in exchange for having invented something really cool? Or is it just intellectual curiosity? Is it benevolence on the part of people who are the natural inventor type? And this open question, I think, is actually really difficult for economists to answer, and yet it’s so crucial to understanding how to incentivize innovation.

Luigi: At the end of the day, it’s an empirical question. Do we see that, in the presence of patents, there is more R&D as there is more innovation, or do we not see that? What is kind of shocking, to me at least, is that the vast majority of empirical evidence seems to suggest that there is very little positive impact of patents, except maybe in the pharmaceutical sector.

Kate: Why do you think it is that people care so much about patenting in that particular industry?

Luigi: I think there are different theories. One is that it’s easier to define a patent in the biochemical world, in the sense that if I invent a new molecule, what I invented is really defined, and it’s not that easy for somebody to copy me. If I invent new software, for example, or I invent a new machine, people can find a way around the patent more easily. So, that’s one interpretation of the result. The second is, to be fair, the amount of money that needs to be paid to introduce a new drug, especially in the United States, is enormous. And very few companies will pay that cost without some monopoly rights ex post.

Kate: Yeah. I think another point is also that it’s relatively, maybe not easy, but it’s possible to measure your market and to measure how many potential consumers you have to get a sense of what the pricing of this drug should be before it’s invented. Whereas if you’re trying to invent flying cars, there’s so much more uncertainty involved, and it’s harder to project out those future earnings.

Luigi: In one study done by an MIT researcher, Heidi Williams, and a colleague of mine, Eric Budish, they actually look at the innovation in cancer drugs as a function of how easy it is to obtain patents. The ability to obtain a patent depends crucially on your ability to prove in experimental trials that there is an improvement. When it comes to terminally ill people, it’s much easier to see improvements in life expectancy than when it comes to people whose lives are much less at risk. And what they show is that there’s more innovation in drugs that are catered to people in a terminally ill phase than the rest.

But more importantly, they show that in drugs that have to do with blood cancer, leukemia and other forms, it’s much easier to have an intermediate way to see whether the drug works, which is whether it changes the composition of your blood. And they show that the progress on these drugs has been phenomenally larger in the last 20 or 30 years, vis-à-vis any type of other form of cancer. So, you can argue that we just got lucky with that particular disease, or you can argue that this is the benefit of patenting, that where you can patent and where it’s easier to patent, people invest more money in research, and the outcome is better.

Kate: At the same time, though, taking a step back from the pharmaceutical industry and looking at some other industries, such as defense and aerospace, in some sense the opposite conclusions have been found. So, there have been empirical studies, too many for me to really cite specifically, but there have been periods in time, particularly during war, when governments have intervened and said, “All right, we understand that you, company A, you have this patent on this aerospace technology, but we really need it right now, so we’re just going to force you to license it to us for free.”

And these studies have looked at these interventions on the part of the government and have found that, actually, after the patents are forcibly invalidated or nullified, this has actually led to an explosion of innovation in these areas. So, to be fair, I think, again, these are industry-specific, so aerospace and defense. I think it happened also with the US when it came to Xerox technology. But this is evidence in favor of the idea that intellectual property rights or patents or copyrights can actually discourage innovation, or follow-on innovation, because follow-on inventors can’t afford to pay those licensing fees.

Luigi: You’re absolutely right, Kate. And it’s not just in those industries. The most famous example, at least as far as I understand, is the transistor example and AT&T. AT&T invented transistors in the late ‘40s, early ‘50s. At the time, it was a highly regulated company. As a result of that regulation, it was forced by the US government to share its license with everybody. Very many people claim that the explosion of Silicon Valley and computers, et cetera, is a result of that sharing of that patent on a broader basis. There is no doubt that patents have that effect of reducing innovation after the fact, after they’ve been invented. Again, the question is when you sum up with the benefit on an ex ante basis, people do patent stuff because they expect a reward.

People go back to history and they see that, for example, Watt, when he invented his better steam engine, he was running out of money, and it was only the prospect of getting a patent that some other external financier came to his rescue and lent him money in order for him to continue and finalize the creation of the new steam engine. And otherwise, this would have taken much, much longer. So, I think that the debate is still unresolved. But there is another aspect that we need to discuss. So far, we have assumed that the optimal length of a patent is designed to trade off, in a socially optimal way, the costs and benefits. But do you really think that this is what goes on?

Kate: No, I don’t really think that that’s what goes on, you’ll be shocked to hear. I think it’s just difficult for the public to really keep up with innovations in the law, in particular innovations with the optimal timing of how long patents should be granted, because this is relatively difficult stuff. It’s hard for anyone to know what the optimal period of time is, and I think that what’s interesting is that around the 1998 law, the one that Disney had lobbied really hard for in order to get this 20-year extension on their copyright on Mickey Mouse, this law actually passed both the Senate and the House unanimously. There just wasn’t that much talk about it, and it sort of even languished a year before. It was really just Disney that was lobbying pretty hard for it. And they lobbied successfully, they were able to talk to the right people, and they got everyone to sign on for it. It wasn’t until after the law was passed that the public woke up, and they were like, “Wait, what just happened? That’s totally unfair. This is Disney just getting a handout.” And I think that it’s likely that that sort of dynamic will continue to persist, which is that companies can secretly lobby for things. Disney made a point of not releasing how much they were spending on the lobbying, not mentioning it in any of their financial reports or their public statements. And all of a sudden, the public might wake up, but at that point it’s too late.

Luigi: Yes. As Kate explained, this is public choice 101. On the one hand, we have a very concentrated interest, in one case, Disney, but in other cases, the pharmaceutical industry. On the other hand, there are very diffused beneficiaries of a shorter patent, like the consumers, the consumers of Disney products, or the consumers of every kind of drug. Not surprisingly, in the political arena, the concentrated interests tend to have the upper hand. And what they are going to do is they’re going to continuously extend the length of patent rights. Certainly this is what happened with copyright. We don’t see the same level of extension with patents, but this is an argument to say that we want no patents at all, because once we put them in place, it is very hard to resist the pressure to extend the period of time. The only defensible line is zero.

Kate: Yeah. You actually raise an interesting point, which is that there is a pretty big difference in the amount of time you get for a patent versus the amount of time you get for a copyright. If anything, I would expect those to be the opposite. We discussed on the last episode that a patent is 20 years. That 20 years is fixed, it’s pretty standardized across a lot of countries, and it’s virtually impossible to get an extension. Even if you do, it’s only going to be for a couple of years. Whereas in copyright law, originally, at least, the idea was that you could double your time by getting an extension, that was the norm. And now that they’ve done away with that, it’s still the norm for every time a powerful company is bumping up against its copyright on valuable assets, it just appeals to Congress, and then they just sign a new law that it extends it even further. So, why is it the case that now, in copyright law, it’s almost 100 years of protection that you get, whereas in patents it’s only 20?

Luigi: Because you know who writes for newspapers and who makes public opinion? They are people who generally benefit from the copyright laws, because they write books. And so, they are very much in favor of extending the copyright law, and they care less about patents.

Kate: Right. But there’s also people on the patent side that are pretty powerful. There’s the pharmaceutical industry, there’s big tech. I mean, there’s everybody. Even though big tech has its qualms with patenting, it’s not like there aren’t powerful interest groups that care about preserving patents.

Luigi: You’re absolutely right. If you look purely from a monetary point of view, I think that we have very strong groups in favor of copyrights or patents in both camps or in both fields. But I think that if we were to extend or try to extend the cost of drugs, you would have a general uproar, and this uproar would probably be led by a lot of intellectuals in the newspapers. You don’t see the same kind of uproar when it comes to extending copyright law, partly because the very people who should lead this revolt benefit from the copyright law.

Kate: Yeah. Part of me also feels like it has something to do with just the nature of the difference in the two forms of intellectual property. There’s the sense that if you’re a scientist and you happen upon a new molecule, and you turn that molecule into some important drug, yeah, you should get some protections on that drug. But I think the public would get angry if you had that protection for a century. Whereas if you are an artist, I think that there’s something about the spirit of being an artist that makes people feel like it’s more fair to get protections on art, because it’s a different spirit of innovation, and it’s something that really appeals to people’s sense of aesthetics. And there’s this idea that if I drew a picture, if I told an original story, then I should get that protection for my entire life.

Luigi: But actually, today, it’s much longer than your entire life. I wish you a long life, but I don’t think that you’ll live 95 years past the production of your thing. Unless you start producing at age five, I think it’s hard to imagine.

Kate: OK, fine. But the point is that I think that there’s something about the sense of fairness that has led to these differences as well.

Kate: OK, so let’s take this relatively extreme stance that these two economic theorists, Boldrin and Levine, take, which is that the whole intellectual property system, it’s not worth it. It doesn’t give us enough innovation. There’s too many potential costs. Do you actually think, Luigi, that we should just get rid of patents and copyrights altogether?

Luigi: If I were king for a day, what I would certainly do is eliminate patents in all the areas outside of pharmaceuticals and maybe chemistry. Because I’m an empiricist, we have no evidence that they are useful. We have plenty of evidence that they create frictions and we should get rid of them. Then, probably either we’ll put a very limited cap on the period of your copyright for intellectual work, or we’ll eliminate that altogether. I would keep in place the patent for pharmaceuticals, because I’m afraid that without it we would not get the same level of innovation that we have today, which has been crucial in extending our life expectancy. So, it’s not a minor contribution.

Kate: But their point is that we can have the government step in and fill that role. All of the expensive R&D that needs to take place in order for pharmaceutical advances to be made, the government can foot that bill, and then any additional changes can be done by the private sector. And then, once they come up with a new drug, that will just be available to everyone for much less than they currently are.

Luigi: It’s funny that you mention this, because it seems like a very socialistic attitude.

Kate: Absolutely.

Luigi: I do think that the government plays an important role through NIH to innovate and promote innovation. I don’t think it’s perfect. The private sector does create an important complement, so I wouldn’t want to rely 100 percent on the government to decide what to invest money and research in, and for what drugs. A mixed system like we have today, where there is part of the money coming from the government, part is coming from donations, like the Gates Foundation, and part is coming from profit motives, I think that’s probably a more balanced system than one in which the government does 100 percent of the effort.

Kate: Yeah, I agree. Even though I like to pretend sometimes that I’m a democratic socialist, I think that this is one of those areas in which too much government control can lead to inefficient outcomes. I’m just imagining a system in which there’s a president, or maybe even a dictator, who’s obsessed with the reputational value of curing cancer. And so, all of the government’s funds go into this one disease, and there’s incentives for scientists to fabricate results or publish the wrong thing so that the dictator can have a plaque that said that they cured cancer.

I mean, I’m worried about that sort of scenario. So, yeah, I agree. Even though I think that . . . I mean, it’s hard for me to say, but I think that as you mentioned, a lot of important research in pharmaceuticals comes out of nonprivate institutions, i.e. the government or foundations. I still think that it’s good for those three different groups to exist to put checks on one another.

All right, so let’s assume that partially because these intellectual property protections are in the Constitution, it is unfortunately going to be a little bit difficult to get rid of copyright protections altogether, to get rid of patents and the USPTO. So, assuming that it’s too much for us to change, and maybe there’s not the political will, what are the tweaks that need to be made to make the system better?

Luigi: The first one is what we’re doing in this podcast, to make people appreciate the cost of patents. I think that most people don’t realize that a Mickey Mouse copyright is a tax on people and a very expensive one. So, I think that by creating the awareness that patents have costs, you will create the political demand to shorten their length and potentially to actually change the patent system.

Kate: Yeah, I think that when it comes to patents, there are some specific things that we talked about on the last episode. People who review patents are only given, in some cases, a matter of hours to do this. It’s really hard and complicated to know whether that patent’s building on other technology. You have to do a lot of historical searches and then understand the technology. And so, we need to have the funding to give them the time to make the right decisions. We shouldn’t just rely ex post on the courts to figure everything out. And that means that maybe we should also change the funding structure of the patent and trademark office.

We shouldn’t just have them be deciding everything on their own and maybe subjecting themselves to these perverse incentives to grant too many patents, because that can lead to some of the practical issues that we’ve seen, like these patent trolls, which actually inhibit innovation. So, I think that there are some practical changes that need to take place on the patent side. On the copyright side, can we just amend the Constitution to say that we’ve reached the upper bound of how much you can be protected in terms of copyrights and just save all the lobbying, save all the money? Let’s stop this ridiculous charade of trying to push it back and make sure that it doesn’t happen again.

Luigi: I think that 95 years is too long. I would actually go back to 15, 20 years or something like that.

Kate: Yeah. Originally it was 14.

Luigi: Yeah. Why don’t you write a shorter term in the Constitution, because then it’s difficult to change? But your idea of being more picky in approving patents is very clever, because potentially it’s a way to go around the constitutional limits. So, you’re saying, “OK, we have a law that allows patents, but you need to be granted one. And we make it so difficult to grant any that de facto we have no patents.”

Kate: Boom. See, there you go. Who’s the one thinking like a lawyer now?

Luigi: Yes, like a perverse lawyer. But maybe all lawyers are perverse.

Kate: Wait, but in the name of consumer welfare, right?

Luigi: Absolutely. But, you know, the biggest tragedies in humankind have been made with good intentions.

Kate: That’s true. OK. So, capital-is, or capitalisn’t?

Luigi: I think this is capital-was.

Kate: Oh, snap.

Luigi: In a sense, I think historically, when it was very difficult to get the system started, probably patents did play a role to get the system started. And today, I think that the world has changed. There is so much money investing in innovation, and the competition is so intense, that maybe we don’t need those patents as much as we did in the past.

Kate: Yeah, I agree. I like your framing of capital-was. Certainly, we wouldn’t have wanted to do away with the Thomas Edisons of the past, but it’s hard to imagine that that same sort of model of invention still exists today. I think that what we do know is that there is a growing body of evidence that our current patent, as well as our copyright, system has overreached. It’s provided too many protections to incumbents or to people who already have monopoly power. So, if there’s any way to rein it in, that would be great, but we just need the political will.

Luigi: So, are you running for office, Kate?

Kate: On the anti-patent platform? I’m not sure that’s going to bring me very far.

Luigi: Actually, there was a party in Europe called the Pirate Party, and one of the key elements of the platform was the total abolition of patents and copyrights.

Kate: I’m not going to lie. There’s something very appealing to me about the idea of a Pirate Party.

Luigi: OK, Captain Kate, let’s launch the party.

After our series about the dangers of monopolies, we're going to investigate a situation in which the government actually works to create monopolies on purpose: the patent system. On the first of two episodes, Luigi and Kate examine whether our current patent system is helping or hurting capitalism.

Luigi: We’ve done a series of episodes about how bad monopolies are and how the government should fight against the formation of monopolies. Now, I want to dedicate a bit of attention to a situation in which the government on purpose creates a monopoly, and that’s called the patent system.

Speaker 2 :In recent years, a broad fight over the enforcement of patents and what should qualify as a true invention has drawn players from every corner.

Kate: Figuring out how our patent system works, or maybe doesn’t work, is an important part of understanding capitalism today.

Speaker 4: At some point, patents are important for innovation, right?

Speaker 5: No.

Speaker 4: I mean, what, you’d blow up the whole patent system?

Speaker 5: Yeah.

Speaker 6: We open-sourced our patents, so anyone who wants to use our fans can use them for free.

Speaker 7: Your patents are open-sourced?

Speaker 6: Yeah.

Luigi: From the University of Chicago, I’m Luigi Zingales.

Kate: And from Georgetown University, I’m Kate Waldock. This is Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On this episode, we’re going to talk about patents and our patent system. Is it a capital-is, or a capital-isn’t?

Do you know anybody with a patent, Luigi?

Luigi: Actually, I discovered that a colleague of mine has a patent on a trading system.

Kate: On a trading, like?

Luigi: A trading mechanism.

Kate: Wow, that’s pretty cool.

Luigi: Yeah, zero citations and zero use, but that’s—you never know.

Kate: Yeah, I mean, I remember when I was a kid, I used to think that getting a patent was like winning the Nobel prize or something. It was this honor that was reserved for a few people. And now they have college classes where the whole point is to try to get a patent at the end of the day, or at least submit a patent application.

Luigi: It’s a bit like having a published paper. It doesn’t really matter to have one. It depends on how influential it is.

Kate: Let’s back up a second and pretend that we’re designing a system from scratch. Let’s pretend that we’re like the founding fathers, and we want to encourage innovation, but we’re not really sure how to do it. Why the patent system? And what are the important things that you need to address, in order to create a functioning patent system?

Luigi: Let me start with a story. I don’t know if you’re familiar, Kate, with a type of violin called a Stradivarius.

Kate: Yes. Yeah.

Luigi: The Stradivarius was invented by an Italian guy called Stradivari, who apparently had a unique varnish that he was using on the violin that makes the violin sound so much better. In order to protect his innovation, he kept his secret. So secret that today, I think three centuries later, we cannot reproduce a Stradivarius violin.

Kate: Seriously?

Luigi: Yeah.

Kate: That’s insane.

Luigi: Nobody has been able to match the quality of the Stradivarius violin. Now, compare that with the saxophone. The saxophone is an instrument created by Mr. Sax. He actually patented the saxophone. He used the patent for a while until the patent expired, and now everybody can produce a saxophone as good as the one that Mr. Sax invented. So, the patent is a way to ensure protection for a while, but it also makes sure that eventually this information is diffused, because the benefits of diffusion of information are enormous, as we know in economics. And we want to make sure that this takes place.

Kate: Yeah. I mean, also, not everyone can keep a secret as well as Mr. Stradivari, apparently. I think if everyone could just hide their secret sauce really well, that’d be one thing. But it’s not as practical these days.

Luigi: Yeah. But historically, the way they were maintaining secrets was actually much more violent. Very often, they were killing people so that the thing would not be reproduced.

Kate: Right.

Luigi: When rich kings or queens were building these complicated clocks that were unique in their features, the way they were ensuring that there was no other clock like that was to either blind or kill the person that designed it.

Kate: OK. Yeah. So that, that’s not ideal in modern-day societies.

Luigi: That’s not an ideal patent system, yes.

Kate: Right. And yet we still want to encourage innovation but also disseminate ideas at the end of the day. And so, one of the tenets of the US patent system, and actually our fee structure is somewhat designed around this, is that everyone needs to be able to participate, right? We want to encourage inventions from big companies and small companies. So, we want everyone to be able to apply.

We don’t want people who have made great inventions to suffer from not being able to get a patent. But on the other hand, if everyone can apply, then anyone can just submit anything, right? And so, you also want to discourage people from submitting bad patents or getting patents on things that are pretty obvious or have already been invented. So, you need some sort of review system. You need some experts who are looking over these patents and making a decision.

Luigi: And actually, do you know, Kate, that Einstein’s first job was to work at the Swiss patent office?

Kate: Really?

Luigi: Oh, yes. So, in the old days, they had pretty talented people in the patent office.

Kate: Part of the reason I thought this episode was cool was because my Uber driver the other day had been working in the patent office, which is not to say, by the way, that he’s not super smart or Einstein, but he was just going over how terrible it was to work there and how much pressure there was on him and how little time he had to review the patents and the little training that he got. So, it seems like if that was the standard that they used to set in Switzerland a long time ago, at least in the US, it’s changed.

Luigi: You bring up an excellent point that there is a tradeoff between doing a very careful job upfront on the quality of the patents, so having an Einstein review whether the patent is really an innovation and whether it’s worth patenting, or being very liberal in granting patents, but then letting litigation ex post fix the problem.

Kate: Luigi, let’s pretend that we’re submitting a patent.

Luigi: OK. Let’s say that I submit my silly patent, and you are the patent office asking me the questions that need to be answered in my patent. OK?

Kate: OK. First of all, what’s your patent?

Luigi: My patent is a way to underline audiobooks.

Kate: Huh. That’s actually not a bad idea. That’s a good one.

Luigi: Actually, to be completely honest, this is my son’s idea.

Kate: Oh, really?

Luigi: Yeah.

Kate: That’s pretty cool. Yeah, I have felt that need before in the past. All right, so what’s your son’s name?

Luigi: Giuseppe.

Kate: OK, so you and Giuseppe are submitting this patent. What are the first things you need to do?

Luigi: First of all, I need to get a provisional patent application, and this is a sort of bridge patent that lasts for a year. This application gives the patent office the time to have a glimpse at the patent and also helps reduce the chance that somebody steals this great idea.

Kate: So now, you’re working on your actual application, and when you file it, since you guys are just individuals, I as the patent office, I’m just going to charge you $785.

Luigi: Wow. That’s a lot.

Kate: I mean, that’s a decent amount of money, but it’s only roughly double for large corporations. And so, for a big corporation to be paying 1,700 bucks for a patent application is not that much.

Luigi: So, why is this fee not a function, number one, of how complex the patent is, and, two, also a function of the success of the patent?

Kate: Well, first, it’s because we want the system to be open to everybody. We want to encourage small innovators, and so that’s why the fee is relatively low, right? The actual fee of filing an application is less than the cost of reviewing the application for the patent office. But if your patent gets approved, then you have to pay maintenance fees and stuff like that that are higher, even though they’re not that high, they’re $1,000 a year or something.

Luigi: So, there is a bit of a payment for success, but very limited, because the patent office does not want to penalize success. In fact, if broadening access was not an issue, the optimal system would be a system in which you put in a big deposit, and if your patent is applied, you get most of your money back. And if it is not accepted, then you forego the deposit, because that is a way to discourage silly patents.

Kate: But at the same time, I think that would only hurt little guys who have liquidity constraints or borrowing constraints.

Luigi: No, no. That’s exactly the reason why the system is designed this way. But if the only concern was to minimize the silly patents and minimize the time wasted by the patent office in reviewing silly patents, that would be, from an economic point of view, the optimal system. We don’t want to use that system, because we want to grant easier access to the little guys, but the cost of that is that potentially we have a lot of silly applications, and we waste a lot of time in silly applications.

Kate: So, going back to your underlinable audio book, what do you need in your patent application?

Luigi: In order to file my application, I need, first of all, to have a picture. Second, I must prove that this stuff is new and useful. Useful in the sense that it provides utility in using it, and new in a sense that it should be nonobvious and not disclosed to the public before.

Kate: Right. So, if you would have written an article about your awesome new invention, then that counts as a disclosure, and that would hurt your chances of getting the patent.

Luigi: So, I should actually clear it with my son, because in this episode I’m disclosing his idea. And then it becomes unpatentable.

Kate: I didn’t even think about that. Oh, no. OK. Well, if Giuseppe is really angry, we might need to pay him. He might sue us, we might have to pay him damages for early disclosure.

All right, so now the patent’s in my hands. I’m the US PTO, Patent and Trademark Officer reviewer. I have to read this application, I have to search for prior patents, which for some reason are called prior art. I guess you can consider innovation art, but that’s probably one of the hardest parts, figuring out exactly what other patents in the past relate to Luigi and Giuseppe’s patent, because it’s not necessary for them to have done a thorough review of this, right? I mean, they have to prove that it’s new, but they don’t necessarily need to know every single patent that’s related. That’s my job.

Then, I have to compare all of this prior art with their patent. Possibly, if you’ve hired a patent attorney, which a lot of people do, I have to interview that person. Then, finally, I make a recommendation. So, in my mind, it seems like all of this should take at least a week. You know, maybe a couple of weeks if drawn out, but on average, each patent examiner only spends 18 hours on this entire process, including the final recommendation.

Luigi: So, does it mean that when I file the patent, within 18 hours, I have my patent back?

Kate: No, so that’s another issue. There’s a pretty huge backlog of patents. I think one of the most famous delayed examples is TiVo. For them to get a patent on their TV recording system, it took them 10 years to get word back from the US PTO.

Luigi: Ten years?

Kate: Yeah.

Luigi: By that time nobody was watching TV anymore.

Kate: Exactly.

Luigi: But help me out here. So, if I start producing the product while the patent is pending, does this make the product not novel and not patentable? Should I wait for the patent to produce?

Kate: No, you can still produce the product. But the question of whether other people have also produced a similar product while the patent is pending and whether you can recover money from sales from them, that I think is still pretty gray.

Luigi: So, if I am TiVo and I’m waiting for my patent, I can still produce TiVo, sell TiVo, and only what I’m not sure of is if somebody else can produce a similar thing at the same time. And, if they do, I don’t have grounds to sue them.

Kate: Yeah, it’s unclear how much you can get back from them. The backlog has gotten better. There were 750,000 patents in backlog, just in backlog, in 2007, and it was recognized that this was a huge issue. And so, the PTO tried to hire a bunch of people, tried to—

Luigi: Including your Uber driver.

Kate: Yeah, actually, that probably would have been around the time that he was hired. So, he might have been swept up in that. And so, they reduced the backlog to 570,000 by 2017, but that’s still a lot of patents in backlog. So, yeah, it usually takes a couple of years for it to get approved.

Luigi: But what are the requirements to work in the patent office? I understand you don’t need to be Einstein, but what do you need to . . . Do you have to have a degree? Do you have to have a . . . in what?

Kate: Yeah, so typically you’re assigned to a specific area, right? The people reviewing things like hammers are not the same people as the people reviewing AI. And, in fact, the amount of time that you get to review a hammer is a lot less than the amount of time you get to review AI. And so, you’re supposed to have a degree in that area. But an undergraduate degree counts.

Luigi: Wow.

Kate: I’m assuming that for people reviewing CS AI, they have more than an undergraduate degree, but still. So, let’s say we grant your patent. That means you get 20 years to be the sole producer or licenser of this new technology. And then, let’s say you find someone who is using your idea, right? Slate, who is definitely not one of our competitors, has implemented your, or a very similar, technology so that people can underline their podcasts. If you want to go after them, you can sue them in federal district court. That’s usually where a lot of patent litigation plays out. And, as of 2012, there is a new law that introduced other, more specific patent courts within the US PTO where you could also sue.

Luigi: Now, tell me a bit about this special court. Because you know, as an Italian, I don’t like special courts, because special courts were introduced during the fascist—

Kate: Right.

Luigi: —to do crazy stuff. So, in general, we don’t like special courts, because we want judges to be impartial. And one way to maintain impartiality is to not be too specific in one particular sector. Here we’re deviating from the general rule, because judges in all the other circumstances are general judges. They can decide from an FBI investigation of drug dealing to the patent. So why, for the patent, do we have this special court?

Kate: Well, I think it makes sense. I mean, you’re right in one sense that it’s weird if you’ve all of a sudden designed a special tribunal that can be subject to the political pressures of that particular institution. But at the same time, patents are so specific. If you’re challenging an AI patent, why not refer that to a judge who’s already familiar with AI patents rather than a federal judge who oversees all sorts of different cases, right? Are they really the right people to be reviewing such complicated matters?

Luigi: This is a very important question, because it is the tradeoff between expertise and capture. Certainly your expert in patents is much more knowledgeable than a general judge. But he also probably has a different agenda, because what kind of job did he do before being a judge, and especially what kind of job is he going to do after being a judge? And who appoints him or her?

Kate: Yeah, so a lot of this concern is legitimate, and some of the proof that it’s legitimate is that these special patent offices, or these special patent judges, do seem to be highly influenced by political pressures, or at least the current political mood. Part of the reason that they were strengthened was because of patent trolls, which we can get into in a second.

But around the ‘90s and the early 2000s, people hated this idea that there were too many patents and there were all these patent trolls that were trying to extract fees from people just using simple technology. And so, even though these patent-specific tribunals or these courts already existed, historically, they always upheld a patent. But then, after the passage of this law, which created more of these types of courts, the pendulum swung in the other direction, and it made it much easier to strike down these patents. So, it’s not really the existence of the court that matters. It’s just the general political mood that matters. And I think that that’s borne out in the evidence of the rulings of these courts.

Kate: Let’s take a step back and talk a little bit about the history of patents. There’s a ton of changes in law, but they’ve been around for a long time, right? The first patent was granted in 1790, so to give you a sense of how the system has changed, in 1980, the US issued about 66,000 patents, and by 2017, they were issuing 347,000 patents. And so, not only the number of patents granted, but also the number of applications, has just exploded in the past 30, 40 years.

A big explosion took place around the IT revolution, right? When we were learning about computers, learning about the internet. And a bunch of people started filing patents then. Then, this concept was born of the patent troll. It’s usually a company, even though it could be an individual, who specializes in getting a bunch of patents and not necessarily using them for any practical purpose, but using them to sue companies that do similar things. And so, these companies, their purpose is either to buy up a bunch of patents or to file patent applications themselves. Not necessarily make the good, but just try to sue whoever has any sort of product that’s similar to something that’s in one of their patents.

Luigi: And actually, Google bought Motorola, not for the quality of the phones they were producing, but for this stock of patents they had, as a way to protect themselves against patent trolls. And also as a way to play some games with other, older patents in a kind of mutual exchange.

Kate: Yeah. The people who hated these patent trolls are understandably large tech companies who are getting attacked constantly by these patent trolls. And to give you a sense of how powerful these patent trolls were, between 2011 and 2012, almost $30 billion of litigation was involved in this patent trolling business. Understandably, high-tech companies hated all of this. And so, they started lobbying pretty hard in the late ‘90s, early 2000s, to try to get Congress to pass legislation that would attack or limit the ability of these patent trolls to sue whatever company had similar patents.

Luigi: Yeah, but to some extent, what is a patent troll? It is a bit in the eye of the beholder. Some patents that, for example, the pharmaceutical companies receive are completely and exclusively designed not to reward innovation, but to keep people out and to force Medicare, Medicaid, to pay higher prices for the drugs, or to force the insurance company to pay a high price for the drugs. So, we can claim that many of those patents are basically patent trolls. But you don’t say the large pharmaceutical companies are patent trolls. You do say that Intellectual Ventures is a patent troll.

Kate: Yeah. You raise a good distinction. Basically, you’re describing two different types of patent manipulation, right? The pharmaceutical company that’s manipulating their drug a little bit and trying to get a new patent on it, that’s not what we’d consider a typical patent troll. But the reason that they do that is because the patent lifetime is limited to 20 years.

Luigi: But it is a manipulation of the patent system.

Kate: Yeah, it’s absolutely manipulation. But it’s specifically because they want to extend the life of their patent, not because they don’t have any legitimate use for the patent within their own company, right? They’re basically just trying to get monopoly rents for longer. And you raise a good point. I mean, we have this 20-year limit on patents. It’s really hard to get an extension. So, that’s one feature of the system that’s difficult to manipulate, which is that patent extensions are almost never granted.

In some cases, if it took a really long time for you to get your patent granted, maybe you’ll get a one- or two-year extension. But they’re pretty rare. In all other circumstances, they require an act of Congress, and Congress is hard to corral.

Luigi: Good luck.

Kate: Yeah. So, it’s pretty tough to get a patent extension, which is why these companies try to manipulate the system by changing their drugs slightly and getting a new patent.

Luigi: But then, actually, of all people, a hedge fund manager, Kyle Bass, saw an opportunity to challenge some of the pharmaceutical patents that are pretty similar to patent trolls. So, you know that when the patent for Prilosec, which is an antireflux drug, expired, the producer, Pfizer, introduced Nexium, which is basically the same chemical formula with a slight variation, but they gave it a patent.

And so, they pushed this Nexium over the Prilosec. The idea of Kyle Bass was to use this special patent system to challenge this kind of pretend patent or useless patent. And you’d say, how would it make money? He was making money by shorting the stock of the company that he was challenging.

Kate: Yeah, I mean, I think that is the perfect example. That’s the case in point, which is that there’s all these issues of the patent system. It’s so hard to get the rules right, and the rules swung in a massive direction from one side to another around 2010, 2011. Prior to that, it was really easy to get patents, and it was really easy to enforce them. And so, we saw all the manipulation by these patent trolls, but then, after these laws were passed that made it really easy to sue and invalidate a patent, then there started being these specialty occupations, or they’re called prior-art searchers, who would just search through these archives of patents to sue specific types of patents for the exact reason that you just described. Either you could get hired by a competitor and undo a competitor’s patent, or if it’s a public company, you could short their stock. Either way, it’s being manipulated.

Luigi: But actually, the interesting story is, I thought he was providing a public service, because he was destroying these useless monopolies of drugs that have no innovation in them. And it’s done to exploit the patent system. And he was trying to get some reward for it, but he was doing something that was socially good. Unfortunately, his enterprise in this direction did not succeed, because the pharmaceutical industry is too powerful, even in the special courts, or I will say, especially in the special courts.

Kate: Good one, Luigi.

Luigi: Who decides? The US patent office decides by itself what are the levels of the fees? And who appoints the patent office?

Kate: It’s actually the director of the US PTO, which doesn’t look great. But there’s actually an interesting study that was done around this. It was conducted by two law professors, Michael Frakes from Duke Law and Melissa Wasserman from UT Law. And they were trying to figure out whether or not the financial constraints of the US PTO actually affected what types of patents were being granted. So, they looked at periods in which the US PTO had some resource constraints, maybe they were a little underfunded. And they compared patent grant rates between the types of applicants that were likely to be repeat patent filers, so good sources of revenue, versus patent filers that were more likely to be one-time patent filers. And they found that when the US PTO was resource-constrained, they were more likely to grant patent applications to these repeat filers, potentially because they were a good source of business.

Luigi: Incentives do work, and even perverse incentives do work perversely.

Think about this: I have a patent, so I am suing somebody else. Imagine that after our episode, Amazon is going to develop for Kindle a product like the one my son Giuseppe wanted to invent. OK?

Kate: Oh, no.

Luigi: And of course, Amazon being Amazon, they’re going to put it in every Kindle, and it’s going to be a big success. And my son decides to sue. Is he a patent troll, or is he a legitimate protector of his right?

Kate: Well, obviously, in the way that you describe what just happened, he’s not a patent troll, right? A patent troll, their singular purpose is to aggregate a bunch of patents and to go after claims. They didn’t necessarily invent anything. They’re not necessarily trying to improve the system at all. They’re just taking advantage of the legal system. And so, if your son actually had this idea and wanted to produce the idea, then he’s, by definition, not a patent troll, especially if he’s not making a living doing this. But the legal system now has become so antagonistic towards people suing for these sorts of patent claims, or to assert their patents, that it has become much, much harder for someone like your son to win a ruling against a company, like Amazon in this case, because of the lobbying that these high-tech companies did in the early 2000s.

Luigi: Yes, so I think there’s a serious distortion, because I imagine my son has better things to do than to sue for this. So, he sells the patent to Intellectual Ventures. Intellectual Ventures sues for him. They did not invent anything, but in a sense, they pay my son some money under the expectation they can make that patent hold. The existence of these brokers is useful to reward innovation and make sure that the little guys get protected. So, I feel that all this rhetoric about patent trolls is very much pushed by big tech that doesn’t want to have any little guy in the middle.

Kate: I think that that’s totally fair, right? I mean, some patents should be litigated, but there’s also obviously room for abuse, right? If you patent a stick and then sue anyone who’s ever made anything involving a stick, then that’s probably you trolling and not looking out for the little guy. But that’s exactly what they claim. They claim to be protecting the little guy. But obviously, in some cases, they can take it too far.

Luigi: But isn’t this saying that our judicial system doesn’t work? Because—maybe the case is too silly, but if I sue for a stick, how long will it take for a judge to dismiss my case? And probably dismiss my case with some notion that I have to pay some costs, some legal costs, because it was preposterous that I was suing about that. I should be punished by the court system. And that would be the best deterrence against patent trolls. Not to add a special court system in which, basically, the big companies get huge favors, because many of the lawyers involved work constantly for them and then become sort of an arbitrator in this judicial system. Thus, I think that that is to me a very serious distortion.

Kate: Great. So, I think that’s an interesting segue into an issue that often comes up with regards to patents, which is that the little guy is becoming less and less a part of this whole system. To put some numbers on that, the share of patents granted to small entities, either individuals or small businesses, those used to be greater than 30 percent of all patent grants in 1995. And, as of 2014, it was less than 20 percent, and I think that number is continuing to drop. Is this something that we should worry about?

Luigi: It depends on what caused this drop, because I can see an argument saying, look, innovating is more and more expensive, so it is hard for the guy in his basement to create a really innovative product. You need to be part of an organization that invests a lot of money to create those products. And so, you see fewer patents produced by individuals. That would be a natural technological explanation, and I would not be worried about that. The other explanation is that the system is broken, I don’t feel that I am protected anyway as a small guy, so I don’t even bother to file a patent, because the patent for me is useless.

Kate: Yeah. I think that one of the reasons that this is a difficult issue to address is precisely what you said. It’s hard to figure out what’s causing this, and obviously, there is a trend towards consolidation of businesses, big businesses. It’s much, much easier for them to innovate. And so, can we really tell whether this is the fault of these strengthened patent courts? Which, by the way, since they make it easier for companies to undo patents, this has in a sense increased the bargaining power of big companies vis-à-vis little firms if the big companies want to buy the patents. And so, that’s one argument, is that it’s the fault of these strengthened patent courts, but it’s hard to tease that apart from the general trend. And so, I don’t know.

Luigi: Hopefully, our conversation has highlighted some of the technical aspects of patent law. But we’ve not touched yet on the fundamental question, which is, does our patent system spur innovation? Because the only reason we want to have a patent system is because we think that we have more innovation with it rather than without it. Is that the case?

Kate: In our next episode, we’re going to be broadening the question a bit to not just patents but all sorts of intellectual property. That also includes trademarks as well as copyrights. And we’ll ask ourselves, at the end of the day, is this whole system worth it?

In part three of our series investigating how digital platforms like Facebook and Google should be regulated, Tyler Cowen from George Mason University argues to Kate and Luigi that more regulation may not be the answer to all our questions about digital platforms.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And this is Luigi Zingales from the University of Chicago.

Tyler CowenTyler Cowen, George Mason University. I’m the guest, I believe.

Kate: No, you don’t get to talk yet.

Tyler CowenOh, sorry.

Luigi: That’s quite all right.

Tyler CowenDo it over again.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

In the past two episodes, we listened to Fiona Scott Morton and Nolan McCarty, who reported about what’s wrong with the digital platforms.

Kate: And on today’s episode we’re going to be talking with Tyler Cowen, who is the Holbert C. Harris chair in the economics department, George Mason University. He’s also the cohost of Marginal Revolution, an economics blog. And he’s written an uncountable number of books, but the most recent of which is called Big Business. Welcome to the show, Tyler.

Tyler CowenHappy to be here.

Kate: Tyler, can you give us a broad summary of your book?

Tyler CowenMy book is called Big Business: A Love Letter to an American Antihero. Several years ago, I noticed that people were villainizing business, and big business in particular, much more in public discourse. We see this in our politics. We see it if we look on the op-ed page of the New York Times. We hear it also from President Trump. We have a president who tweets against CEOs. That is unprecedented. Since we’re treating business more as a scapegoat, I thought I would provide a dispassionate look at the actual facts about big business in America, and I cover big tech and the financial sector, monopolization, and many of the topics that people care about in this context. And the book came out this April.

Luigi: I think that in the book you make a very important point, which is that progress has been great. It has been great in America for the last 200 years, but it’s been great also in the last 20 years, and that a lot of the things that we have today are much better than what we had in the past. Now, the question is not whether we love cars or we don’t love cars. When cars were invented, they were great, but also, we invented traffic lights, and as a result of traffic lights, the number of people killed per miles driven dropped by a factor of 25. I think that the real question is not whether this business is good or not. It is whether we want to intervene.

Tyler CowenWell, I think for all businesses, we should enforce laws against fraud much more strongly. A point I make in the book, which a lot of Americans don’t actually know, is that you’re more likely to be defrauded by a small business than by a big business. If you go to McDonald’s or Walmart, there’s a remarkable predictability and regularity to your experience. So, big business tends to be not very popular in opinion polls, but, say, your local TV-repair person is much more likely to rip you off. And you mentioned traffic lights, it’s interesting, but the trend these days is to do away with traffic lights and have traffic circles. So, which works better? It depends. It seems we invested in too many traffic lights, and now we’re relying a bit more on the spontaneous order of traffic flow, like the Dutch do.

Luigi: I think that you very brilliantly dodge the question, and that is, do you see anything that should be done in the sector of big tech?

Tyler CowenI think, in general, there is too much crony capitalism in America. I agree with many of your writings on this topic. Sometimes big tech is the recipient of those subsidies. I would do away with those subsidies as much as we possibly can.

I would not break up the big tech companies. I would not stop them from competing effectively abroad. I think they’ve given us high consumer surplus and overall a pretty remarkable deal, often at zero price. I would, in principle, tighten privacy legislation, but I don’t think we’ve figured out very well just yet how to do that.

Kate: I think in your book, Tyler, you say, why are people mad at big businesses? Why are people mad at Facebook and Google in particular? You talk about things like fraud, and you talk about things like monopoly power, but I think people are mad because they feel like they don’t have enough control over their everyday. They feel like, if I go search for a new microwave, then I’m going to be shown pictures of microwaves until I can’t take it anymore, and then I have to buy a microwave. If I want to interact with my friends, I’m forced to interact in a platform where I have to share data with people that I don’t understand. I don’t know them. I don’t know how they’re going to use it. I think people are frustrated with the lack of choices and with an invasion of privacy and with the exploitation of personal biases, behavioral biases that we all have.

Tyler CowenI don’t think people mind ads in their email very much, for the most part. I have a Facebook page. I don’t use it. I have an email system where they don’t send me ads. It’s not hard to get these today. There’s competition. Obviously, the services that can send you ads may give you better terms along some other dimensions, because they’re making money from having you as a user. You know, people sort themselves accordingly. It seems to me there’s really quite a bit of choice as to how you will connect with other people.

Luigi: Wait a second. When you say that there’s a lot of choice, you are forgetting the importance of network externalities. At the conference, you mentioned the fact that you can use your email or even your, whatever you say, Google . . .

Tyler CowenYou can connect with people using Fortnite, using Pinterest, you can write a blog, you can do it on Twitter, you can call them on the phone, you can text them, you can knock on their door. Believe it or not, you can still write them letters. There are different levels of advertising on all these media, but plenty of them are ad-free, or close to ad-free, and we pick and choose. Most people do a mix of those.

Luigi: But the value of a platform, the value of a medium, is also the number of other people who are there. If I want to reach a large number of my friends, I’m probably on WhatsApp. If I am a student and I want to communicate with my university, they often . . . I have to be on Facebook. If you don’t live in the middle of the jungle and in a completely isolated way, you have to use this stuff. It is an essential utility.

Tyler CowenMost of us are on, say, five or six platforms. So, I’m on Linkedin, which I use a tiny bit for some purposes. I use Twitter for very different purposes. If one of those becomes too burdensome, I just stop using it. So, it’s one reason I don’t use Facebook. The page to me is too cluttered, but not even mainly by ads, just by messages from my so-called friends. But for other people, Facebook works great. I much prefer WhatsApp, a totally clean page. So, again, it seems to me there’s a lot of choice, but even when you’re somewhat inconveniently induced to use a network that has more ads than you would like, you have to compare that to the world of network television that existed when I was a kid, where you were just blasted by ads. You watch Mary Tyler Mooreand it’s like 12 minutes of ads in a 30-minute show. That was awful. So, you have a lot more autonomy to control, pick, and choose what ads you get than you used to.

Kate: I don’t think that that’s perfectly fair. I think you are probably the most disciplined person in the world, or you’re among the top few. Even you, Luigi, who’s almost certainly not as disciplined as Tyler, have admitted to looking at Lyft and Uber every time you’re going to go for a ride, and you compare the prices. Most people don’t do that. Most people feel like they’re bound to a platform. I instinctively, when I open my computer, my fingers type F, A, C, because then my browser goes to Facebook and then I check what’s going on in my feed. I see that all my friends are living great lives and have beautiful children. I don’t have those things. I immediately feel bad, but I can’t stop doing this because I'm addicted to it, and I hate it. I’ve tried going off it for a little while. That’s helped to some extent, but I think a lot of people feel like they don’t have choices.

Tyler CowenMillions and millions of people have quit Facebook. You can switch to something like Snap, for instance. Very commonly young people think Facebook is where old, square people are. It might be addictive for some people in some way, but again, you see an enormous amount of out-movement from all of these services.

Kate: Great, and Snap is even worse, because it distorts your face to look even more beautiful than you actually are.

Tyler CowenBut again, you’re getting amazing free things we didn’t have not long ago. You’re not forced to use them. Everything that’s fun has an appealing quality where you might sometimes regret having done too much of it, but all forms of progress are going to have that feature. There are people who read too many novels, listen to too much music, but again, when you evaluate these on the whole . . . there’s one estimate from early last year, the consumer surplus from Facebook for a typical American can be over a thousand dollars a year. How many other companies even come close to that?

Luigi: But look, nobody’s talking about abolishing Facebook. When you’re talking about the fact that they add value, you’re saying something we all agree with. The question is whether we can do better. You mentioned Linkedin, you’re not using Linkedin. Why? Because you’re a tenured professor, you’re not on the labor market, but if you want . . .

Tyler CowenTo hire people.

Luigi: I understand, but as a user, if you had to put yourself out there in order to actually get a job, you don’t have a lot of choices outside Linkedin. I think Linkedin is the place to be. So, we need to recognize that there is an intrinsic winner-take-all component in digital platforms. We need to think about, because these tend to be monopolies, whether we need to regulate, because I think you agree that a private monopoly is a terrible thing, don’t you?

Tyler CowenMonopoly is a tricky word in the context of platform goods. I don’t think we should add regulations to Linkedin, if that’s what you’re asking specifically.

Luigi: Should we add any regulation to Facebook?

Tyler CowenI do think general privacy regulation we can improve, and it’s likely that regulation would cover Facebook, but I readily admit that I don’t have the answer as to how we should best do that.

Luigi: Aren’t you a bit offended by the fact that even if you de-register from Facebook, Facebook keeps following you and getting information about what sites you visit and keeps basically surveilling you on every action you make?

Tyler CowenOn the list of my offenses, it’s not in the top 2,000. Am I thrilled by it? No. To me, it's a minor problem.

Luigi: Can you give us the first three offenses on your list?

Tyler CowenWell, it’s how people treat me in real life. I mean, those are by far the biggest problems most of us have. Online life is a kind of sanctuary. It does get funded, it gets funded by some things we don’t consider ideal. It’s a package deal. I’m really not worried about Facebook somehow selling what they have on me to my supposed enemies, who then somehow do me in. I just don’t think it’s a big practical problem. I would rather we had greater protections than we have today.

Kate: But when you talk about digital platforms being monopolies, you give examples of, oh, I can go on Snapchat, I can go on Pinterest, I can go on Fortnite. Isn’t that a video game?

Tyler CowenYeah.

Kate: In any case.

Tyler CowenBig game. Bigger than a game.

Kate: Right. Yes. I don’t do the whole Twitch gamer chat thing, but I know a lot of people do that. But to me that’s a bit of a red herring, because the monopoly issue isn’t on the consumer side. It’s on the advertiser side, and on the advertiser side, we do know that Google and Facebook combined control, what, 85 percent of the online digital marketplace in the United States. That, to me, definitely seems like an oligopoly, and you even admitted in your book that when you were starting your blog, I believe, you were advertising on Facebook. When we have thought about advertising for this podcast, which we haven’t done much of, I immediately thought Facebook, maybe Twitter.

Tyler CowenYou should. I hope you do.

Kate: But I didn't think that there’s that many options, and that’s why we see Google and Facebook earning billions of dollars of profit every year. That those are profits that could have translated to lower prices for consumers.

Tyler CowenWhen there’s large market share because it’s superior service and much—and I mean much—lower prices than the status quo ex ante, I am not worried about that. That, to me, is progress.

Luigi: Wait a second, you like cryptocurrencies, and at some point . . .

Tyler CowenWell, I don’t own any, and I’m somewhat of a skeptic, but I like people experimenting with them, is a better way to put it.

Luigi: OK. You know that a year ago, both Facebook and Google decided to ban ads of cryptocurrencies. Basically, this amounts to private regulation. When you have 80, 85 percent of the market share, you’re basically a private regulator. Now, you have spoken very often against public regulation. I think that there’s only one thing worse than public regulation, and that is private regulation. Two individuals who are not accountable to anybody. In fact, Mark Zuckerberg controls 60 percent of the voting shares, and Brin and Page control the majority of the voting shares in Google. So, you have three individuals that have more power than any government official.

Tyler CowenAgain, you’re mixing in specific and general claims. If we take the specific case of not running cryptocurrency ads, there was a general perception, probably true, that quite a high percentage of these ads were just outright fraud. Now, I run a blog, various websites, we used to have ads on the blog. No more. I didn’t want fraudulent ads. I think that’s a good thing if I exercise that self-regulation. Probably in this case that was the right private-sector decision. So, I say, great.

Now, if you ask, would we be better off in a world where some particular kinds of social media were much more fragmented, would we have a higher or lower quality of ads? I actually suspect the quality of ads would be lower. So, I’m not looking to split up Facebook hoping there’ll be all these little services, and somehow they will have better ads. I think you’ll have less monitoring, less scrutiny, less capitalization, less accountability, and there are plenty of fragmented social networks today. I mean, look at 4chan or live.ly, my goodness, and you think what gets on those is much more disturbing than what you might object to on Facebook or YouTube.

Luigi: But wait a second, you might agree with this particular decision. I actually don’t disagree that many of the cryptocurrencies were fraud. So, the issue is not the particular decision, the issue is the principle. Is it possible that two companies that control 80 percent or 85 percent of the market have the power to regulate you out of existence? If you are a new business, and you want to enter, and they decide you should not enter, basically you cannot enter, because you cannot advertise, you cannot reach your customers. It is a chokepoint that gives them an enormous amount of power.

Tyler CowenBut the actual fact of the situation is that Facebook has used this so-called power, if we are to call it that, to allow millions and millions of more businesses to advertise than ever could do so before, right?

Luigi: I’m not disagreeing with that. I’m worried that they have the power to actually regulate business out of existence and even if you don't exercise . . .

Tyler CowenBut they don’t do that.

Luigi: Even if you don’t exercise the threat point, you know in economics the threat point is good enough to scare people and deter people. So, they have the threat point, and they do exercise it. The example of the cryptocurrency shows that they do exercise it, maybe with a well-intended reason, but do we really trust the good intentions of an individual so much?

Tyler CowenLook, every system has imperfections. If we ask the general question, the filter of which ads get through today compared to how it was 30 years ago, I much, much, much prefer it today. Would I entrust a regulator with perhaps the head of the agency appointed by Donald Trump and accountable to Trump and/or Congress with those decisions, and then that becomes to me a potential free speech violation? No, I would rather we had the current system. The overall configuration of what can be advertised, how many choices, how many options you have, I think has never been better or even remotely as good as it is today. And if Facebook or Google, they make a few bad decisions de-platforming people, that is a shame. We should be concerned. But again, compared to the de-platforming that existed in the old days, where you never even got close to a platform, I think it’s a far, far exaggerated worry.

Luigi: We know that Google has an enormous power in rank and use. The ranking of different products by Google tremendously affects the way people buy those products. There are some other experiments done in the political arena that show that the way you rank news, the existing news of candidates, might tremendously impact the way undecided voters would vote. So, basically, you have two people, Brin and Page, who can decide who wins the election in most countries in the world. And I’m not saying . . .

Tyler CowenThat’s not true.

Luigi: I’m not saying they’ve done it so far.

Tyler CowenDid they support Donald Trump? I don’t know, but I don’t think so.

Luigi: I’m not saying that they have done it. I’m saying that they could do it. I’m not so worried for the United States because I think that there’s more visibility, but there are a lot of countries in the world. The facts are that their ranking distorts choices or affects choices. So, they have this power. Do you want to leave it completely unregulated?

Tyler CowenThere are many countries in the world, I can’t speak to all of them, but I do know in Africa, if you poll Africans, the general view is they face a lot of state-run media, which is massive and extreme propaganda, and the use of Google and other Western services to get them to better news is quite significant, and they think it is overall improving their news quality. So, I wouldn’t just dismiss other countries as somehow Google-run, crazy, electing tyrants. There are many significantly positive political effects of Google and social media in poorer countries. There are many cases of propaganda before social media. Are there cases where social media from the US made foreign propaganda worse? Probably. Should we be concerned? Yes. But let’s not overlook the positive side of the picture.

Luigi: But Tyler, you are an economist. You know the difference between average and margin. You keep answering that, on average, we’re better off, which I agree. It is not a dispute. Nobody says we want to go back to the world of the past. The question is, can we do better by regulation? You keep saying that it is better than what it was 20 years ago, which is not answering the question.

Tyler CowenI don’t want our government to regulate Google search rankings. No. I don’t think we can do better. I think we would be doing much worse. Even completely honest regulation, the best you can hope for is that things . . . you can just rank them by price, and then you have a lot of low-quality options which rise to the top, because the price is lowest, and consumers end up seeing too many low-price, low-quality options, and that’s the case where regulation is perfectly honest.

It’s a hornet’s nest. It’s going to violate free speech. There are also plenty of search engines. Google provides superior service by, for the most part, trying to be objective, and no, I don’t think we can do better. Who is it you want to put in charge of this? Tell me.

Luigi: First of all, I would like to avoid Google having other businesses, because when they favor the other businesses, they are distorting the marketplace. This is what European antitrust is about. So, are you in favor of blocking Google from entering any other market?

Tyler CowenIt depends what you mean by any other market, and there’s also an Alphabet/Google distinction here. So, Alphabet, for instance, is supporting research into driverless cars, correct? These are in the process of becoming products. I favor Alphabet, or earlier it was just Google, being able to do that. You know, might there be a problem in 13 years’ time that if you search to buy a driverless car, the ones sponsored by Alphabet will come up first? I mean, maybe. But again, in terms of monopoly problems today, that seems really quite remote, and the ability of the internet to help you price-search, including through Google, or just use Amazon to get cheaper stuff, or even just buy online from Walmart, which you can do. I don’t really see how the government will improve on their now really quite strong incentives for lower prices, better selection.

Luigi: But in Europe . . .

Tyler CowenAnd you know all about crony capitalism, right? You should be worried at least as much as I am, that if the government is controlling search services, it won’t be fair, objective. It will favor incumbents. It will tend to lead to entry barriers, higher prices, lower quality, right? It’s a common pattern you've written about, more eloquently perhaps than anyone, and all of a sudden regulation of Google search is supposed to come along and just be customer-friendly? I don’t think so.

Luigi: I don’t think that we necessarily want government regulation, but I am worried about the political and economic consequences. From an economic point of view, I think there is a case to prohibit Google from entering into businesses in which it is competing in the search component. Now, you're saying the driverless car . . . there is not a product, so there’s no search for the product. But the moment they have a product, I think they should divest, as they should divest from the shopping network. I think that the case is clear. On the political side, I’m not claiming I have a solution, but I think I’m very worried. You don’t even seem to be worried.

Tyler CowenWell, look. What does worried mean? You used the word “could” a lot, like, should I be worried? Well, yes, you should worry about everything. But if you just prioritize, what are the actual monopoly problems in America? What are the actual unfairness problems? What are the actual barriers to entry? I think the issues you’re raising, they’re not just far from the top. I think they’re far from the median. Something like lack of price transparency in the healthcare sector is, like, literally 50,000 times a bigger problem. And I know we’re not solving that problem now, but if you ask, is Google likely to be part of that solution? I think it probably is. It’s not part of the problem. You know, it has the potential to be part of the solution.

Again, I want to flip this and think, how can we change other sectors of our economy so the strengths of Google can be brought to bear on them? And maybe we can do that, but it’s a very different emphasis. I’m not that worried about Google somehow directing me to the wrong vacation or if we have driverless cars in the future. I would ask the simple question, how many sources of information are there about driverless cars? If there’s 20 different sources, I’m not too worried about the Google ranking. People don’t just spend more money because they feel like it, right? Most markets, not all, are pretty competitive.

Kate: I think that the biggest problems in today’s economy are wage stagnation and inequality, and maybe that’s not Google's fault, maybe it’s not Facebook’s fault, but I do think that those are the faults of big business. I think that they are in large part responsible for experiencing increases in corporate profits of roughly 400 percent over the past 40 years, whereas real median wages have stayed pretty much stagnant. And in your book, you talk about how people have good relationships with their employers, have good relationships with corporations, they provide them with food and with meaningful interpersonal interactions. But at the end of the day, corporations haven't provided . . . they haven’t shared any of the gains with their employees.

Tyler CowenI agree that wage stagnation is our biggest problem. I’ll note that if you have a four-year college degree and work for a big business, your wages probably have been doing fine, never better, robust income growth for those individuals. To me, the question is, how can we get more businesses in that position? I think if you want to be critical of the American economy, some of this, but not all of the blame falling on business. Look at our stagnant-productivity service sector, at least some parts of it. American business is often too bureaucratic, but I think it needs to be more businessy in a sense, more dynamic, more innovative. In the medium term, especially in the long term, wages do match to productivity. We need to get productivity higher. It has not all been a big, huge success. But big business for the most part actually has been.

Luigi: Actually, first of all, it is not true that in the last 10 or 15 years, wages have matched productivity in the United States.

Tyler CowenIt is true if you use the same deflators. I know this literature . . .

Luigi: In my book, I show that even if you adjust for the deflator you cover most of it, but not all of it.

Tyler CowenYou cover . . .

Kate: It’s whose deflator is correct.

Luigi: Especially in the last period, the last part, I think that there is this divergence. I think that that’s probably number one. Problem number two, since you are in love with all big business.

Tyler CowenNo, not all big business.

Luigi: Let’s look at what big business has done to middle America. We covered in this podcast, the issue of opioid epidemics, where we have seen business bribing doctors to prescribe drugs. That’s a criminal activity. And they’ve done it in large quantities. You know that more people died from 2000 to today of opioid epidemics than all American casualties in World War I and World War II put together. That’s basically a massacre, and this was caused by business.

Tyler CowenI agree. Our healthcare sector is very bad.

Luigi: No, this is not the healthcare sector, this is criminal business. It’s different. It’s not healthcare. In healthcare there are a lot of problems . . .

Tyler CowenThis depends on the regulatory framework, and we have had a regulatory framework where often that is allowed or encouraged. I very much strongly agree we should enforce laws against fraud much more strongly. That would include not being allowed to pay doctors to prescribe what is, in essence, poison to patients, right?

Luigi: No, but they were not paying doctors directly. They were inviting doctors to conferences, they were fake conferences, paying $1 million to present at a fake conference in order to reward the fact you prescribe a lot of fentanyl to your patients. This is a criminal activity.

Tyler CowenKeep in mind, at the time, most of America was asleep about this problem. These were drugs cleared by regulators typically, correct?

Luigi: Captured by the very business.

Tyler CowenNo, we didn't understand how bad a problem it was.

Luigi: Come on, opioids . . .

Tyler CowenThe Democratic Party . . .

Luigi: We understood opioids were a problem since the Opioid War in 1842.

Tyler CowenIf you look at politics right before the election of Donald Trump, most people in this country did not understand the scope of this problem. Trump did. It is one reason why he won. We were asleep collectively. But I agree, business is partly at fault for this. It’s a terrible series of events. My book does not say everything businesses have . . . that everything business has done is correct. It says there are many instances where people blame business where business in fact has been perfectly fine. So, I absolutely agree that on opioids, alcohol for that matter, cigarettes would be another example, business bears a big part of the blame. Absolutely. And I say as such.

Kate: I . . .

Tyler CowenThat doesn’t mean Facebook is to blame. It doesn’t mean that the airlines are all monopolies . . .

Kate: . . . they are to blame for making me addicted to them, me and my friends and everyone else in my generation. Anyway. I want to ask you a slightly more friendly question, which is also more of a thought question. Say, hypothetically, we do have a monopoly in the US. Let’s say it’s limiting quantities and it’s charging prices that are too high

Tyler CowenLike many hospitals.

Kate: OK, well, hospitals aren’t a great example, because what I'm going to segue this into is, let’s say another country has a similar monopoly.

Tyler CowenOK.

Kate: And both of these countries, the US and this other country, are kind of supporting these businesses or these industries as their national champions. What do you do in a situation like that? What should the government do?

Tyler CowenI mean, I really think it’s context-specific. As you know, right now our president is waging a trade war against China because they support their state-owned enterprises in many ways, some of them sneaky, and we’re demanding they stop, and if they don’t stop, we’re going to slap tariffs on them. I don’t know how that will work out. I would say I’m agnostic. My best guess to date is that it will not work out for the better. I do think there’s some logic to using the strategic power of the United States in many situations, but in this particular case, I don’t think we’ve strengthened our alliances and done our groundwork well enough for this to work out for the better. So, I really do think it’s case by case.

Kate: I think most economists would agree, though, that tariffs and protectionism aren’t necessarily good for two countries, but in the specific context of a monopoly, let’s say Google, for example, Google versus Alibaba, do you think that it could hurt the US competitive position if we overregulate here?

Tyler CowenIf you’re comparing, say, Alibaba and Amazon, who are competing to do online commerce and shipping. If you bring an antitrust suit against a major company, it’s a big, major distraction for senior management. Lawyers in many ways tend to end up either running a company or controlling its culture, and I do think, say, that would hurt the ability of Amazon to compete against Alibaba in other parts of the world. It’s one reason not to do it.

Luigi: One of the things that emerged at the conference is the decimation of local newspapers. At least traditionally, we think about media and newspapers in a different way. They’re not just any business, but they are a business that is crucial for our democratic process. Do you see any concern on that front?

Tyler CowenI do. I think they will be replaced in some way. I don’t think we’ve seen the new business model yet. I think there are plenty of other ways in which state and local governments have become more transparent. Some of that is social media. It’s not even always for the better, right? There can be rumors which circulate. I wouldn’t equate local news with information about state and local government, but I do agree that’s a problem. I think local news will make some sort of comeback. We are waiting to see what that will look like.

Kate: OK, Luigi, so we’ve been talking for three episodes about digital platforms and antitrust. Regulating Google and Facebook, is that a capital-is or capitalisn’t?

Luigi: It depends on how you regulate them and what is the outcome. Opening more competition by making the social graph portable or by making these closed networks open is definitely capitalism. If you were to impose a regulator that decides what they can publish or not publish, that would be terrible, but I don’t think that anybody proposes that. Will it come to breaking them up? I think that at the conference, everybody was saying breaking up Google doesn’t make any sense. You cannot have searches from letter A to M in one place and from M to Z in the other. But, for example, I don’t see the big damage of breaking up Facebook from Instagram. I think that that would probably increase the competition in the market and would overall be a positive thing.

Kate: I think that there are reasons people are unhappy about these companies that are legitimate. I think that there are abuses of privacy and I think that there’s too much exploitation of behavioral bias. I don’t think that these should necessarily be addressed with antitrust. Some of the proposals that have come up in the conference, either creating a new digital authority or giving more powers to the existing authorities to address some of these areas, could be useful, but from the strict antitrust perspective, I do think that Google and Facebook are oligopolies in the online advertising space, and I also think that they’ve engaged in practices that are anticompetitive.

We talked a long time ago about House Party, I think, being destroyed or crushed by Facebook. The Facebook-Instagram acquisition is another example. But, Tyler, I also think that you’ve raised some really great points. I think that we should be worried about competition from abroad. I also think that obviously, at the end of the day, no one’s trying to say that we’re getting rid of capitalism, right? Companies like Google and Facebook do innovate a lot. They do create great products for us, and we should be careful about overstepping our bounds and not suppressing that creative spirit. And also, you’ve raised a great point that some of what we’ve been talking about, where are the big antitrust issues? They’re not necessarily in the digital platform space. Maybe they’re more in the healthcare space. So, I agree with you on this.

Tyler CowenAnd most of the criticisms I hear of big tech, I think consumer harm is not demonstrated. There’s just a general sense that bigness is bad. But in many of these instances, the law has not been broken. The consumer harm is not there, and I would stress the negative secondary consequences of regulation.

Luigi, a moment ago, mentioned making the social graph portable, out of Facebook. Well, portable into what? That’s going to mean some regulator ends up deciding what is a legitimate social network and what is not, and that to me is a very dangerous step. It’s an entry barrier. It’s an opportunity for rent-seeking. It will limit innovation. What if you do something totally different with 5G and it’s so complex you don’t have importability, exportability with Facebook? Well, then you’re possibly in violation of the law. When you think through a lot of the remedies, they’re not nearly as attractive as they sound at first, and I think we’ve been seeing a sector that, in terms of benefiting this nation and American consumers, actually has been pretty extraordinary.

Kate: All right, well, it sounds like even though we’ve had three episodes on this, the debate is not over yet. We all agree?

Luigi: Yes, the debate continues. Thank you, Tyler, for . . .

Kate: Tyler, thanks for joining us.

Tyler CowenMy pleasure. Thanks to you both.

In part two of our series investigating how digital platforms like Facebook and Google should be regulated, Kate and Luigi dissect the ways these companies interact with our political system by speaking with Nolan McCarty, Susan Dod Brown Professor of Politics and Public Affairs at Princeton University.

Luigi: Last week, the Stigler Center at the University of Chicago organized a conference scrutinizing the digital platforms, especially Facebook and Google.

Kate: On our last episode, we spoke with one of the conference leaders, Fiona Scott Morton, about the market structure of these companies.

Luigi: On this episode, we’re going to investigate these companies from a political economy perspective.

Kate: From Georgetown University, I’m Kate Waldock.

Luigi: And from the University of Chicago, this is Luigi Zingales.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: In today’s episode, we have the honor of having as a guest Nolan McCarty, Susan Dod Brown Professor of Politics and Public Affairs at the Woodrow Wilson School at Princeton University. An author of very many successful books, the last of which is Polarized America: The Dance of Ideology and Unequal Riches. Nolan was the head of the political economy subcommittee. Welcome, Nolan.

Nolan McCartyGreat. Thank you. Glad to be here.

Kate: Can you start us off by explaining why a political scientist like you is interested in companies like Facebook and Google?

Nolan McCartyWell, after the outcome of the 2016 election and the Brexit referendum in the UK, there’s been a lot of scrutiny as to how these platforms were used to manipulate elections, both in the US and the UK. But a second reason, and one that I think is much more important, is that these platforms and the corporations that run them have themselves become very important political actors. And so what our subcommittee tried to do was try to bring those two issues together and analyze them jointly.

Luigi: Would you mind defining for us what it means to be a powerful political actor, but more importantly, why are Facebook and Google so special in this dimension?

Nolan McCartyWell, first of all, we believe that large corporations are just inherently politically powerful. They have lots of economic resources. Those economic resources are things that politicians tend to defer to. Politicians, to get reelected, need economic growth and good performance.

Secondly, large corporations are often quite politically active. This is certainly true of the major digital media platforms. They’re all engaged in making large campaign contributions. They engage in lobbying. In fact, they’re some of the biggest, most active lobbyists in the country, and they do so not on issues related directly to digital media, but on a wide variety of issues. If you think about a company like Amazon, they’re not only lobbying on things related to digital technology but related to things on land use, consumer product safety, a wide variety of things. And so, these have become quite dominant actors simply because they’re powerful corporations.

Kate: I guess it makes sense for Amazon to care about issues like land use and consumer product safety, because they have big warehouses and they sell a lot of consumer products. But it seems like Facebook and Google also touched these areas even though they’re more purely digital. Why would Facebook and Google care about these sorts of issues?

Nolan McCartyWell, I mean, they’re involved in selling advertising to a large degree. And so, anything that might affect their business models related to advertising would also come under their umbrella. They too have very large agendas. One’s related to international trade, copyright protection, privacy. A very large number of issues are covered by these firms. In fact, if you just look at statistics provided by Opensecrets.org, among corporate lobbyists, Alphabet, which is the parent company of Google, Amazon and Facebook were the first-, fifth- and eighth-most prolific spenders on lobbying.

A second issue is that they play a role as kind of a quasi-media outlet. So, they have certain First Amendment claims that they might be able to exploit to avoid regulating the content on their platforms. They also are involved in very complex activities — artificial intelligence, data — all of which is fairly nontransparent and opaque, which also makes it less likely to face public scrutiny and accountability. The third is that they’re highly connected. Unlike most corporations, they have a direct connection with their users and consumers on a daily basis. While Coca-Cola has millions of consumers, their ability to communicate, mobilize, and engage those consumers on political issues is somewhat limited.

But Facebook and Google can routinely utilize their platforms to mobilize them on a set of policy questions that other corporate groups can’t. In a lot of ways, these platform companies are less like corporate lobbyists than like big, major membership organizations such as the National Rifle Association or the American Association of Retired Persons. And, finally, these companies get a certain amount of latitude from policymakers due to the emergence of economic nationalism and the race to be on top in artificial intelligence and data science, part of the national economic strategy to not fall too far behind in technology and artificial intelligence, vis-à-vis China in particular. Those are claims that these firms often make when lobbying in pursuit of their corporate goals.

Luigi: If I get this right now, what you’re saying is Facebook and Google sum up the power that normally rests in the hands of the NRA, CNN, Boeing as for the national champion, and JP Morgan in terms of money. This is the first time in human history that corporations have all these powers together. Am I right?

Nolan McCarty: I can’t say for all of history. Perhaps the East India Company in Britain or something like that, maybe. But, it’s hard for me to think in, at least in American corporate history, a company or set of companies that have all of these attributes rolled into one.

Kate: All of these powers combined made me think, if I were one of the founding fathers, and I could foresee that digital platforms would have this type of power in the future, would I have cared at the time? Is there anything that I should have been concerned about? And, if so, what could I have done about it?

Nolan McCartyI mean, certainly it’s the case that I believe the founders were quite concerned with concentrations of power, period. But it’s pretty clear that, at least in the modern world, the real concerns about heavily concentrated power are less about democratic governance and much more about corporations. To draw an analogy that’s discussed in our report, think about the printing press. The printing press is a technological innovation, which had a profound political impact, but its scale was small. One can’t monopolize the printing press, so it didn’t concentrate political power. It deconcentrated it. Here we have the opposite situation, where we have new technology with a lot of potential to disrupt politics, to dictate the ways in which elections and political discussions take place. Yet at the same time, a power is concentrated into a few hands such that the analogy might be one in which you have a printing press, but with a single entity with the ability to turn off and turn on that press at will. That’s the concern about the concentration of power.

Luigi: But aren’t we overreacting a bit, because in 2010, 2011, everybody was proclaiming how great social media were, how equalizing. After all, it’s true that the printing press was decentralized, but it’s also true that at a pretty large fixed cost, and so the ordinary citizen could not have access to his own or her own printing press. Now, everybody has access to Facebook. Everybody has access to Google. Everybody has access to Twitter. They can participate in the political arena in a way that they couldn’t participate before. Why is this necessarily bad?

Nolan McCartyI don’t think those aspects are bad. The political effects of social media platforms are both positive and negative. Social media has the potential to be a tool for mobilizing. This has been especially important in authoritarian countries where activists are trying to undertake democratic reforms. It’s become a tool for political engagement and, as Luigi suggested, has also broken down the monopolies that the powerful have over information. Social media allows individual citizens to communicate with one another with very little interference from authorities. But there’s dark sides to political mobilization, engagement, and the breakdown of informational gatekeepers. People can be mobilized in hate campaigns. They can be mobilized to engage in ethnic conflict. They can engage in hate speech and rhetoric. The lack of informational gatekeepers has meant a deterioration in some of the quality of the information that’s available on the Internet. When we’re concerned about misinformation and bad information, that goes hand in hand with this democratization of access.

Luigi: One of the elements to identify is that certainly Facebook and Google, I don’t know about the other platforms, but Facebook and Google look like media companies. They fight very aggressively against this definition, but at the end of the day, Facebook edits the news that they feed in our profile. In fact, it edits them for a very specific purpose, to maximize the time and attention we spend on the platform. Google does the same with YouTube. This objective is reached by feeding customers more and more extreme news. In feeding this news, Facebook and Google take no responsibility for the content of the news. They’re happy just to take the profits. Ironically, they’re able to do so thanks to part of a law that was approved in 1996, The Telecommunications Act. In Section 230 of that act, there is a special exemption for digital platforms about their responsibility as editors. What do you think about this particular law, and what can be done to fix this problem?

Nolan McCartyYeah. This is one of the most controversial issues that we encountered, was platform liability. They act a lot like media companies, so they should be subject perhaps to defamation laws and all of the sorts of liabilities that go with news publication. I think the concern, however, with eliminating this liability comes from the fact that the social media landscape is so concentrated that if one were to remove their liability and that were to have a conservative effect in the moderation policies of the company, such that they would throw a lot of speech offline, close off their platforms to users who engaged in allegedly hate speech or manipulation or misinformation, there wouldn’t be the competitive forces to get those moderation policies right. Social media platforms may be just too aggressive in moderating speech.

If, say, Facebook and Google become too vigilant in terms of policing speech, then that speech will just move to less public, less accountable forums such as certain chat rooms on Reddit, et cetera. In the end, our committee didn’t make a strong recommendation with respect to changing liability protections because of these competing concerns and our lack of clear guidance about whether or not Google and Facebook will get the moderation policies right in the face of liability regime.

Luigi: Nolan, I’m very sympathetic to your concerns that digital platforms are monopolies and as such not accountable. I’m concerned about giving them too much editorial power. However, remember Section 230 simply removes the liability. It does not remove the editorial power. They still remain in power to edit. They edit what kind of advertising they release. At some point, they decided, we don’t advertise cryptocurrency anymore. Now, I don’t particularly care for this topic, but the fact that Facebook and Google together can become a regulatory agency is a bit scary. They can decide what is appropriate or not. At some point, they decided that using the logo of Facebook in Facebook ads was bad. As a result, the ad of Elizabeth Warren was edited out. So, it’s not that these platforms don’t have editorial power, it’s that they have editorial power with no accountability and no liability. That seems like the worst possible outcome.

Nolan McCartyI don’t disagree. I think the debate centers upon those who want the maximal amount of free expression and worry that removing liability will be much more restrictive in those people who think that most of what goes on in Facebook and Google should receive more moderation. At the end of the day, one’s views about removing Section 230 liability protection really depends on whether or not you think that there’s too little free expression or too much free expression. You know, the point about monopoly simply is that we would only have the liability and the courts to define proper moderation. You wouldn’t have the competitive pressures to allow certain platforms to moderate more intensely and some less intensely and let consumers decide which type of platform they want to spend their time engaging with.

Luigi: Yeah, but if I can follow up on this, think about the famous or infamous case where Facebook basically keeps feeding news about abuses of Rohingyas in Myanmar, that fed part of the massacre that took place in that country. Why don’t you want them to be responsible for feeding this news to many, many more people and, in a sense, cultivating some hate that eventually brought them to ethnic cleansing or rioting and a lot of people being dead? Why don’t you want to put some responsibility on them in editing this stuff out?

Nolan McCartyI’m more or less reporting a lack of consensus on a committee. In some sense, I’m answering a question about how others on the committee felt about this issue rather than my own personal views. I should clarify that. I guess the response would simply be that we don’t want to allow certain events to create bad regulatory regimes, which will exacerbate other types of problems. So getting the balance right is very important on these things. But, as you point out, there have been some terrible things that happened with respect to social media. I think the consensus at the committee was that changing the liability laws would not do it, but perhaps other forms of government supervision, regulation, increased transparency might have a much more direct effect without hampering free expression on the platforms in the same way.

Kate: If the jury or the committee is out on Section 230, could you tell us more about these other proposed forms of regulation?

Nolan McCartyIn some sense, we concurred with other working groups, which was that we felt that purely self-regulation of the media platforms was not going to work. There’s not a great track record of self-regulation in this industry when it comes to privacy and other areas. We endorsed the idea of creating a digital regulator, a digital authority that would be somewhat empowered to supervise and write rules, facilitate transparency and disclosure within the social media environment.

Designing a regulator in such a way that we could balance the concerns that a powerful industry such as social media platforms would have undue influence among the digital regulator and perhaps not regulate enough, not go far enough, with the notion that the digital authority, digital regulator would have to be democratically accountable. We put forward some principles for designing such an agency. But the main thing that we stressed, and I think this is consistent with the other groups in the conference, was that the digital authority should collect data in real time, should make that data available both to researchers within the government and outside the government, in ways that we can actually better understand how social media platforms generate the political consequences that they do.

Kate: The overarching theme of this conference is antitrust in digital platforms. We’ve had as a guest on one of our previous episodes Lina Khan, who introduced us to this idea of New Brandeis and the New Brandeisian approach to antitrust, which claims that’s part of its mission. The idea that antitrust law as well as enforcers should consider political economy concerns in addition to just the consumer welfare, the traditional economic approach to what makes a monopoly. But, in suggesting that we should create this digital authority, you’re necessarily partitioning the political concerns from the traditional economic concerns. Does this mean that you disagree with the New Brandeisians?

Nolan McCartyNo, I don’t think so. In fact, one of the things we’re open to saying is that one of the things the digital authority could do is to conduct analyses of the political implications of social media mergers and either provide that information to the traditional antitrust regulator or, perhaps more ambitiously, could form the basis of a dual review of mergers in which the digital authority might evaluate mergers in terms of their political and social consequences and have to sign off on those. The difficulty we face on the political side is that the research on the political impacts of social media is relatively nascent. We don’t really know as much as we should about the impacts of Facebook’s platform and its policies on elections and polarization, manipulation.

I think the first step really is to have the digital authority open the data vaults, make them available to independent researchers, so independent researchers can study these questions, with the goal of perhaps coming up with quantifiable standards for when we might expect additional concentration to have negative political consequences. One of the reasons that antitrust seems dominated by economic concerns is that they’re quantifiable. I mean, not perfectly, but at least data can be brought to the table.

On the political side, again, we’re entirely sympathetic with the notion that antitrust should serve these political and social considerations as well as economic ones. But we lack the methodologies and the data to evaluate those. This should be something that the digital authority should look into. Use its research and facilitate independent research toward the goal of being able to study the question of the extent to which social media concentration negatively impacts political outcomes. Then, once we know that answer, then it can be brought into public policy more readily.

Luigi: Nolan, you’re right that we don’t have good tools to analyze, if you want, the political concentration. But, to be fair, the media subcommittee did look at the aspect of media concentration, and there, there is more of a tradition. In fact, in the UK, when they look at concentration of media, the antitrust authority brought in some form of citizen welfare, as an alternative to consumer welfare, in thinking about the effect of a merger, and said that even if the merger does not have an impact on price and quality, but it does have an impact on the diversity of information or the potential diversity of information sources, I think that must be considered anticompetitive. Do you have a view on this citizen welfare as an alternative or as a complement, I would say, to consumer welfare as an antitrust criterion?

Nolan McCartyI’m certainly very sympathetic. If we knew for certain that a particular merger would lead to say more misinformation, more manipulation of elections and deteriorate the quality of democratic governance, that certainly is a merger that should at least receive extra scrutiny. So, the principle is one I subscribe to. The issue, really, is that, say, unlike newspapers and perhaps broadcast journalism, we don’t really have a good sense of how mergers would affect audience and diversity of viewpoints, because we don’t really have a good evidence on which Facebook posts receive the most attention and basic information about what is the diversity of information on Facebook and how that might be affected, say, by Facebook’s acquisition of Instagram, for example.

We’ve kind of lacked the information about audience and how audience might be affected by mergers that we would have with newspapers and broadcast media. What I guess I’m proposing is that we get the data, we study the question, and if it can be shown that mergers or acquisitions like Facebook’s acquisition of Instagram lead to less diversity of options in terms of political information, or lead to other bad political outcomes, that those mergers should receive extra scrutiny, and those considerations should be taken as seriously as the traditional economic ones.

Luigi: It doesn’t look like we have to wait for a long time to figure out that the acquisition of WhatsApp or Instagram by Facebook did increase significantly the monopoly power of Facebook in social media, and as such should have been blocked or maybe now should be reverted.

Nolan McCartyYeah. I actually, in my own personal view, I don’t disagree with that at all. It’s especially telling that many of the implicit promises Facebook made to keep to run Instagram separately and to not destroy the niche of WhatsApp, the encryption niche, seems to have gone by the wayside by both the decision to run Instagram as part of Facebook and by Facebook’s decision to come up with an encrypted version of Messenger, which would make WhatsApp obsolete. I think there’s little doubt that those acquisitions were anticompetitive, both in sort of economic ways but also important political ways, by depriving citizens of alternative venues to communicate with one another. It’s just simply that we don’t have the kind of hard quantitative evidence on the magnitude of those effects that I think we would require to be successful in blocking those mergers on political grounds.

Kate: To this point about hard quantitative evidence, though, do you necessarily need to have hard quantitative evidence about the potential problems that, let’s say, a digital platform could bring up in order to properly regulate it? And one thing that comes to mind is, should we be concerned about black-swan-type events where, let’s hope this doesn’t happen, but the CEO of a large digital platform that has its fingers in every single country, all of a sudden does something to like incite war, or engages in some sort of terrorist attack because the CEO feels strongly about that? We’re never going to have any hard quantitative evidence on these types of risks, and these types of risks might be minuscule. And yet, I think that from a policy perspective, it’s something that we should consider.

Nolan McCartyAbsolutely. Actually, that’s a very good point that I don’t disagree with. But let me take another issue. One of the concerns about social media is that it’s polarizing. The reason why people argue it’s polarizing is it allows users to only engage in content that confirms their preexisting biases. We can get situations in which clusters of users group themselves into liberal online communities and conservative online communities and communities associated with this group or that group. From an individual perspective, that’s totally rational, and individuals might derive some benefit from being able to identify likeminded people, likeminded information, and engage with ideas that they more or less agree with. But from a social perspective, that might be destructive. So, the question is, before we regulate, we ought to really know how socially destructive this behavior is.

If it turns out that it’s not much of a problem, that it doesn’t have hard, observable manifestations, then maybe we should allow people the free will to choose who to interact with and allow platforms to design themselves in such a way that those people can find each other. If we do decide that such things are destructive, then maybe we do want to force platforms to develop architectures that force people to engage with people that they disagree with. I guess my view is before we intervene in something as basic as the freedom of association online, we really ought to know how big the social consequences are.

Luigi: One thing is to restrict association online, which would be a very strong intervention. Another thing is to limit the power of Facebook and Google to feed you the most extreme stuff to maximize their profits. To some extent, what is new, because people have sorted in ideological communities since the beginning of humankind? What is new? One thing is the scale, of course. But the other part is how much these communities are fed with the worst and worst because this keeps them attached to their smartphones.

Nolan McCartyYeah, I mean to push back, though, a little bit, we also need to know whether or not Google and Facebook are doing this because presumably they have some sense of this is exactly what users want and will keep them engaged. So, I still think we need to know something empirical about the consequences of those platform designs before we say that Google and Facebook can’t provide a service that they believe that their users want. You know, I agree, it’s likely to be the case that we don’t want YouTube to feed people more and more extreme videos just to keep them engaged. But I think as a scholar, we have a responsibility not to leap to those conclusions but to document them as well as we can empirically, to justify regulatory actions that prevent YouTube from engaging in those activities.

Luigi: Yeah. Unless you think that this stuff is addictive because when cigarette manufacturers were producing cigarettes that were more and more addictive, you didn’t need a lot of thought about putting a regulation in place.

Nolan McCartyThat’s a great analogy that I want to bring up. One of the things that we focus on, I mentioned it earlier, is that these platforms do an awful lot of research internally about their algorithms and how those algorithms influence people to remain engaged and presumably have data that can tell us the extent to which this is something that users want or something that users get addicted to. In exactly the same way the tobacco companies did tons of internal research on exactly the same questions.

One of the things that I think a digital regulator might want to know is exactly how these companies came to the conclusions that they came to develop those policies. Just as we eventually learned a lot from seeing the internal research of tobacco companies, I think we might learn a lot from the internal research of the platform companies that could help us to adjudicate exactly whether or not these platforms are responding to legitimate consumer demands or just feeding addictions.

Kate: Nolan, I have a somewhat philosophical question for you, which is maybe a little outside the scope of the committee report, but let’s say that misinformation and hate speech and these sorts of issues like fake news, let’s say they weren’t necessarily a problem, but that companies like Facebook and Google have more information about people’s consumer patterns and what businesses exist in the economy and where people are driving and what infrastructure is crumbling. Let’s just say that we have companies that know much more about our society and about our economy than the government does. Is that in and of itself a problem?

Nolan McCartyI guess it depends somewhat how those companies would use it. However, given that the capacity of our government to solve problems is in some ways hindered by a lack of knowledge about those problems, it would probably be a good, responsible corporate citizenry to share much more of that information, obviously protecting privacy, but share much more of that information with the government. We’re in a unique situation where economic concentration, political concentration, and as you suggest, the concentration of information into a few entities makes them uniquely powerful, is something that we really ought to focus on. Because if we become more dependent on Facebook and Google and their private philanthropic efforts to solve problems than we do government, then the types of problems that will get solved will reflect those priorities and not democratically established priorities. In that sense, I think the scenario you lay out is in fact a problem.

Luigi: Nolan, thank you very much for being on the program. This has been incredibly useful. For people who want to know more, they can access the Stigler webpage, where they can find all the panels of the conference. There’s more than probably you can take.

Nolan McCartyThank you.

As digital platforms like Facebook and Google become globally powerful, some countries are investigating and even proposing legislation to regulate these companies. Building off a conference happening at the Stigler Center at the University of Chicago, Kate and Luigi speak with Fiona Scott Morton, a Professor of Economics at Yale, to interrogate these platforms from a traditional market structure perspective.

Luigi: Next week, the Stigler Center of the University of Chicago is organizing a major conference about the so-called digital platforms. The European Union has released a report about digital platforms. So have the United Kingdom and Australia. Even India is proposing legislation in this arena. The United States government has been completely silent on this front. So, the Stigler Center is substituting for the US government by presenting not one but four reports on this topic. And the conference will be streamed, so you can all follow it on the internet.

Kate: Luigi, if you want people to follow, you should probably explain what a digital platform is.

Luigi: You’re right, especially because the conference is all about two very special digital platforms, Google and Facebook. In general, a digital platform is simply software designed to facilitate transactions and connect users to data resources. So, Uber is a digital platform, and so is Amazon, yet the main focus of the conference is on platforms that have a big media component to them, such as Google and Facebook.

Kate: Wait, but Mark Zuckerberg has insisted many times that Facebook isn’t a media company.

Mark Zuckerberg: We’re a technology company. We’re not a media company.

Kate: So, are you saying that he’s lying or that he’s wrong?

Luigi: I think you’re hitting the real heart of the conference. Why is Zuckerberg pretending that social media like Facebook is not media? After all, he doesn’t call it a social technology or a social platform. He calls it social media. More seriously, the problem of what these companies are and how they should be treated from a regulatory perspective is at the center of this conference. These are new animals which we find difficult to box in the traditional definitions. For this reason, the conference is organized with four different subcommittees that analyze the companies from four different perspectives.

The first is a traditional market structure perspective. Then, a media perspective. Third, from a privacy perspective, and, last but not least, from a political economy perspective. In anticipation of this conference, we’ll talk to the head of the market structure subcommittee.

Kate: From Georgetown University, I’m Kate Waldock.

Luigi: And from the University of Chicago, this is Luigi Zingales.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On today’s episode, we have the honor of having as a guest Fiona Scott Morton, Theodore Nierenberg Professor at the Yale School of Management, and the former deputy assistant attorney general for economics at the antitrust division of the US Department of Justice, where she helped enforce the nation’s antitrust laws.

I’m going to start off by asking you, what’s so special about these digital platforms that generate all this international attention and spurred you to actively participate in this conference?

Fiona Scott MortonWell, I’m actively participating in this conference because Luigi twisted my arm, and he’s very charming. So, that worked.

Kate: I know the feeling.

Fiona Scott MortonIt’s also, of course, just a tremendously interesting problem. It’s the problem of our age.

Kate: Could you give us a high-level summary of the report that you wrote for this conference?

Fiona Scott MortonThe report is about the way in which we should think about digital platforms, in the way that they tend to exhibit a concentrated market structure, the problems that flow from that, and the solutions that we might think about using as a society to address those problems. The start of the report talks about the really large economies of scale and network effects which come from everyone wanting to be on the same platform, and global reach, and economies of scope, and use of data that make it very, very efficient for a firm to grow big. When you have a firm growing big, you tend to, instead of having 10 firms, you have one firm or two firms. So, these markets exhibit more concentration because of these characteristics.

That concentration makes it difficult for entrants to get in. There are entry barriers that come along with these forces of economies of scale and network effects, and when entrants can’t come in or find it hard to grow, then you end up with less competitive pressure on those one or two large firms in an industry. That leads to problems like high prices, low quality, less innovation. Then, after identifying those problems, we move on to some solutions.

One of the solutions that’s often proposed is self-correction. Let’s just wait and see if it works its way out. The committee decided that that was not likely and that public policy should really depend on either increased antitrust or some regulation.

Luigi: Fiona, this is all wonderful, but most of our listeners think that there is no real problem with the digital platforms. Most of them, and I’m one of them, actually, benefit tremendously from Facebook and Google. We live doing Google searches, we travel with Google Maps, and we keep contact with our friends through Facebook or WhatsApp. We don’t pay a penny for all these services. So, why do you see a problem here?

Fiona Scott MortonWell, you’re quite right, and I agree with you about the tremendous benefits of all this technology. The report actually starts out by saying it’s just incredible what we have now and the quality and nature of the innovation. The idea of the report is to say, “Well, many fantastic things come with some downsides, and we use public policy and regulation and laws to limit those downsides.” So, we invent the car, and we also invent a crosswalk and a traffic light, because cars are really fantastic, but they’re better if there are crosswalks. We totally acknowledge the upsides, and we’re just trying to make some points about downsides, and the downsides are not trivial.

These are downsides that can affect elections, though that’s not the subject of my report, and affect the pace of innovation and the quality that we all experience. It’s hard to know, of course, the quality of services you’d get if there was more competition. We only see the quality of services we actually do get.

Luigi: OK, but most people associate concentration problems, monopoly problems, with higher prices. But when it comes to Facebook and Google, we get all our services for free. We don’t pay a dime for it. So, how can you talk about harm to consumers?

Fiona Scott MortonThat’s a great question, and I think that the first thing your listeners have to think about is that free is not some special zone. Free just means the money price is equal to zero. The money price is often positive when we go to the store and buy a loaf of bread, but it’s also possible for prices to be negative. We could be paid to use Gmail or Facebook. Now, why would Gmail or Facebook pay us? Because what we’re giving them in return is not money but data. We’re giving them lots of data about where we go, what we eat, what we buy. We let them read the contents of our email and determine that we’re about to go on vacation or we’ve just had a baby or we’re upset with our friend or it’s a difficult time at work. All of these things are in our email that can be read by the platform, and then the platform’s going to use that to sell us stuff.

So, this is very valuable data. We’re paying for these services that we get. We’re just paying in a bartered kind of way. We’re not paying with money, we’re paying with data.

Kate: If my data is so valuable, more valuable than the services that they’re providing me, these digital platforms, why isn’t it the case that I haven’t been paid, say, a dollar a month by Google to have a Gmail account?

Fiona Scott MortonI think this is a really good question, and we don’t quite know the answer to it. I mean, one part of the answer is micropayments actually are hard to do. There are transaction costs with paying somebody a tenth of a cent. There’s another issue that if a website just paid a tenth of a cent to anybody who came, there would be bots immediately created that would just click on websites in order to make money, and they wouldn’t be real people. But I think these problems are surmountable. Open standards, identity verification and aggregation. I could imagine my cell phone provider collecting payments from all the places I went on my mobile phone, knowing that it was me because it was my mobile phone, and lowering my monthly bill.

I think we need to explore some of these options, because it would be really great for consumers to be able to be paid in money rather than having a zero price. Negative price is even better.

Luigi: Actually, for our listeners who follow us, when we analyzed the initial coin offerings, we had a discussion about how maybe cryptocurrencies could be such a form of payment. So, in the future, they might help resolve this problem. But for the time being, this problem does exist, and one of the things you say in the report is that one indication that there is something wrong, to some extent, is that these companies are making a lot of profits. But people enter into this exchange freely. If they’re willing to give up their data for the service, whether this data is worth the service they receive or not is a bit in the eye of the beholder. They are voluntarily entering this transaction, and that suggests that they are better off in this transaction. Why should we interfere with that free exchange?

Fiona Scott MortonThat’s a nicely presented question, and the reason that we interfere is when we think there’s insufficient competition. A monopolist, for example . . . Let’s imagine there is a monopolist of all cars in the United States. There would still be people buying cars. The monopolist would choose a price at which it would sell cars. There would be many millions of people buying cars. They would freely be buying cars, and why would we want to intervene? Because if there were competition, if there were nine or 10 makers of cars like we see in the United States today, the price of the car would be lower, the quality would be higher, the service would be higher, and the consumer would have thousands of dollars that she could spend on something else besides a car.

Competitive markets are extremely valuable for consumers because it gives them more choice, lower prices, better quality, and then money to spend on other things that they value.

Kate: OK. Most economists or many economists think of people as rational. By rational, I mean they take in as much information as they possibly can. They make decisions that are best for themselves given that information, and they have a sense of what the future will look like, and so they’re making those decisions to make themselves best off not only now but also in future states of the world. But your report really highlights that people have a lot of behavioral biases, and digital platforms can take advantage of these. Can you tell us a little bit about those behavioral biases?

Fiona Scott MortonAbsolutely. The economics profession has been really interested in the intersection of economics and psychology for the last several decades. The old model was a neoclassical model of the consumer that did exactly what you’re describing, Kate. But in real life, consumers are not that good. They turn out to have behavioral biases of several well-known types. For example, consumers really respond to defaults. If something is presented as the default option, it takes energy to switch away from that. When certain boxes are checked on a website, when certain options are presented first, the framing of those options and the default nature of those options really lead people to use those services.

So, defaults really matter . . . Consumers are also really impatient. They don’t like to wait until tomorrow to get something. That’s called present bias, and what it means is that consumers will watch addictive video, or they will gamble, or they will buy the candy bar in the supermarket checkout aisle because they’re hungry. They know they are going to get dinner when they get home, but they’re hungry right now, and they can’t impose self-control enough to wait.

Kate: Or they’ll sign away all their rights to data by clicking through an agreement or a warranty very quickly without reading it, right?

Fiona Scott MortonYes. I mean, one of the things is we’re all not lawyers, so it’s not clear that we would learn anything from reading that text. Secondly, if you click “no,” you can’t open your phone or get onto the web or use the service, so clicking “no” is not really a very viable option, and then secondly everybody’s in a hurry.

Luigi: Some people actually experimented by putting terms where you say you’re giving up your firstborn child or whatever, and people sign because they didn’t read it. So, this is the standard these days.

Fiona Scott MortonYes, exactly, and actually the German cartel office has said, “We don’t really think this constitutes an agreement, because there isn’t any other option for the consumer, and so the click is a little bit meaningless.” Let’s go back to that candy bar in the supermarket checkout aisle. That checkout aisle is designed for everybody. Everybody goes through there. Old, young, every demographic. People who are hungry, people who are not, and it’s set up, yes, to take advantage of that behavioral bias of impatience, but it’s also set up for everybody.

That means that it’s not always effective for everybody. When you go on a digital platform, that platform knows what you bought yesterday. It knows what you’re talking about in your email today. It sees your hand movements. Maybe it sees your eye movements. Maybe it knows geographically where you are. So, it’s able to target your weaknesses and your behavioral biases very precisely. It knows what they are. It knows when you’re likely to be susceptible, and it’s able to pick a product or an ad or a suggestion that’s just for you, and that really is new. That’s quite different than the mass-produced kind of, “Let’s get people to subscribe to the gym in January, because we know they’ll do that and then they won’t come.”

Luigi: And God forbid that you are connected to a Fitbit, because then they also know your heartbeat and probably pretty soon your sugar level, so they’re going to come and make you an offer when they know you’re low on sugar and not able to fully connect.

Fiona Scott MortonYes, if the supermarket knew who was low on sugar and could offer them a candy bar, that would be a little closer to what we see on the digital platforms.

Kate: Another feature of these digital platforms is that they’re pretty good at keeping out the competition. Can you tell us about how these companies erect barriers to entry?

Fiona Scott MortonYeah, barriers to entry are very important in this world. Firms use barriers to entry all the time to try to preserve their profits, and this is one of the things that antitrust enforcement does, is to prevent the creation of market power, the maintenance of market power, in a way that’s not competition that helps consumers, but just exclusionary, just designed to stop an entrant or designed to shut down competition. Digital platforms are quite amenable to these entry barriers. I mean, they come naturally because of network effects, which are when everybody wants to be on the same platform.

A social media site, for example, is more valuable the more of my friends are already on it. Nobody wants to be on a social media site by themselves. Who would they talk to? The more other people are on the social media site, the more attractive that social media site gets. Many platforms have this characteristic. The more people use Uber, the more Uber drivers there will be, and that makes Uber more attractive and so on.

A barrier to entry then becomes a really important way to keep out an entrant, because let’s suppose I’m a new car-hailing platform. How do I get started? It’s a bit of a chicken and an egg. I don’t have drivers, so I don’t have customers, but if I don’t have customers, I don’t have drivers, and it’s going to be challenging to get going. The platform that’s in power, the incumbent platform with market power, is going to use all the tactics it can to try to keep those entrants out, because those entrants threaten its profits by creating competition. This is where antitrust comes in. Antitrust laws are designed to stop that behavior when it’s harmful to consumers.

Luigi: But this is a very important point, Fiona, because very often, consumers don’t perceive that behavior as necessarily hurtful to them. So, one way which you assert your incumbent’s power is to prevent people from using other platforms at the same time. Let’s say, in jargon it’s called multi-homing. Suppose you look both at Uber and Lyft. In principle, you can choose anytime which one to use. Even the riders, they can choose any minute which one they’re going to use. So, this is allowing for multi-homing, and this is allowing for competition.

Now, imagine that Uber offers me . . . In fact, that’s what happened to me the other day. Uber offered me a possibility of paying $20 for adding a 20 percent discount on all the rides next month. On the one hand, this seems like a great deal, because I travel by Uber a lot, and so I’m going to save money by doing that. On the other hand, what they are doing is making me not multi-home, not look at my Lyft application all the time. As a result, they are making it more difficult for Lyft to survive. And so, eventually, they’re going to have the entire market, and they’re going to do whatever they want to me and all the other customers. So, how do you deal with this exclusionary practice or loyalty practice that appears to be in favor of consumers but eventually ends up actually being hurtful to consumers?

Fiona Scott MortonThe answer to that is probably longer than will fit in one podcast, but you’re exactly right about the impact of that scheme. The idea is to get people to single-home, and when a user is single-homing, their eyeballs are only going to that platform, and that platform then has market power over that user, because they’re not even considering any of the competition. What do we do about these kinds of tactics? Well, the report talks about this at some length. We haven’t been enforcing the antitrust laws in the United States to the extent that we could have been, and the result of that is that we’re quite behind in enforcement in general, and we’re certainly behind in enforcement of digital platforms, because digital platforms present a number of new issues.

One of those issues is the complexity of offering a pricing scheme that might look like it’s a reduction in price to the consumer but makes the consumer single-home, then possibly leads to a higher price to the consumer or the exit of a competitor that down the road leads to a higher price for the consumer. If the set of facts brought to a court convinces the court that this is exclusionary conduct, it’s not actually helping the consumer in the long run, then that could be found to violate the antitrust laws, and then that would be prohibited.

But antitrust is kind of slow. It’s going to take years. First of all, you’d have to have a government that wanted to enforce in this way. Then you would have to convince courts that it’s important to enforce in this way, and then it would take years to do it. So, the report is pretty clear about all the changes that we would have to have in order for antitrust laws to work to protect us from this type of thing that you’re describing.

Kate: Just out of curiosity, Luigi, after the discount period was over, did you go back to checking both Lyft and Uber?

Luigi: Yes, I did, but they offered me another discount.

Kate: OK. So at least you go back to multi-homing when the discount period’s over.

Fiona Scott MortonYeah, and Luigi did also mention that the drivers could be offered incentives to single-home also, and so you might get an effect on both sides of the platform encouraging single-homing, which is again quite interesting.

Kate: I’d like to take a step back and think about what market power looks like from the context of, or in the context of, a digital platform. Let’s say, for example, Google has 100 percent of the market share in search engines. In traditional economics, we think of a monopolist as, OK, when you have monopoly power, you jack up prices. Maybe you limit quantities and maybe the quality of a product is degraded. But in the context of a search engine, if we’re not paying anything, then how is Google going to jack up the prices? How is it actually going to limit quantities? It’s hard to grasp what the digital platform could do as a monopolist or oligopolist. So, what are the harms if they have a lot of market power?

Fiona Scott MortonWell, the first really obvious harm is higher prices for advertisers. We say they’re free, but let’s remember, they’re making billions and billions of dollars every year, so there’s something not free happening there if we’re generating billions of dollars, and the something that’s not free is the advertising. These are platforms that are selling our attention. They’re selling ads. They’re an ad-supported platform, and the higher prices are coming about as higher prices for advertising than there might be if there was more competition. That’s the first place to look. But then the second place—

Kate: Wait, so can I butt in there for a second?

Fiona Scott MortonMm-hmm.

Kate: So, I know that Google and Facebook address this potential criticism by saying, “Oh, we have a competitive bidding process for our advertisements, therefore we’re charging the lowest price possible.” How does that square with what you just said?

Fiona Scott MortonWell, what we see is sustained, high economic profits from this business model with anecdotal evidence of entrants attempting to get in and, for example, being bought. So, WhatsApp, Instagram. We see the European Commission’s cases against Google in exclusive dealing, in bundling. The reason that I can’t answer your question more specifically than that is because we don’t have antitrust cases against these platforms in the United States. That’s what you need to do to find out, how is the market power existing? Is it there, or isn’t it? How is it being exercised? In what way? Price, quality, innovation? Who is it harming? What’s the magnitude of those harms? And that’s what you learn when you open an investigation.

Luigi: And also, I think another damage, and correct me if I’m wrong here, is the lack of protection for our privacy, because when Facebook was competing with Myspace in the early phase, it was very protective of individual privacy. It’s only when Myspace was completely defeated that Facebook started to insert the more aggressive cookies that will follow exactly what we’re doing and the level of surveillance that was not present before. So, I think that the lack of competition leads to lack of privacy.

Fiona Scott MortonCertainly, privacy is a dimension of quality, and if consumers care about it, there could be a platform that says, “Look, I have a different business model. I have a subscription model. Pay $2 a month and I will not sell your personal data. I will not collect your personal data. I’ll just collect that $2 and offer you whatever the service is.” That would be a useful business model to have competing with the ad-supported business model. Some people might choose one, some people might choose the other. There’s also the issue that sometimes these privacy violations have externalities on other people or what the behavioral economists call internalities. They hurt me. I do it, but it’s like not going to the gym. I’m hurting myself in the future.

In those cases, we might actually need regulation or rules that prevent some types of contracts or some types of content that we think as a society are harmful.

Luigi: When you mention more privacy or an alternative, in some cases these alternatives do exist. There is a search engine called Duck Duck Go that does exactly that. They protect your privacy. They don’t collect information about you. If I were Google, I would say the alternative is a click away.

Fiona Scott MortonYes. So, I use Duck Duck Go. It’s on my phone, exactly, because I was writing this report and felt like I should try out all these technologies. The reason that the click away is such a deceptive phrase is what we were talking about before, consumers’ susceptibility to defaults and the status quo. So, yes, you can scroll down and look at page three of the search results, but consumers don’t do that. Many things are easy, and yet we don’t do them.

Luigi: Yeah, but it’s not just our laziness, because you are not lazy. You sometimes use Duck Duck Go, but you don’t use it all the time. Why don’t you use it all the time?

Fiona Scott MortonBecause there are default installed browsers on my machine in my office. It’s as simple as that.

Luigi: I guess that’s one reason, but I think the second reason is that Google is better in searching for complicated stuff. Why? Because they had the time to accumulate all those searches. This is the economies of scale we were discussing before that does represent an important barrier to entry.

Fiona Scott MortonYes, that’s exactly right. When there’s more users of a search engine, then it can learn more quickly, get better at answering rare queries, and provide a higher-quality experience to users. I don’t tend to use the search engine for things that are difficult. I’m trying to find a train time or opening hours of a store or something, so pretty well any browser can do that, but the more sophisticated your question, the better a browser you want to have, and that responds very strongly to economies of scale. This is why the European Commission found that it was a problem that Google was, for example, paying Apple to be the exclusive installed browser on the iPhone, because that was going to generate a lot of scale for Google and continue to keep it ahead of competing browsers, because there would be all those users due to the iPhone contract.

Luigi: How much are they willing to pay for that?

Fiona Scott MortonIn the last year, it was $12 billion. So, that really tells you that defaults, the default search engine that you get on your phone, is going to be the one you use. Otherwise, why would anyone pay $12 billion for that privilege?

Luigi: And it’s funny, because very often in discussion and litigation, the economists of Google are trying to make the case that this is irrelevant, while at the same time, their business people pay $12 billion, so there is a contradiction in terms here.

Fiona Scott MortonIt’s a lot of money.

Kate: Luigi, when Fiona was talking about Google search results, I saw you smiling. Why were you smiling?

Luigi: Yeah, I was smiling because I remembered this joke that I saw online that said that the body was buried in the second page of a Google search where nobody would find it.

Kate: OK. Let’s say that we can’t convince everybody to voluntarily use Duck Duck Go or to get back on Myspace and Facebook at the same time. In order to combat the harms that we’ve discussed so far, what sort of changes would you propose?

Fiona Scott MortonWell, let me preface my answer by saying these changes would have to be put in place in a responsible way. That is to say, as remedies for violations of the law or as regulations that as a society we decided we wanted. But I think we can do a number of things that are more productive than fining the companies, which seems to be what the European Commission does and the FTC is thinking about doing with Facebook, and fines don’t restore competition. They don’t change the competitive landscape at all. But you can do things like require firms to give to consumers their own data in a usable format. Suppose that I could go to Amazon and say, “I would like a file that tells me what I bought for the last three years, and I’m going to take that file and I’m going to give it to Jet.com. Then Jet will know what it is that I bought for the last three years, and they can make suggestions and serve me in a better way, because I’ll have addresses, names, all the things I purchased. All the data that I put into the Amazon platform.”

That would really lower switching costs between Amazon and entrants. That might make entrants think, “Wow, if I enter, I could get a bunch of people quickly and I could serve them pretty well. I could start training my own search engine on that data that they give me.” But why would it be in the interest of Amazon to give me my data, and what format would they use? So, you need a regulator, a regulator to say, “Here’s the format and, yes, this is going to be a rule, and we’re going to enforce it to make sure that established platforms give their data when they’re asked.”

That’s one kind of remedy. A second kind of remedy you could think about is interconnection. Suppose that an entering, small social media platform didn’t have network effects. It had some users, but those users had friends on Facebook. Well, suppose that a regulator said, “Facebook, you must interconnect with small platforms that would like to interconnect,” and the small platform could then go into Facebook, retrieve the information of the friends, with their permission and the user’s permission, and then be able to display that on the new . . . the entrant’s social media site.

So, even though the entrant has very few users, it doesn’t suffer from bad network effects because it can take the data. It can connect to Facebook and bring the data across.

Luigi: And let’s remind our listeners that, to some extent, this is what the US government did at the beginning of the telephone era. There were a lot of different networks that were not interconnected with each other, and they forced openness in the network, so they destroyed the natural externalities, and I think that that is, to some extent, a potential remedy for the social networks.

Kate: Yeah, we just need to turn social networks into regulated utilities.

Fiona Scott MortonWell, interconnection is not regulation of the price, right? Interconnection is saying, “I want everybody to be able to talk to each other.” Certainly, my children would agree that the telephone is a fairly useless thing, and social media is much, much more important and the place where they do all their business and socializing. But the point about the regulated utilities, this is something that Senator Warren has put forward as a proposal and that is actually a little bit different, that regulated utilities like electricity and so on are places where we as the government actually control the price and say, “Here’s how much a utility may charge for electricity.” So, that’s a little different.

Kate: Fiona, can you tell us more about what sort of authorities would be enforcing some of your proposals?

Fiona Scott MortonWe don’t have in the United States an authority that’s dedicated to digital issues. The issues that we discuss in the report about competition and how to set up baseline conditions in data so that you get more competition and more choice and more entry, like data portability, like open standards for micropayments. These are kind of baseline activities that I think it would be really helpful to have put together into a specialist agency that would be good at handling all kinds of data issues.

Kate: And what about antitrust?

Fiona Scott MortonThe antitrust for digital platforms could be also placed inside this agency if we wanted to. Some advantage of that would be, let’s say, the exclusionary tactic that violated the antitrust laws was something technical that was a little bit hard to see, and so, a regular agency like the Department of Justice wouldn’t see it as quickly as a digital authority might see it, because they’re working with that data and those situations and markets every day. So, you could certainly empower a digital authority to enforce the antitrust laws or actually go a little bit beyond them.

In the report we suggest that if you’re one of these very large digital platforms, the Googles and the Facebooks, that transactions, purchasing small rivals that represent possibly nascent competition that might one day overthrow the platform, that these transactions need to be scrutinized especially carefully, and not by the standards of ordinary antitrust law but by a higher standard, because the benefit to consumers of having even a tiny fragment of competition would be so high that we really want to protect and preserve those small entrants.

Luigi: But you are also recommending some legislation as far as antitrust is concerned. Can you explain why you resort to this idea that we need to fix antitrust laws in the United States?

Fiona Scott MortonIt goes back to the influence of the Chicago School from the ’70s, which was about using economics in antitrust, and that was a good idea at the time, but it was interpreted to mean less enforcement is good, and that was a drumbeat that was repeated for three or four decades. So, we’ve been enforcing the antitrust laws less every year for three or four decades, and I think there’s quite a bit of evidence now demonstrating that we have overshot the mark. We’re under-enforcing at this point.

How do you get courts to appreciate that we’re under-enforcing, to sort of absorb all of that evidence and change what they’re doing? Well, that would take a long time. It would probably take decades to reverse that. So, do we want to wait decades? I don’t, really. It seems to me that a more sensible approach would be to pass a new law that would essentially be the same thing we’ve got, the Sherman Act, but it would say Congress would like to re-pass the Sherman Act, and we really mean it this time, and here’s all the things that we would like you, the courts, to be doing to enforce the antitrust laws.

Kate: These remedies that you’ve proposed, do you think there’s any chance that they may be implemented any time soon?

Fiona Scott MortonI have no idea about that. I think the role of this report and having a bunch of academics get together and think about these problems and put forward solutions is really to try to be rigorous and careful and thoughtful about those solutions and to start the conversation about what we might do and where we might go. I’m not the elected official. Politics is messy. It’s sausage-making, and legislation is sausage-making, and I am not going to be very good at that, so really, what we are attempting to do here is not engage with that problem at all but just to say, “Look, here are some good ideas. Here’s some analysis that’s clear. Here’s some evidence that we have. Here’s a lot of literature on this topic. Here’s some proposals that actually make sense in light of the problems that we’ve brought forward, and go out and do the best you can with them.”

Luigi: Thank you, Fiona, for all the effort you put into the report and for sharing it with us.

Kate: Thank you, Fiona.

Fiona Scott MortonYou’re welcome.

With Democrats like Alexandria Ocasio-Cortez and presidential candidate Elizabeth Warren proposing wealth taxes, Kate and Luigi break down how these taxes have or haven't worked in other countries and whether they could work in America.

Kate: Hello, Capitalisn’t listeners. Thanks so much for joining our program. I just wanted to mention that you might be hearing some changes to the show’s sound. We want to know what you think. Do you like the changes? Do you hate them? Send us an email at capitalisnt.podcast@gmail.com. That's Capitalisnt, without an apostrophe, dot podcast at gmail dot com.

Luigi: A wealth tax. You may have heard this term thrown around a lot lately.

Kate: Plans to implement a tax specifically on wealth have been put forward by Democrats like Alexandria Ocasio-Cortez and Elizabeth Warren.

Luigi: The pushback to those ideas has been intense.

Speaker 1: I think the idea that rich people are undertaxed is ridiculous.

Speaker 2: I mean, I think the question of fairness is a really crucial one, right? We live in a time of extreme wealth inequality, and that means inequality of power.

Kate: I’m Kate Waldock from Georgetown University.

Luigi: And this is Luigi Zingales from the University of Chicago.

Kate: And you’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

On this episode, we want to talk about wealth taxes. What are they? How do they work? And should we consider implementing one in America?

Debate around this idea of a wealth tax started entering the headlines in January, when Senator Warren proposed a wealth tax on the super rich. Under Warren’s plan, the tax rate on wealth would be 2 percent up to $50 million. If your wealth exceeds a billion dollars, then on the exceeding part it would be 3 percent. Just to give you an idea, it targets only 80,000 families in America. The estimates done by two economists at Berkeley suggest that you should be able to raise $2.75 trillion over 10 years. Now, Warren’s proposal includes what is called a punitive exit tax. So, if you are a US citizen and you want to give up your citizenship in order to avoid a tax, you have to pay 40 percent on the net worth above $50 million, and that’s a lot.

Kate: Yeah. Here's looking at you, Eduardo Saverin, the Facebook guy who gave up his citizenship in order to protect his Facebook wealth.

Luigi: Yes. And, not surprisingly, a lot of rich people said that this was crazy. So, Mike Bloomberg said Warren’s proposal was unconstitutional and made an analogy with Venezuela.

Michael Bloomberg: We need a healthy economy, and we shouldn’t be embarrassed about our system. If you want to look at a system that’s noncapitalistic, just take a look at what was perhaps the wealthiest country in the world, and today, people are starving to death. It’s called Venezuela.

Luigi: And Howard Schultz, the former Starbucks CEO, called the Warren plan ridiculous.

Howard Schultz: Well, if that plan was put in place, it probably could fund the government for a day or two. So, that’s not the answer.

Kate: To be honest, I am surprised that they didn’t have more choice words to use to describe the plan considering that they are billionaires. Obviously, they are going to say bad things about it.

Luigi: First of all, let’s think about a wealth tax in an international context, because the idea that wealth taxes exist only in places like Venezuela is completely wrong. They do exist in developed countries. There is an association of developed countries that is called the OECD. Five nations within the OECD do raise wealth taxes, even if the amount of money they raise with these taxes is relatively limited. Now, what is interesting is, of those countries, the most famous for adding wealth taxes is Switzerland.

Now, you don’t associate Switzerland with socialistic ideas, and so the idea of having a wealth tax is not necessarily a socialist idea. Now, it depends a lot about how high those taxes are. In Switzerland, they actually vary by canton, so not all cantons have the same tax.

Kate: What is a canton?

Luigi: A canton is kind of a county, but they have much more independence. Switzerland has a form of provinces. The level of wealth tax is more of the order of 0.5 percent, 0.7 percent, not as aggressive as the one that Senator Warren proposed. However, they start at a much, much lower level. They start at the order of $200,000, $300,000, not at $50 million. It's quite different.

Kate: So, if a bunch of other countries have implemented a wealth tax before, then that’s good news for us. That means that there’s a precedent and we can look at them for empirical evidence of the efficacy of this sort of tax. So, how effective has it been?

Luigi: Interestingly, there is less research than you would expect on this, but there is a very relevant paper that has been written precisely on this Switzerland experiment, because there is so much variation in tax rates across cantons. The bottom line is that the kind of sensitivity of reported wealth to taxes is higher than the sensitivity that we observe of reported income on income taxes. The question that is raised is, what drives this sensitivity? Because most people will expect that, especially in Switzerland, people will move from one canton to the other. If my canton raises taxes, I might move to the next one with the lower taxes. That doesn’t seem to be a first-order effect in Switzerland.

Now, it seems that the major source of this variation is either underreporting, that people tend to report less when taxes go up, which is not that surprising. And the second is that they might save less, and that is the part that as economists, we’re more concerned, because, of course, we would like people to save and invest, and a tax on wealth is a tax on savings, a tax on the willingness to actually invest in the long term. As Switzerland shows, and other countries have shown, it is possible to have wealth taxes. The question is, what are the benefits and costs?

Kate: Back in 1995, there were 15 countries with a wealth tax, and, as you mentioned, now there’s only five OECD countries that have one. So, in your opinion, what's the primary reason that wealth taxes are disappearing?

Luigi: I think it's twofold. First of all, Europe tends to have a taxation based on residency, not citizenship. So, if you are a wealthy guy in Sweden, you move to Monte Carlo, and you avoid income tax and wealth tax. Some economists have studied that all the best Swedish soccer players move to Spain, because income taxes are lower there, and so there is nobody left in Sweden playing soccer of any value because the taxes are too high. So, the mobility to avoid taxes in Europe is much bigger as a result of the fact that if you get out of the country, you don't have to pay the local wealth or income tax.

The Warren proposal is clever, if oppressive, if you want, but clever in this dimension, because you say, there is an exit tax. So, if you want to relocate to Monte Carlo, you're welcome, but we take away basically almost half of your wealth if you go.

Kate: Don’t you think that lobbying had anything to do with it, though? I mean, yes, there’s one component that’s like, yeah, they weren’t as successful in raising money and revenue as they expected to be, but surely, there were a lot of rich people who lobbied against these wealth taxes as well.

Luigi: This is certainly a possibility, and some people claim that Macron, the president of France, abolished the wealth tax as a compensation for the rich donors who supported his presidential campaign. We cannot know because there is not a lot of disclosure, but I think that it is surprising that a candidate that comes from the Socialist Party and would like to have a more, if you want, egalitarian society, decides to eliminate precisely what? The wealth tax.

Kate: Yeah. Another issue with a wealth tax is that it’s hard to track wealthy people, right? They are sneaky, and they have a lot of wealth and a lot of holdings and a lot of different types of assets, and you have to hire people, whether it’s the IRS in the United States, or other taxing authorities in other countries, you have to hire people to go after wealthy people and keep track of what they have. And so, there’s pretty high administration costs with a sweeping tax like a wealth tax.

Luigi: Actually, the IRS already keeps track of what you own around the world, and in fact, recently, they have stepped up the level of monitoring so much so that it is very difficult for American citizens to open accounts in other countries. My daughter moved to France, and she has been trying for six months to open a bank account in France, and because she's an American citizen, most banks say, “We don't want to deal with you. You are too expensive because we need to report to the IRS what you deposit and what you make.” And because she's not going to deposit a lot of money, the cost is bigger than the benefit. So, I think that, in fact, a lot of monitoring is already taking place.

Kate: All right, so Warren has put forward this wealth tax plan. Other countries have tried it with different degrees of success. Overall, it hasn’t been the biggest revenue raiser, but it has raised some money. What are the actual benefits and costs of a wealth tax?

Luigi: The biggest benefit, in my view, is to diversify your source of tax raising. There is a fundamental principle in public finance that you don’t want to raise all your taxes in one form. Why? Because every form of taxation is distortive, and so spreading it out across various forms tends to reduce this distortion. The second is a good way to reduce tax elusion. Our listeners probably remember that during the 2012 presidential campaign, it came out how little taxes Mitt Romney was paying. If you are super wealthy, you find a lot of ways to elude. And here we're not talking about evasion. Elusion is perfectly legal, but the richer you are, the better your lawyers and the more creative they are in finding loopholes.

Having a wealth tax is a way to compensate for that, especially if you make this compensation explicit. So, imagine that you say, you pay 2 percent in tax on your wealth above $50 million, but you can deduct from that 2 percent every income tax on that wealth you actually paid. That would be a compensatory tax for all the wealth that you have and you don’t pay taxes on. The third argument, which is an argument that has a long intellectual history, is that you would like to tax unproductive capital. So, imagine that there are two siblings with the same amount of wealth, and one of these siblings invests all his money in productive enterprises, and the other one buys a gigantic real estate and a few Monets and just enjoys life looking at the Monets, spending his time in the big real estate.

The second guy will pay much, much less in taxes than the first one, when the first one is really helping society to produce more and create more jobs, create more growth. So, I can see an argument to increase the taxes or introduce a wealth tax and maybe decrease the income tax. So, very often, the argument of a wealth tax or not a wealth tax is always framed in the context of, do we add another tax? And so, people say, “No. We don’t want to add another tax.” But the question is not whether we want to add another tax. The question is, what is the optimal mix of taxes we want to use? And I think that the wealth tax with some qualification might be a good component in this portfolio of fundraising or revenue-raising mechanisms.

Kate: I would say that the benefit that most people envision is much simpler. Which is that it seems fairer. Maybe it will reduce inequality, unclear whether or not it would be large enough to reduce inequality. But if you need to pay for something, if the government needs to raise some revenue in order to pay down some of its debt or to pay off some of its interest, where should that money be coming from? Should it be coming from wealthy rich people who are worth over a billion dollars? Or should it be taxes that are raised on people who earn $10,000 a year? And the former just seems a little bit more fair, and it may reduce inequality.

Luigi: You might be right that this is what people emotionally like about it. Personally, that’s not what I like. In fact, it’s what I fear. For two reasons. Number one, I think that taxes at the level that have been used in the past or even at the level much higher than was proposed by Senator Warren, are not going to fix the inequality in the country. So, if you really want to fix inequality, then we are starting to talk about expropriation, and we know the experience of countries where there was a gigantic inequality in land ownership, that some countries went the direction of expropriating some of the largest landowners’ plots in order to redistribute land. That’s a redistributive policy that is pretty aggressive. I think it’s going to cause a lot of tension.

Second, I understand that at some level you say, it’s easy that when I want something, somebody else pays for it. The problem is, if you go down that path, you don't know what the limit is. Both in terms of spending and what are the terms of taxing? In fact, one of the strongest arguments against the introduction of a wealth tax is the so-called slippery slope argument. Why do you want to stop at 1 percent? Why don't you want to go to two? Why don't you want to go to three? What is the limit in the taxation of wealth?

Kate: I’m sorry, but the slippery slope argument, I am just tired of hearing it as an excuse for no government intervention whatsoever, because if the government does anything, then it’s going to lead to the slippery slope, and then they are just going to be expropriating everyone’s wealth, and they are just going to be nationalizing every industry, and pretty soon we’re going to end up like Venezuela. Sorry. Sorry if am sounding a little bit like Michael Bloomberg there. It is just so ridiculous to imagine that poor, single mothers are going to have so much power that the 1 percent tax on wealth that’s levied on rich people is all of a sudden going to go to 100 percent. Just because we’ve never had this sort of tax before, and it’s unclear how it would be implemented and it would just run out of control. I mean, given the extreme distortions of power in favor of the wealthy, rather than the normal person in this country, I think, if anything, the truth would be the opposite.

If this sort of wealth tax were ever implemented at all, the slippery slope would move in the opposite direction. We would just chip away at it over time so that it eventually disappeared, kind of like what’s happened with the inheritance tax in the United States.

Luigi: But actually, the history goes in the opposite direction, because the income tax was introduced at the beginning of the 20th century and initially was only 1 percent. Within 50 years, it reached 90 percent, so once you start to introduce a taxation, I think that there is a tendency to use that as a source of revenue every time you need some. And the other question is, who do you define as rich? Because the definition of rich is somebody that makes more than you do. Everybody is happy to tax the ones that are above $50 million because none of us is in that category. But if you keep going down, at some point it will reach your level of wealth, and then you start saying, “Why me?”

Kate: I mean, A, that’s the whole point of a progressive tax system. Yeah, there will be discontinuities. There are with any tax system. That’s fine. And, B, if it reaches down to the level of someone who has a wealth of $100,000, even though that person just from a distributional perspective is not terribly wealthy within the United States, as long as they are only paying a penny of additional wealth tax, fine.

Luigi: But they are not paying just pennies in the sense. In Switzerland, in many cantons, they pay 0.7 percent, 0.8 percent of their wealth above $300,000, which is a significant amount of money. Now, the good news in Switzerland, they pay very little, sometimes none, in income taxes, and that compensates for this. But if you keep adding, then it is true that it does create a strong disincentive to accumulate and work. We need to consider the incentive effect of taxes, and often they are exaggerated, but they do exist, and they should not be ignored.

Do you really think that if you are taxed 90 percent, you are going to work as hard as if you are taxed at 15 percent?

Kate: No, I don’t think that that’s true, but I also don’t think that a 90 percent marginal tax rate shuts down productivity all together, as many people argue it would.

Luigi: Honestly, I do think that it will have a negative effect, but I think that a taxation of 90 percent even on a margin, is in my view, immoral, because it is taking away. So, it’s expropriation. I wouldn’t call it taxation. It is expropriation. I’m the first one to say we all should contribute to funding the public goods and people who are more wealthy should contribute more. There is no doubt about this. More in absolute terms, and in proportional terms. I am in favor of progressive taxation. However, I think that there should be limits. The risk of not adding limits justifies why there is this fear for introducing new taxes. If there was a constitutional amendment, say, that you cannot tax more than X percent of the wealth, I think that it would be easier today to introduce a tax on wealth, because people are afraid of the slippery slope, and I think there is some value to the argument, even if wealthy people can be very influential in presidential campaigns and in congressional elections.

However, I think that the risk of saying, let’s sort of soak the rich and just redistribute, is a very poisonous policy that historically has not led to very great outcomes.

Kate: All right, fine. I'll meet you halfway. I am in favor of a wealth tax and a constitutional amendment that limits the wealth tax for 45 percent of your wealth.

Luigi: That's called expropriation.

Kate: In Piketty’s book, which we’ve discussed on this podcast, so I don’t want to rehash those issues, but he does present a great example that was salient in my mind, which is that he compares Liliane Bettencourt, the heiress of the L’Oréal fortune, to Bill Gates. And between 1990 and 2010, Bill Gates’s wealth grew from $4 billion to $50 billion, so a 12.5 X return. Whereas Liliane Bettencourt’s wealth grew from $2 billion to $25 billion. Same return, but she didn’t work at all. Doesn’t this highlight the problem with wealth and taxation? Which is that once you have a lot of money, if markets are doing well, it’s just easy to make a ton of money without being a productive member of society.

Luigi: That’s definitely true, but if you invest that money in the stock market, you take the risk, you provide the capital to innovate and grow, I don’t know why you should be penalized. I think it’s much more problematic if that money was invested in Monet paintings, and I’ve nothing against Monet, but Monet paintings, and they tripled or quadrupled in value. In fact, there is a long tradition even among classical liberal economists to favor some form of taxation of rent or taxation of the unimproved value of land. And even Milton Friedman, one of the most free-marketeer and antitax economists, said that some form of taxation on land is probably the least evil of all the taxes and should be a part of it. So, the idea of taxing something that grows in value without any contribution on your part, I think it is a sound idea. I disagree that if you invest in the stock market, and I think that Bettencourt was investing money in the family company, this is saying it is completely a passive thing, because you are taking a lot of risk in the process.

So, I will . . . I agree with part of the argument but disagree with the rest.

Kate: I mean, we were talking about capital gains in particular. I think the fairness fundamentally comes down to whether or not you think capital markets are already efficient. How much efficiency loss or how many distortions would be introduced to the system by raising taxes or introducing a new type of tax, and also how profits are being made in the first place, right? Are stocks going up because entrepreneurs are innovating and they are creating new goods and they are improving society? Or are stocks going up because companies are monopolies, or because they have cozy relationships with the government and they are able to entrench themselves? And I think if you take the view that, first, a lot of profits or a lot of rents come from sources that are not necessarily good for society. And, number two, that capital markets are actually pretty efficient, at least in the United States, and that if we change taxes a bit, it’s not like people are going to stop investing in new ventures.

It’s not like entrepreneurs are going to stop creating new businesses. I think this is where a lot of the debate needs to take place, but at the same time, we don’t really know the answers to those questions. It’s impossible to know.

Luigi: Wait a minute, we do know that there is an elasticity of investments to taxation. So, if you increase taxes, you are going to have less investment. Now, of course, the big question is, what is the magnitude? But the fact that it exists, I think is undoubtful. On the other point, I agree that we have monopolies. We have distortion, et cetera. But we know in economics that you cannot use an instrument to fix all the problems. You tend to have the need to have one instrument per objective. So, if you are concerned about monopolies, as we discuss in this podcast, there is the antitrust to do that. And you can do even more legislation targeted to that. If you are concerned about corruption or cronies, you want to introduce legislation or enforce legislation on that front. I don’t think that a generic tax on wealth will fix the problem.

Kate: In response to your response to my point about the elasticity of investment, sure, that’s true, but another thing that’s true is that that’s going to constantly change over time. It’s going to change as economies mature, and it’s going to change as the types of investments we have to make also change, right? As innovation itself changes. And so, it’s impossible to know in this exact moment what that magnitude is. And, yeah, you said that, sure, we might not know magnitudes, we just know signs, but if the magnitude is pretty small, then I’m not too concerned.

The recent example that we have is that when Trump cut taxes in 2017, there wasn’t a huge increase in investment, at least not what we were expecting. What happened was that companies ended up paying out a lot of that money to their shareholders. And so, if we had a ton of great investments to make, we would have expected more investments to be made as companies had more money. And so, this tells me that there is room to raise taxes without introducing these huge distortions to capital markets.

Luigi: Certainly, there is some room in this direction, and if I remember correctly, when we discussed the Trump tax reform, both of us agreed that it would not have spurred investments. Some of the promises that were made were a bit excessive. So, I will certainly not disagree on this. But I think what is important to understand, and this is one of the reasons that people are so negative about the idea of a wealth tax, is that it feels like you are taking advantage of the people who have saved in the past and they cannot change their decision. So, the good thing about the income tax is that you generally know how much you are going to be taxed before you work. And so, at the end of the day, it is a choice you make, do I work more, and I make more money, but I am taxed more? Or do I work less? With the wealth tax, the decision to accumulate has been done in the past.

That decision is sunk, and then you come and say, “I want to take a piece of the action.” Why is this so problematic? In economics, we call this time inconsistency, because if you start fearing that this is what's going to happen, people will not invest on a massive scale. In countries where expropriation is likely, and Latin America comes to mind, foreign companies tend not to invest. Why? Because they have experienced situations in which they invested, and after the investment, they were expropriated in one form or another. You can fool people only once, because later they learn. The risk of introducing a system of a wealth taxation is that people will not invest for fear that this taxation will be an expropriation later on in the future. That’s the reason why some form of bound, a constitutional bound to this, will be useful precisely to avoid this fear.

Kate: OK. Sure. If you want to implement a constitutional bound in order to make this tax, or in order to rein it in and make sure it’s not expropriative, that’s fine, but still, we need to go back to the point that the numbers being introduced are on the order of 1 or 2 percent, maybe. In some countries, much less. A, I don't think that that is a punishment or a burden on people who have saved. And, B, I don’t think that if wealthy people were taxed on the order of 1 percent of their wealth, then all of a sudden, they are going to stop saving, and all of a sudden they are going to start consuming caviar for every single meal because it’s just so not worth it for them to save. I don’t think that that would really change their behavior at all, actually.

Luigi: For sure it would change their behavior. They will start to distribute the wealth to their children and relatives, so as to be below the threshold of $50 million or below the threshold of $1 billion. And they will spend an enormous amount of money in lawyers to try to figure out ways to avoid that. So, in the current system, there are so many loopholes in inheritance tax because you can create a trust and avoid the tax that, basically, it ends up being a subsidy to tax lawyers. That’s one of the reasons why in many countries it was either reduced or abolished. You start with a clean wealth tax, and then the lobbying introduces so many loopholes that by the end, it raises very little revenue and creates a lot of distortion. So, unless you are able to eliminate all those distortions, then creating a wealth tax or inheritance tax does not make a lot of sense.

Kate: I sort of feel like you just contradicted your earlier point about the slippery slope, right? How can it be that a potential cost of a wealth tax is that it’s going to increase so much that it’s expropriative to rich people, but at the same time, another problem with it is that rich people will lobby so much for the introduction of loopholes that eventually they won’t be paying any wealth tax at all.

Luigi: Actually, no, because I think that there are some aspects that are very visible and become politically salient. What is the tax rate? And the idea of soaking the rich is a pretty popular idea throughout the world. And so, the idea of increasing the rate, you can win a campaign by saying, “I'm going to tax the rich. And I'm going to increase the rate at X.” It is very hard to say I win a campaign by eliminating a loophole that most people don’t understand what it is. And, as a result, I think that the vested interests are particularly good at creating the loopholes. And, if you want, the more popular, or populist, parties, are very good at increasing the tax rate. And then you end up exactly like in the ’60s, where you had a very, very high tax rate and an enormous amount of deductions and loopholes that make the system incredibly inefficient.

Kate: Yeah. I think that that’s a great point. When it comes to taxation, a lot of people say, “What's the issue? Is it the rate or the base?” The rate is the percentage of the tax, and the base is how much money you are being charged that tax on, and loopholes allow you to shrink the base, because they allow you to hide how much money it looks like you are either making or how much you actually have. And, in practical reality, the real issues right now revolve around the base. But the base is hard to understand because there are so many rules, and there are so many laws, and it’s just hard to have a simple conversation about it, whereas it’s easy to talk about the rate. So, as you mentioned, Luigi, all of the political discussion is about the rate, when the actual discussion we need to be having should be about the base.

So, Luigi, a wealth tax. Is that a Capital-is or a Capitalisn't?

Luigi: I think in the proper form and shape as we have discussed, a wealth tax is Capital-is. I think Switzerland is a very capitalistic country, and they have a very well-functioning wealth tax.

Kate: I think it's a Capital-is as well, probably for reasons that you disagree with, but at the end of the day, if 1 percent of American households own 40 percent of the country's wealth, that’s a problem to me. Solutions that may have been proposed to combat an issue like that, they’re not working, and so something needs to happen. If this becomes expropriative, fine. I acknowledge that there is potential for it to be expropriative, and so put a cap on the tax.

There’s an acronym you’ve probably heard in the news a lot lately: IPO. With companies like Pinterest, Airbnb and UBER all considering going public this year, Kate and Luigi break down why these companies already have huge valuations, and whether rich people have an unfair advantage when it comes to investing.

Kate WaldockHello, Capitalisn’t listeners. Thanks so much for joining our program. We have a fascinating episode about IPOs today. But before we get into it, I just wanted to mention that you might be hearing some changes to the show sound. We have a new producer, Matt Hodapp.

But we want to know what you think. Do you like the changes? Do you hate them? Send us an email at capitalisntpodcast@gmail.com. That’s Capitalisnt without an apostrophe, dot podcast at gmail dot com.

Speaking of new producers, we want to thank Derek John, whose calm baritone voice you may have heard at the end of our episodes. Derek has been our producer. He’s been with us since the beginning, and he’s leaving us to go work for Slate full time. Slate, you’re incredibly lucky to have Derek. We know we were, and, Derek, we’re going to miss you a lot. A lot. And also, Emily, your awesome wife.

There’s an acronym you’ve probably heard in the news a lot lately: IPO. Just for the economically uninitiated, this stands for initial public offering, and it’s shaping up to be one of the biggest economic trends of the year, especially for tech companies.

Speaker 1: I think 2019 is setting up to be the most exciting IPO year since 2012.

Luigi ZingalesSlack, Pinterest, Lyft, companies many of us probably use on a daily basis, are all throwing their hats into the IPO ring.

Speaker 2: We’re talking like $200 billion in terms of potential IPOs coming out of the gate, in terms of valuations. And so, I mean, when you look at the big five that are coming out, from Uber, to Palantir, to Airbnb, to Lyft . . .

Speaker 3: . . . Slack . . .

Speaker 2: . . . these are big numbers that are coming out.

Kate: For those of you who may not know, an initial public offering, also sometimes referred to as a stock market launch, is essentially when a private company decides to go public, to be listed on the stock exchanges for anyone to purchase shares.

Luigi: But this sudden interest in IPOs is a bit strange. In the past few years, IPOs have been on the decline. Still, with all the big tech companies considering going public this year, some are saying it could turn the IPO market around.

Speaker 4: I think the tech IPOs are really going to get the market moving, but we have IPOs across the board looking at the tech group, saying, “If they perform well, I’m going out, too.”

Luigi: I’m Luigi Zingales from the University of Chicago.

Kate: And I’m Kate Waldock from Georgetown University. And this is the Capitalisn’t podcast, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

On this episode, we are going to talk about why companies going public these days already have huge, multibillion-dollar valuations. And whether rich people have an unfair advantage when it comes to investing, because they have access to better companies earlier on.

Kate: So, here’s an interesting fact. The number of publicly listed companies is shrinking. In 1997, a little bit before the dot-com bust, there were 8,884 companies listed on US exchanges, mostly on the NYSE and NASDAQ. Since then, the number has fallen. So, right now, it’s less than half of that.

Luigi: But this phenomenon is a result of two underlying forces. On the one hand, we’re not just talking about domestic IPOs, we’re talking about foreign companies listing in the United States, which might be an indication that the financial markets in the United States have become less attractive.

And, second, there is a trend that the startups tend to not go public so early. It used to be the case that, if you wanted to make money in a startup, you were dreaming to do the IPO. The IPO was the jackpot. Today, you get valuations when you are purchased by Facebook or Google of $12 billion. You can hit a jackpot without doing the IPO.

So, Kate, why would a company go public in the first place?

Kate: There are a lot of theories behind this. But I’m going to talk about two main ideas. One is that you need capital as a startup, right? Let’s say you have some great project that you want to invest in. Let’s say that you’re Uber, and you want to start doing more research in driverless car technologies, but you need an extra $2 billion. What if the private equity markets don’t have $2 billion? That there’s just not enough capital in private equity? If that’s the case, then you might want to go public. That way, you can raise that much money, that huge amount, from public markets.

There’s another element to this, which is that some say that you could raise that equity at an even cheaper price. And the whole idea behind that is that, if you’re getting it from private investors, chances are that they’ve got this concentrated position in just your company, right? Because a few individuals are investing a lot of money in just one company. Whereas if you’re raising that money from public markets, it’s a bunch of people who hold diversified portfolios that are investing in a lot of stocks. And so, they’re not really exposed to your specific risk, and therefore you’re going to get a better price by raising money from public sources.

And the second thing is this liquidity issue. So, if you’re a founder, one of my mentors in grad school, his name is Aswath Damodaran, he likes to say, “You can’t buy a yacht with Facebook stock. You can’t buy a yacht with equity, you buy a yacht with cash.” And, once you’ve started a great company, and you’ve got stock that’s worth a lot, but if it’s still tied up in these private markets, you want that cash, right? You want to IPO, so that you can have liquidity for your equity, and then you can receive that cash to buy whatever you want.

Luigi: The first reason, we like to portray that as a main reason. I think that most of the time it is not. In a sense, most of the time companies have already done their most intense phase of growth before they go public. They raise the money in order to grow in the venture capital arena, where, as you said, it is more expensive. But also, where there is more of a kind of selection, because it’s not easy for capital markets to mentor and direct young entrepreneurs.

The money that you raise in the public market is cheap money, as you said, but it’s cheap money that comes with no advice, no mentoring, no relationship, not anything. And, when you are in the early phase of your company, you need all these other things. That’s the reason why, traditionally at least, startups tend to raise their money in the private equity market.

Kate: So, Luigi, why would a company not want to go public? What are the big costs of going public?

Luigi: I think that the two biggest ones are, number one, there is a cost of compliance with regulation. When you go public, number one, you have to disclose a bunch of stuff, because you want to put everybody on the same page. And so, you need to hire lawyers, you need to report in a particular way, and so on and so forth.

And with that comes an additional cost of risk of disclosure in the sense that, if you miss your earnings, and the stock price drops dramatically, you’re almost certainly going to have a security class action. Now, it might be dismissed if it is frivolous, but there is the risk of a security class action every time there’s a major drop in the stock price. And that’s, at the very minimum, distracting for the CEO, especially in the early phase of a company’s life.

The second issue that is often ignored but is quite important, is that you need to disclose your profits and your business model to investors. But you cannot disclose to investors in a private room because they’re public investors. You have to disclose in front of everybody. You’re also disclosing in front of potential competitors. People realize how profitable your business is, and, sure enough, they decide maybe to enter your line of business and compete with you.

These disclosure costs are pretty relevant costs, especially in the early phase of your company’s life, when you don’t have strong moats, as Warren Buffett likes to say, a strong source of comparative advantage that protects you from competition.

Kate: Right. So, we’ve discussed some of the reasons why a company might want to go public or stay private. But the issue that we want to get to is, why are way fewer companies going public today than we used to see in the ’90s?

There have been a few big changes to regulations that have affected the relative cost and benefits of going public. One of them happened in 1996. It was called the National Securities Markets Improvement Act. It did two things. It made it easier for private firms to sell securities to qualified purchasers, which are basically just rich people, because it exempted them from blue-sky laws that used to exist. It used to be the case that each state had its own regulations about private firms being able to raise money from investors. And you would have to comply with all of these different states’ rules, and that was incredibly costly.

It also made it easier for private equity and venture capital firms to raise capital by increasing the maximum number of investors in a fund, before that fund would also have to meet certain disclosure rules.

Luigi: But let’s be clear here. What you are describing is a reduction in the cost of raising funds outside of public equity.

Kate: Right, exactly. So, this made it easier for you to raise private-equity funds.

Luigi: Just so that our listeners understand, there is a long tradition in securities markets to try to protect investors. They often are described as naïve, unsophisticated investors against fraudsters and people that try to swindle them.

The idea underlying this protection is, if you want ordinary people to invest in the stock market, you need to guarantee that the stock market is not a place full of fraudsters. How do you guarantee this? You don’t want to take a position on whether this is a good or a bad business venture. That’s the business risk that everybody should face.

But you want to make sure that the people are honest. There was a tradition, first in state law, this is the blue-sky laws Kate was talking about, and later with SEC regulation, that was forcing people that raise funds in the public market to subject themselves to certain rules. And so, over the years, and the law that Kate described is just one step in a long process that started almost immediately after SEC regulation approval in the ’30s, was to say, “Wait a minute. If you are a rich and sophisticated investor, I don’t need to protect you. You are big enough, sophisticated enough, that you can buy at your own risk.”

Regulations started to make it easier for these sophisticated investors to buy equity without going through the formal process of an initial public offering.

Kate: All right. We have to take a quick break, and then we’ll be back, so stay with us.

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David Axelrod: If you know people, if you understand something about them, it’s harder to dehumanize them, it’s harder to hate them, even if you disagree with them.

Speaker 5: Richard Thaler.

Richard Thaler: Those two were systematic bias. That was the big “aha” moment. If there is systematic biases, then you can make better predictions.

Speaker 5: And Eve Ewing

Eve Ewing: We now in the past couple of decades have started thinking about schools, not as things that we have rights to, but rather something that we are to consume and choose.

Speaker 5: You’ll hear the stories behind the research reshaping our world. Listen and subscribe to Big Brains wherever you get your podcasts.

Kate: To recap, anybody can invest in public equity. Only rich people can invest in, not only private equity, but other sorts of asset classes that are deemed by the government too risky for regular people. By asset class, I mean the sort of things that you can invest in. So, real estate is an asset class, public stocks are an asset class, private equity is an asset class, bonds, debt is an asset class.

Luigi: Yeah, but Kate, sorry, you say that with what appears to me a salt of condescension. I see some logic in that, and it may have some negative consequences. But the idea that you want to make sure that ordinary investors are protected, and they don’t face fraudsters, is a good idea. And, honestly, I don’t think that you need to protect Warren Buffett. First of all, he’s more sophisticated than both of us. And, second, even if he were to lose a little bit of money, it would not be the end of the world. So, I don’t know why the government should be in the business of protecting Warren Buffett, but I do believe that the government should be in the business of protecting the small investors.

Kate: No, don’t get me wrong. I might sound like I’m unhappy about this, but that doesn’t mean that I disagree with it. I remember when I was . . . I think I was maybe 27 or 28. I was in the middle of my PhD in finance, and I was talking to one of my friends who was working for a hedge fund. And she was making a lot of money.

I think the accredited investor rule for certain asset classes is you have to have an income of $200,000 or more, which she met, and I obviously didn’t. And so, she was trying to make this argument that she should be able to invest in certain types of assets when I shouldn’t, because I didn’t make enough money, because I was an unsophisticated investor. And even though I was very frustrated by the situation, I think that, in general, there is some truth in this argument.

Luigi: And, by the way, there is a third rule besides your income and your wealth. If you are a professor of finance, you qualify as a qualified investor.

Kate: Really?

Luigi: Yeah.

Kate: We shouldn’t say that, because it’s a little self-serving.

Luigi: No, no. But it says you can qualify based on your professional knowledge.

Kate: The National Securities Markets Improvement Act made it easier for private equity to get bigger and private companies to stay private for longer. There was also something that happened in 2012 called the JOBS Act.

Barack Obama: And for startups and small businesses, this bill is a potential game changer. Right now, you can only turn to a limited group of investors, including banks and wealthy individuals, to get funding. Laws that are nearly eight decades old make it impossible for others to invest. But lots changed in 80 years. And it’s time our laws did as well.

Kate: This increased the maximum accredited investor threshold, right? What we just talked about. Rich people that you can raise money from. The threshold used to be 500, and that was bumped up to 2,000. This is pretty important.

So, when you think about Facebook’s IPO, and they IPO’d in 2012 . . .

Mark Zuckerberg: Going public is an important milestone in our history.

Kate: The reason they did so is because they bumped up against that threshold. At some point, they had 499 accredited investors who were holding that company stock, and if they wanted to raise any more money from a larger pool of people, they had to go public.

Mark Zuckerberg: But here’s the thing. Our mission isn’t to be a public company. Our mission is to make the world more open and connected.

Kate: And an interesting point is that part of this also had to do with their employee stock options. So, tech companies often like to compensate their employees with stock in the company, or with stock options that will become valuable later on. And, when those options vest or when the employee eventually has a stake in the equity of the company, they used to count towards this limit of 500 people.

And another thing that the JOBS Act did, in addition to upping this limit, is that they said, OK, employees that are compensated with restricted stock units, or certain type of exempt units, they don’t count towards this limit anymore.

Luigi: In this analysis, you describe two pieces of legislation that basically made it easier to raise private equity. We should also point out that there was another piece of legislation in 2002, Sarbanes-Oxley, that increased the cost of public ownership by mandating a number of requirements. And so, at the same time in which private equity became easier to get, also public equity became more expensive to raise.

Kate: All this additional compliance and regulatory burden does sound pretty complicated and pretty costly. And people started noticing that after 2000, the number of IPOs was decreasing. So, part of the JOBS Act, it reduced the burden of Sarbanes-Oxley on small companies.

Barack Obama: Because of this bill, startups and small business will now have access to a big new pool of potential investors, namely, the American people.

Kate: The idea was that this regulatory burden was just too high for them as a fraction of their value. It was preventing them from going public. It was sort of too little, too late. And, at the same time, the JOBS Act, on the other side, was making it much easier for private equity to get bigger.

In fact, after the JOBS Act, according to McKinsey, the capital invested in private tech companies almost tripled from 2013 to 2015. So, even though part of the JOBS Act was designed to make public equity more attractive by reducing this SOX burden, Sarbanes-Oxley burden for small companies, what ended up happening was that increasing the threshold of accredited investors, that part mattered much more.

Luigi: But I think that it is not a competition of where you raise more money. I think that the ultimate purpose is to facilitate the growth of the economy. And so, the question is, are we imposing an undue burden in one market or the other? And, if so, we should reduce that burden, or are we not imposing the checks and balances sufficient to make that process a healthy process? In a sense, some of the stuff introduced by SOX, by Sarbanes-Oxley, was in my view useful to make the investment in public equity more reliable.

Public equity is where most of us invest our savings, time and savings. So, a loss of trust in the system can be quite devastating for the overall economy. And so, I think we need to protect that channel. If there is a Wild West for some rich people, I’m not so worried about that, are you?

Kate: No. Your point is good, which is that, at the end of the day, what we want is for the right investments to be made, so that the economy can grow. But I also think there’s this interesting other angle, which is that, if only rich people are allowed to invest in the good stuff, that can exacerbate a huge inequality problem that we have today. So far, what we’ve talked about has been pointing in this direction of, yeah, it does sort of seem like only the rich people can access private equity markets. And that seems unfair.

Luigi: First of all, it depends on the . . . private equity, because the average return in private equity, and even venture capital, is not that spectacular. If you can invest in Kleiner Perkins, which is one of the best venture capital funds, the track record is fantastic. Lucky you. Short of being the Yale endowment fund and a few other rich individuals, you don’t get to invest there.

So, many of the people who invest in private equity, I think invest in cleverly sort of moderate-quality deals. So, I don’t see this as necessarily a big advantage to them versus the ordinary investor. What I’m more worried about is two things.

Number one is how nontransparent private equity is. So, indirectly, some of our pension money and, particularly if you’re a public employee, is invested in this stuff. But we don’t know, really, how good their return is, because they don’t disclose very well the risks they are taking and all this stuff. So, from a public policy perspective, I am worried that there is too much opacity in that world.

The second is, I’m worried that there is too much, let’s call it quid pro quo, not to use a more direct name, in that world. In a sense that, imagine that . . . I’m a CEO of a company, and I invested my own private money in a venture capital fund. And that venture capital fund comes to me and offers me a startup. I, CEO of that company, end up overpaying for that startup.

Now, why did I overpay? Because I overpaid with other people’s money. And, why do I want to overpay with other people’s money? Because, at the end of the thing — I’m a CEO, in some sense I’m responsible — is because I get a special deal to enter into this VC fund.

So, that’s the kind of quid pro quo that I’m worried about. And, unfortunately, there is no monitoring of this. No transparency, nothing.

Kate: Do you think that these are CEOs of public companies or private companies that are doing this?

Luigi: Of public companies. In fact, one CEO told me that he was offered precisely that deal and he refused. So, I know that this is something that goes on. I don’t know how widespread this is, but it is definitely there.

Kate: But then, that’s fraud.

Luigi: You know, what is the limit of fraud with this sort of, I scratch your back, you scratch my back? And it says, if I willingly overpay, sure, it is fraud, but as we know, there is a pretty wide range of valuations. So, if I choose the upper end of the range of valuations, I don’t think anybody can sue me because I am within the range. But clearly, I’m doing a favor to your venture capital fund.

And, if you offered to me the possibility of entering in a fund where nobody else can enter, you’re still doing something that is legal, but you’re doing a favor to me. These kinds of deals are the ones that makes rich people richer, because you give them a set of deals that other people don’t have.

Kate: OK. On the surface, it seems like private equity is unfair to ordinary investors. But we’ve talked about how private equity markets have opened up, right? Some people can access private equity markets through their pensions, and also there are ETFs that allow you to invest in private equity markets. Whether or not I recommend them, that’s a different story, but they do exist.

Also, returns aren’t actually that much better than the S&P 500, if you’re looking at private equity as an asset class as a whole. And, also, there are some economic benefits to the private equity system. Small firms can get monitoring and advice, and this can help them invest better. So, maybe that’s not the real problem.

OK, we’re going to take a short break. We’ll be right back.

If you enjoy listening to Capitalisn’t, check out Building Local Power, a biweekly podcast from our friends at the Institute for Local Self-Reliance. Building Local Power features conversations you won’t hear anywhere else. Tune in for thought-provoking discussions on the policies that shape our economy and new ideas on how local communities can chart their own economic futures. You can find them on iTunes, Stitcher, or wherever you get your podcasts.

I want to go back to this point about companies that are IPO-ing this year. 2018 was a bad year. It was one of the worst years, at least in the past few years, for the private equity space in terms of fundraising, and, in particular, the stock market did pretty badly in December.

I think once these large startups, or these firms that were private that had really big valuations and still need a lot of capital, once they realized that fundraising was getting tough in the beginning of 2018, and then they started thinking about IPO-ing, and then, all of a sudden, in December markets were really terrible, they were like, “Uh-oh. If we rely on the private equity space, and we need more capital to invest later on, we might not be able to raise it, if there’s a recession or something.” So, I don’t think it’s a coincidence that a lot of these IPOs were announced in December of 2018.

Luigi: And wait. You are forgetting the government shutdown. And then, in the later part of the year there was a government shutdown, so the SEC was not processing the IPOs. So, part of the accumulation of this is the result of the shutdown at the end of last year, beginning of this year.

Kate: Right. So, we saw Lyft’s IPO that happened at the end of March. At least in terms of first-day trading, it was very successful, but it sort of seems to me like the opposite should be true. That, back in the day when private companies went public, it was because they were forced to, right? Because they really needed that extra capital. Either the capital didn’t exist in the private world, or they just had too many investors, and they were forced by regulators to go public because of this 500-investor rule.

And that doesn’t exist anymore. Right? If Lyft were bumping up against the 2,000-investor limit, that would be one thing, but I don’t think that they are. And so, if they are going public, and the costs of going public are pretty high, as they seem, isn’t that a sign that Lyft is a bad company? It’s a sign that they couldn’t have gotten that money from the private equity world, which is why they’re forced to go public, because they’re not as good as they used to be.

Luigi: I think you’re making a very good point here. And this is not a point that might be obvious to all the listeners. It’s the idea that, when there is a lot of asymmetry of information, if you give more choice, there is more risk of people selecting what they bring to market. And, as a result of selecting, they’re only bringing stuff that is way overvalued. In our jargon, it is called the lemon discount, because you only bring to market the lemons, and you keep for yourself the better stuff.

Kate: A lemon’s like a turd, by the way.

Luigi: I think that there is definitely that risk, but it’s also true that both Lyft and Uber, which is considering going public, they now have reached such large valuations that even the original investors want to diversify away.

Once I invited to my class an alum who started a telecom company in the late ’90s. And he went from being worth zero to being worth $100 million. And then, he was able to sell some, but the CEO did not sell anything and went back to zero again.

Kate: Oh, no.

Luigi: So, the ride from zero to $100 million is fun, but the ride from $100 million to zero is pretty painful. There is a need to diversify. Once you start to accumulate an enormous amount of money, that’s a compensating factor that pushes entrepreneurs to actually try to sell, even venture capitalists to try to sell. Because, remember, many VCs that invest in these deals have a fund that has a 10-year life.

And they want to distribute their stocks to investors before the end of the 10 years. Because they get the money as a function of the realized return during those 10 years. So, there are pretty strong incentives, actually, either to bring companies to market or to sell them off somewhere else.

Kate: I think another point is whether it’s problematic that these huge, money-losing companies are able to sustain such massive valuations.

I think there are two sides to this argument in a very simple sense. One is that people are just forward-looking, right? You can be losing a lot of money today, but if you’re making good investments, if you’re building good machines, or if you’re doing research and development that hasn’t actually generated cash flows yet, the idea is that, in the future, you will make these cash flows. And that’s what’s generating the current high valuation.

So, that’s totally fine. So, to the extent that a company like Lyft or Uber has a really high valuation, because maybe they’re going to be inventing these really cool driverless cars in 10 years, that’s great. And it’s also a sign that markets are long term, right? They’re not as short term as people claim they are.

On the flip side, part of what worries me is that this isn’t the full story. That maybe these money-losing companies are sustaining these high valuations because people believe that they’re going to become dominant players in a market. That they are losing money because they’re engaging in predatory pricing, right? They are pricing their products below where potential competitors are pricing those products, in order to push those competitors out of the market, so that they’re the only person left in the market, or the only company left in the market, and then they’ll be able to charge monopoly prices later on.

This would happen in a system where you believe that the antitrust regulators won’t eventually go after you for doing this. And, I hate to say it, but I’m a little bit worried that that’s also what’s going on, at least with companies that sort of have Amazon’s business model.

Luigi: I think you’re absolutely right, and particularly in a world of network externalities, and where digital platforms basically take the entire market if they succeed. So, my bet on Uber or Lyft is a bet that they eventually are going to consolidate and be only one game in town. And they’re going to make a lot of profits as a result of being the one game in town.

This is a situation in which even antitrust will be challenged, because they said, “Oh, there are so many efficiencies of consolidation. And, why should you challenge us now that we are so efficient?” So, I think that investors are farsighted, but they are not so farsighted in the technology. We can make a bet, I don’t believe that driverless cars will take over the world in 10 years. But I do believe there will be a consolidation in the driver market or whatever the market is called. And they’re going to make extra profits.

Jim Cramer: Thirty-nine percent of this market is Lyft, 60 percent is Uber. After these deals are done, they’re going to raise prices, after they’ve wiped out all the yellow cabs everywhere. That’s what you do. Now, people are never going to say that, but I just thought that with two different companies going at it, they’re going to end up with good pricing power.

Kate: I think we’re in agreement that the government, as patronizing as it may be, and as annoying as it may be, when you’re a student who’s only making a couple of thousand dollars to live on, there is some role for the government to try to protect everyday investors from investing in stuff that’s really risky and really opaque. But there’s still this issue of, if firms are getting $25 billion and $40 billion valuations without going public, are there other reasons that we should be worried?

Luigi: What should we worry about?

Kate: Well, let’s say that firms never go public. Let’s say that public equity just disappears, and all firms remain private forever. I think a potential source of social concern is that risks could build up inside these companies that we don’t know about. And I guess you could argue that we wouldn’t know about them anyway, right? It’s not necessarily information that would have been disclosed according to public equity disclosure rules, but the more information, the better.

Let’s say that ride-sharing firms are using some sort of technology that’s easily hackable by some foreign country, and there’s no way, if all of these companies remain private forever, for us to ever really pick up on that vulnerability. But once these companies go public, there’s more disclosure, maybe somebody would realize that this vulnerability exists. I think the government should have some role in knowing what sorts of companies exist in the economy, and, in particular, monitoring potential vulnerabilities that could lead to big crashes or a big crisis.

Luigi: I was in a meeting few days ago in which we were discussing cyber threats, and an expert told me, “Just assume that everything that is online is known to the Chinese and the Russians.” I think that the so-called vulnerability, I take it for granted. It’s not even an issue.

Kate: OK.

Luigi: And, the second point is, I’m not so sure that by going public, you have all this visibility on all these threats in the sense that, did we know that Equifax had been completely sort of hacked by people, or Target? I think we know that after the fact, not necessarily before. And we know it as consumers, not necessarily as investors.

I think that, yeah, there is a little bit more visibility when you’re public, but I’m not so sure that that is the most important thing. I think that the concern is, if we don’t have a good sense of the set of assets we can invest in, and their return, and their correlation, the investment decisions of the pension funds, et cetera, will not be done well.

And that is to me a first-order concern. Because a 1 percent difference in return on our pensions, means the difference between retiring happy, over 30 or 40 years, makes a difference between having a healthy retirement with enough money to live or being poor.

Kate: But isn’t return something that you can just infer based on what they’re paying out? If I have my money in a pension fund, and that pension fund is invested in private equity, maybe I don’t know what they hold, but I know how much money I have in my account based on if I want to withdraw that money from my account, let’s say I’m retired, I can do it. And I know—

Luigi: Oh, certainly. You, Kate, if you are the Kate retirement fund, a big fund, and you invest in this, you have the return on that particular private equity fund. However, if I am a different fund and I want to decide whether to invest in the fund you invested in or not, I need to have a reliable disclosure of that return, and the reliable disclosure of all the other returns in order to make a comparison. This is what is not so available in private markets. Now, there are companies that are trying to provide these, et cetera. But even—

Kate: Yeah, exactly.

Luigi: Yeah. But even a very simple number, like the internal rate of return, you think that is a mathematical concept that should be objective. In fact, you can manipulate it very easily by changing a bit the timing in which you are sending the cash flow, or how you factor in the extra investment, and so on and so forth. And, because a 2 percent extra return in the IRR makes a difference between raising a lot of funds or not being able to raise the funds, people are prepared to do anything for it.

I think that the beauty of the SEC disclosure is, you have a system that tries to provide objective information to everybody, and punishes the one that lies . . . In addition to that, you have a standard. The SEC said, “You have to disclose in this way.” It’s annoying, but it’s a standard that makes it very easy to compare what you do versus what I do. And lack of standards in investment is an issue.

Kate: OK. So, we can’t just say, this year’s IPOs are capital-is or capitalisn’t, because we’ve talked about 10 different things. But let’s divide this out into different categories. So, in terms of their effect on market efficiency, and, I don’t know, inequality, is this capital-is or a capitalisn’t?

Luigi: The coming back of IPOs this year, I think that, in the point of view of the market, that’s a capital-is. I think that, at first pass, I will say this is a good sign that the capital market is working in providing capital, even for very long-term projects. Many people accuse the stock market of being short-termist, but, in fact, the valuations they give to Lyft and other startups that are not profitable are very generous. So, it seems that the market is actually very long-termist.

Kate: Yeah, I agree, from a market efficiency perspective, I think that this is fine. I think that this is a capital-is. These are companies that are going public after already generating huge valuations. But I’m OK with the fact that private equity markets are now very large and very liquid. Venture capital and private equity funds can provide meaningful advice and mentorship to these firms, that’s valuable. And there’s some research that shows that private firms actually invest better.

Luigi: Where I would be more in the direction of capitalisn’t, is an expectation of winner takes all. We know from evidence on even traded securities that the vast majority of publicly traded companies don’t make any money. All the profits are made by a few companies at the top. So, the inequality that we discuss in people seems to also be an inequality in firms that tends to reward the bigger and the winners.

Kate: Yeah, I agree with you on that one too. This is boring, we’re too much in agreement.

I also think that from an inequality perspective, at least in terms of regular people, not necessarily being able to invest in private equity, I don’t think that that’s such a big problem, or at least it’s not as big a problem as meets the eye. Partially for this reason that private equity comes with its own efficiencies, partially because regular people can have access to the private equity space for ways we discussed earlier. And partially because private equity returns maybe are not that much greater than regular public equity returns.

Last year Elizabeth Warren proposed the controversial Accountable Capitalism Act. One of its most talked about proposals was focused on "codetermination." Kate & Luigi explain how it works, its effectiveness and examine one country that's been trying it out since the 1950s.

In the wake of a blocked merger between the German and French rail giants Siemens and Alstom, Kate & Luigi debate the role of global antitrust regulators. How do they protect consumers while also helping domestic companies compete with state-supported rivals from China?

Are millennials giving up on capitalism? A recent survey found a majority now prefer socialism. Luigi gets the scoop from our resident millennial, Kate, who says most simply want European-style social welfare, student-loan debt relief and campaign finance reform. Is that really so radical?

Speaker 1: Madam Speaker, the President of the United States.

Kate: During his recent State of the Union speech, Trump made a comment that caused quite a stir on the Democratic side amongst the new, younger cohort.

Donald Trump: Tonight, we renew our resolve that America will never be a socialist country.

Luigi: The concept of socialism has been having a good revival in the last few years, since 2016, when Bernie Sanders was running for president. Being identified as socialist is not an insult, but actually something that young people want to be recognized as.

Speaker 2: But you’re a young person and you say, “I support capitalism. I support the free market.” It’s a dirty word.

Kate: But what is it exactly that’s drawing young people to this concept of socialism? Is it that they like socialism? Is it that they don’t like capitalism, or is it something else?

Speaker 3: Can you be a democratic socialist and a capitalist?

Speaker 4: Well, I think it depends on your interpretation. So, there are some democratic socialists that would say, “absolutely not.” There are other people that are democratic socialists that would say, “I think it’s possible.”

Speaker 3: What are you?

Speaker 4: I think it’s possible.

Luigi: This is Luigi Zingales from the University of Chicago.

Kate: And I’m Kate Waldock from Georgetown University.

Luigi: And this is Capitalisn’t . . .

Kate: . . . a podcast about what’s working in capitalism today—and, most importantly, what isn't.

I think before we get into the economics, it’s probably important to define what we mean when we say millennial, because this word gets thrown around a lot, sometimes in an accusatory fashion.

Luigi: Let’s be clear, I’m not a millennial, but you are.

Kate: I am a millennial. There is no technical definition of what it is. I think the best rule of thumb to go by is that the millennial generation includes people who were born between 1980 and 2000. I was born in 1987, which is on the older side of that, but pretty much in the middle of that range.

Luigi: Actually, I was discussing this with my son, who is a millennial, and he said that the millennials are the generation that was not born with the internet at home.

Kate: Sure. I still remember when I was 10 years old, that dial-up modem that we had to deal with, but that went away pretty quickly between middle school to high school.

Luigi: The other definition I saw that makes some sense is that millennials are the ones who actually remember September 11 with some degree of consciousness.

Kate: In any case, now we’ve totally confused everyone, introducing seven different definitions of millennial. But Luigi’s definitely not one, I definitely am.

Luigi: I don't identify as any generation.

Kate: That’s a cop-out.

Luigi: The reason why we’re interested in the millennial generation is not only because it’s becoming the most populous generation at the moment in America, but also because, in a recent Gallup poll, it was found that 45 percent of the people in the millennial generation have a positive view of capitalism, while 51 percent have a positive view of socialism. So, it seems that millennials prefer socialism to capitalism.

Kate: It’s pretty much common wisdom that younger people are more idealistic and more left-leaning than their older counterparts. And so, maybe this is just a standard trend. Maybe it’s just that it’s cool to call yourself a socialist rather than a liberal now. Or maybe it’s something that reflects fundamental differences between the millennial generation and older generations, and maybe these differences will persist.

Luigi: There’s a famous quote misattributed to Churchill, also to Clemenceau, that says if you’re not a socialist at 25, you have no heart. And if you are not a conservative by age 35, you’re without a brain.

Kate: Wait, it’s socialist or liberal?

Luigi: Depends on the quote. Actually, the original quote was Republican, at the time when Republican was left-leaning. So, things have changed. It’s such an old quote—

Kate: This is very confusing.

Luigi: —adapted to location and place. But the spirit of the quote is saying that young people tend to be more, if you want, left-leaning, more open to new ideas, less conservative than older people. But what I find interesting is that if you look at the polls, this positive view of capitalism has dropped very recently in time. It’s not something that has been around for a long time, but just between 2010 and 2018, the percentage of millennials who had a positive view of capitalism went from 68 percent to 45 percent.

Kate: On this episode, we’re going to explore what’s different about the millennial generation and a few different theories that we have about whether or not the millennials’ positive view of socialism is something that will persist.

Luigi: And to begin with, let’s be very clear that this negative view of capitalism is very highly concentrated among people who lean Democrat or consider themselves Democrats. Of course, Democrats on average tend to be less supportive of capitalism than Republicans. In fact, in 2010, 72 percent of the Republican-leaning people supported capitalism as a positive view of capitalism. And in 2018, the number is 71. So, it’s exactly the same, while Democrats went from 53 percent to 47 percent. So, there is a significant drop in the support of capitalism among Democrats.

Kate: But, actually, we shouldn’t necessarily just associate being young with being pro-Democrat and being pro-socialist necessarily. According to a Reuters/Ipsos poll from 2018, young people’s support for Democrats over Republicans actually slipped by 9 percent in the past two years. And if we look particularly at white males between the age of 18 and 34, their support for the Democratic Party has actually dropped significantly since 2016. It went from around a little bit less than 50 percent now to closer to around 33 percent.

Luigi: Not the majority, but at least a plurality of white males voted for Trump over any other candidate. So, I think that it is not such a homogeneous picture. Millennials are a fragmented generation. In this respect, they are as divided as everybody else. Can we agree on the term socialist, because, maybe because I’m old, but when I think socialist, I think about the Soviet Union. I think long lines for food. I think disaster. Since you are a millennial, what do you think when you think of socialism?

Kate: I'll answer you as a professor, and then I’ll answer you as a millennial, I guess. I think that as a professor, I would say that the definition of pure socialism is a system in which the state owns and controls all means of production. Anything that you think of a regular corporation making, whether it’s computers or construction materials, all of those businesses or all of those means of production are owned by the state in a purely socialist setting. Now, is that what most people think of when they say “you’re a socialist” or “I’m a socialist” these days? Probably not. I associate the socialism of today and the socialism of the millennial generation with the state provision of things like healthcare, child care, elderly care, and education financed through higher taxes, particularly on the wealthy.

Luigi: So, by the millennial definition, the entirety of Europe is socialist.

Kate: Yes. But in particular, I think when millennials think of the ideal society, we think particularly of Nordic countries like Denmark and Finland and Sweden as the ideal.

Luigi: But that’s very interesting, because my experience of Scandinavian countries is that they do have a lot of redistribution. They do have a large welfare state, but also, they are quite capitalist in the sense of having a free enterprise system, having competition. And, in fact, one of the institutions of those countries, which is the flex security, a system of flexibility and security, is designed to protect workers, but also at the same time to make the firing of workers easier so that the companies are more flexible. It is, in a sense, a very capitalistic society looking at the means of production, but with a healthy dose of welfare system.

Kate: Yeah. And I think that most millennials would be on board with that. When we say that we disapprove of capitalism, I don’t think we disapprove of all of capitalism. I think we still want most companies to be able to exist. It’s just that, I guess, the tipping point or the threshold of what sorts of industries the state should have control over is a little bit further to the left than the prevailing regime in the United States right now.

Let’s jump into, I think, the prevailing view of why millennials are disaffected and why they claim to support socialism, which is that they’ve had a pretty rough go of it. They experienced the Great Recession. They have had a harder time across the board in a number of economic characteristics. So, let’s go through each of these and talk about why this hardship wouldn’t necessarily make you lean socialist.

Luigi: I think that, as you said, one cause is that millennials were hit by the worst crisis since the Great Depression. And so, of course, this shaped their view of the economy and the system very deeply. And, in fact, there is some new research in economics that shows that your experience of inflation early in your life shapes your expectation about inflation in the future. So, if you come of age at a time where the economy is not working very well, it was hard to find a job, you’re going to be more negative about the system for the rest of your life.

Kate: Yeah. The general takeaway is that if you’ve experienced a huge crisis at some point in your life, then that tends to stick around in your mind in a lot of choices and expectations that you form going forward.

Luigi: But if this is the reason, actually this is quite important, because this suggests that this generation might be more in favor of the welfare system and less in favor of a more, if you want, cutthroat competition, than previous generations, and not just temporarily, but maybe for the rest of their lives.

Kate: All right, so we experienced the Great Recession. Unemployment jumped 10 percent. Not only did we experience it, but the people in the middle of the millennial generation graduated close to that time. I remember, and I’ve mentioned this on the podcast before, but I had to take time off from college because all of the expectations that I had about getting a job after college and having everything be great went out the window. And I was very concerned about my ability to get a job at all. I thought the only recourse at the time was to take time off from school so I would be able to stay in college a little bit longer, hopefully ride out the recession.

Luigi: In your case, things turned out pretty good. I would say that the recovery was slow, but eventually it gave a job to most people. Today, the unemployment rate is a particularly low by historical standards. So, it’s hard to tell a story where these people did not get a job.

Kate: Yeah, I think that that’s totally fair, and that’s central to this question of whether or not it was a transitory shock or something that will stick around in people’s minds. But I think that the potential of not being able to get a job is something that lasts, even once economic conditions get better.

Luigi: There are a lot of people who have a job, but a job that doesn’t pay particularly well, and they still live at home with their parents. In fact, one of the characteristics of this generation is that they stay at home much longer than the previous generations, and they get married much later than the previous generations.

Kate: Right. So, to put some statistics on that. For the first time ever, living with your parents is the most common form of household arrangement for people in the age 18-to-34 group. That was according to a 2016 Pew Research study. And, in terms of dating and marriage, if we were living in 1970, the median guy would be getting married around the age of 23, whereas today, that number is more like 30. We’re staying sad and lonely for longer, Luigi.

Luigi: Yes. But as somebody who remembers 1970, I will tell you that Tinder was not around back then. And so, people were getting married earlier, because it was more difficult to find a mate online.

Kate: Fair, but I think that the millennial response would be that Tinder is hardly what people think of when we imagined fulfilling, satisfying life partners and relationships. Even though that is how I met my boyfriend. So, I’m a fan.

Luigi: One of the problems is not so much in my view the economy overall, but the distributional impact that the economic recovery had. While a lot of people found a job, not all jobs paid very well, and—this is the important difference—many of the members of the millennial generation came to their first jobs with an enormous amount of student debt that was not there before.

Kate: To put statistics on that, if we’re comparing Generation X to millennials, in 2004, 20 percent of Generation X had student loans, whereas in 2017, that was 33 percent. It went from about one-fifth to about one-third of people with loans. And then, in terms of the average balances, in 2017, student loan balances were more than double the average balance in 2004. The total amount of debt really ballooned in this time.

Luigi: And the problem is, when you start with a very different distribution of outcomes, owning debt or financing education with debt becomes a very inefficient way of financing. This is where our corporate-finance background comes in handy, because if you are in a company with a very volatile cash flow, you don’t want to finance your investments with that, because you’re very likely to go bankrupt. The same is true for a student. In the old days, where all the education was paid handsomely, financing your education with debt made a lot of sense. But in the world in which there are huge winners and a lot of less-lucky ones, financing with debt means that a lot of people would go bankrupt, and the number of people that are defaulting on their student debt is skyrocketing.

Kate: I think something that doesn’t get enough attention is how the cost of education affects inequality within cohorts. I remember that in terms of the job options that were available to people whose parents paid for college versus the people who were paying for it themselves. It just seemed like there was this huge unfairness, that you didn’t have this big burden to carry around if your parents footed the college bill, and you could choose whatever career you wanted. And I remember being deeply jealous of my friends who had that sort of freedom.

Luigi: But let me play for a second the devil’s advocate and say that all that you’re saying is true, but there are other elements that lead to the dissatisfaction of millennials. One is that they seem to have different goals in life. One anecdote that I just learned today, a former student of mine is running a bank in Topeka, Kansas. It is not the type of bank you imagine. This is the most advanced fintech bank in America, very state of the art, using technology, really revolutionizing payment systems, out of Topeka, Kansas. And the problem she has is that she cannot find workers who want to work there. And she just lost one of the best employees, who decided to be a waitress in Chicago rather than a software programmer in Topeka, Kansas, because of lifestyle considerations.

Kate: I mean, that seems like a little bit of an extreme example, but it is true that millennials are more urban. Eighty-eight percent of millennials live in metro areas, whereas that number was only 68 percent for baby boomers. Having said that, though, A, I think Topeka, Kansas, counts as a metro area, and, B, to not take a software job when you have the ability to do so and give that up is pretty wild to me.

Luigi: But it is important to see that this generation that was born in a very affluent world, at least, values other things besides money in a much greater way. I can see in my kids that one of the first questions they want to know from a job is, how much vacation do you have? And I find it actually refreshing that this generation wants something different than just money.

Kate: Yeah. It’s hard for me to necessarily tell whether this is my own bias, having always lived in cities or relatively close to them, or if this is truly a reflection of being a millennial. But I think one of the ideas for why living in a metro area is so much more appealing is that the whole idea of what pulled together a suburban or a rural community in the 20th century is this idea of church and family. Those ideas have maybe not fallen apart, but they don’t really have as much of a grip on the millennial generation. I mean, we’re much less religious than our former counterparts. And also, it’s harder for us to start families, partially because we’re getting married later and we’re not owning houses as quickly. And so, this idea of community that I think attracts people to living outside cities is not something that even necessarily seems attainable to us.

Can I talk about another reason that I think doesn’t get enough attention in the common discourse about how the millennial generation has been shafted in some sense?

Luigi: Please.

Kate: At least for millennials growing up in the US, we didn’t get a very strong education in STEM. And STEM is the one area where, like the 2000s or today, the job market looks a little bit like what I imagined the US job market looked like in the 1960s, where as long as you go to a decent college and you do decently well, you’re pretty much going to get a job afterwards, right? You'll find gainful employment and you’ll be making a decent salary and you’ll be able to afford a house within 15 years of working there, 10 years of working there. Whereas, outside of the hard sciences, that really doesn’t exist anymore. And yet I also feel, as an American having been educated in the US system, I just didn’t get those sorts of skills.

Luigi: It's funny because, actually, coming from Europe, coming from Italy, I thought that the only thing my kids learned in high school was math, and they did not learn history. In fact, they don’t know what socialism is about because they did not learn history. They did not learn literature so well. They did not learn very useful ancient languages that I learned, like Latin and ancient Greek. They only did math. So, I’m a bit surprised to hear that.

Kate: Yeah. I mean, maybe it’s all relative. I would say that the last thing I want to mention is that we’ve experienced a lot more inequality than older generations. The top 1 percent’s share of income in 1975 was less than 9 percent, whereas in 2015, it was 22 percent. And this is according to data collected by Emmanuel Saez. We’re just experiencing much more extremes in inequality. And I think that it’s much more obvious that this is an unfair system.

Luigi: You’re raising is an excellent point, and I think this is probably combined with social media. In 1970, there were a lot of rich people, maybe not as many as today, but you only saw them sometimes in some magazines with some pictures. You didn’t know how they were living, where they were vacationing. Unless you were very close to them geographically or because of some blood relation, you didn’t know about them. Today, you have many of these super rich, especially kids, posting their lives on Instagram, and Facebook is for old people like me, but whatever.

Kate: No. Instagram and Snapchat.

Luigi: OK. If I am an average kid, I get exposed to what the billionaires do in life. This inequality is also perceived in a much stronger way.

Kate: Yeah. And I would add to that one thing, which is that on Instagram and on Snapchat, if you’re a famous celebrity or if you’re some sort of socialite billionaire, like 20-year-old, there’s this culture of being accessible while at the same time being inaccessible. So, even though you might post pictures of yourself like your birthday party with Taylor Swift and Heidi Klum and stuff, you’re also messaging your fans and you’re responding to them. And in some cases, you’re even in private messages with them being like, “Oh, thank you for all of your support and for your love.” And so, there is the sense that these are my friends. These are my people, even though you really don’t know them.

Luigi: If you add to the real increase in inequality, this increase in perception of inequality, I think that you create a lot of disappointment for people, because many people graduate with a large debt but expect the world to turn into a successful startup that will make me a billionaire by the age of 29. You know what? This is extremely rare.

Kate: All right, so I feel like we’ve gone through several explanations or several reasons why the millennials got the short end of the stick. But what really bothers me, and, you know, maybe it’s fair, maybe it’s unfair, is that I feel like older generations have a different response to why millennials lean socialist, or at least they claim to, which is that we just don’t remember what it was like during the Cold War or the post-World War II era, when socialism and communism were actually very real and very scary threats. And we just sort of take for granted that if we were to become more of a socialist country in the United States, for example, that we would look like Finland and like Denmark, rather than like some of the countries that have had less-pleasant experiences with socialism.

Luigi: But I think that this explanation is a bit misleading. As we discussed earlier, I don’t think millennials want the Soviet Union. Millennials are more intrigued by an alternative way of living, like in Europe. You don’t need to be socialist to appreciate the lifestyle in Sweden. So, their like for socialism is more like a dislike of capitalism to begin with. And, second, a dream that, as all dreams, seems very nice from afar, but you don’t really manage all the details.

Kate: I mean I think we’re sort of on the same page here, which is to say that socialism goes hand in hand with repressive authoritarianism is kind of a false dichotomy. I mean, the socialism of today has actually been much more successful, I guess as long as we’re not counting Venezuela. And I think that when millennials think about socialism, what they really mean is social democracy. But even so, I think that it’s an important question as to whether, let’s say, in addition to what we’ve got going on in the United States right now, we had universal healthcare for everyone. Would that necessarily lead to authoritarianism?

Luigi: No. But I will distinguish very much between the redistribution of the welfare component from the production component. You can have healthcare for everybody, but not necessarily healthcare provided by the government. In Switzerland, you have a private system that insures everybody and is actually much more effective and much cheaper than the one in the United States. The same is true for schooling. The fact that you want to give schooling to K-12 or even university, free tuition, is independent of who provides those services. So, I think that very often there is a confusion in the debate between the degree of redistribution that you want and the degree of what I would call social insurance you want to provide. And the mechanism of allocation of control in the economy and how the economy really works. Very often, you can have the two merge, and the Soviet Union was trying to control one and provide insurance on the other.

But you can have a mix-and-match system. You have a system like Sweden, where you have a lot of social insurance, but you have a very effective system of competition and really a capitalist economy in all senses. And on the other hand, you can have very socialist economies that don’t necessarily provide a lot of social insurance. China, for example, does not have a good system of healthcare for elderly people. It is a system that calls itself socialist but does not provide some social insurance. So, I think that it is important that we distinguish between these two components. And my view of the millennials—but you are one, so you can reply on that—my view is what they want is, number one, more social insurance. And, number two, they want a capitalist system that works. And they see so many distortions in the existing system that they will vote against the distortions, and then they embrace the opposite just out of desperation, not out of conviction.

Kate: OK. Well, so then I think that’s a good segue into a third theory for why millennials are disillusioned with capitalism or prosocialism, which is just that it’s more of a reaction to the way that politics are today. And I guess you could say that there is some overlap between this and our first theory, which is that millennials are just disaffected.

But I think that there is some legitimacy to this idea that under the Obama administration, we tried to be fair and work both sides of the aisle and to trust the establishment, and to try to come to some sort of agreement in terms of how we would reform our healthcare system. And it just didn’t work. We are supremely disappointed with the way that reaching across the aisle and the status quo have worked out. And so, because of that utter failure, we’ve been forced all the way over to the left in order to be heard at all. And, in some sense, that’s also a response to what the Republicans did, to what Mitch McConnell did, just digging in his heels and being completely obstructionist. And so, even though the dissatisfaction with politics might be there across all generations, I think it’s easier for millennials to just say, “Hey, we’re giving up on capitalism. We’re going to move even further to the left.”

Luigi: Yeah. But, actually, this is one concern I have. When they say they move to the left, I understand they are pissed and they want to move somewhere else. But what does it mean to move to the left? It is not clear that there is a coherent platform that you can say today, this is a socialist platform of America or the social democratic platform of America. When you’re saying “I embrace socialism,” in practice, what do you mean? Because you don’t say that you want to nationalize Google and American Airlines.

Kate: No, I think that the two unifying elements of what millennials mean by the socialist agenda are universal healthcare and higher taxes on the wealthy.

Luigi: I will say that has nothing to do with the distinction between socialism and capitalism. It has to do with how much welfare you want in the system.

Kate: Yeah, I totally agree, and I think that most millennials, whether or not they’re also finance professors, would also agree. I think that millennials are woke enough to know that when we say that we’re socialists, this is a rhetorical device to make people wake up and realize that the stuff that we’re talking about really is not that farfetched. It’s really not that different than the model of capitalism that we already have. It’s just one that makes more sense from an equitable perspective. And if you have to call it socialism in order for people to pay attention, then so be it.

Luigi: It’s interesting, because that explains why so many millennials actually ended up voting for Donald Trump, because Donald Trump, at least in words, did advocate a higher level of social insurance. He was very much unlike the traditional conservative Republican in favoring some form of social insurance.

Kate: Yeah, absolutely. I mean, I still personally believe, and I think that maybe this is just my own view, but it’s not necessarily that millennials have had a tough time. It’s that baby boomers had an abnormally great time and that we’re never going to go back to that sort of growth. And that maybe capitalism in its American form worked for that period and happened to allow for the type of innovation and the type of growth that we saw, but that it’s not suited to the low-growth environment that I believe we’re going to have to live with going forward.

Luigi: I think this is a very important point, because one of the fundamental myths of America is this idea that everybody can make gigantic progress. To go from rags to riches is the American dream. For a long time, this American dream was guaranteed by an expanding country. This was the idea of the frontier. Then, when the expansion of the country ended, there was at some point a major crisis with the Great Depression. But after that it was guaranteed for many years by a very booming economy. When the level of boom sort of subsided and became a more normal growth, it was more difficult to provide and fulfill everybody with a dream. I think that Europeans converted earlier to a system of welfare because the opportunity for growth was seen as more limited. We did not have the ability to expand. The only way of expansion was fighting with a neighbor, and that did not work out very well.

Kate: Yeah. I think, unfortunately, today’s version of the American dream means graduating from your master’s degree program when you’re 28 years old with $250,000 of debt and getting a job that pays $50,000 a year. So, you have to get a second job driving an Uber car in order to even be able to begin paying off some of those student loans. And no one wants to date you because you’re not going to be able to pay off your debt until you’re 65. And so, you’re not going to have a family, and you’re not going to have a house. I mean, I think that that today is what the American dream is. And if we just sit around and don’t change anything, I think that that’s going to be devastating for the country.

Luigi: Let me try to make the optimistic case. We are in an era of enormous transformation, and I think that the millennials are exactly the generation on the cusp of this transformation. And, as a result of this, they suffer most of the costs of this transformation. But it’s not obvious that once we get over this cusp, the situation is not much better. So, I think history always provides a guide in this respect.

The end of the 19th, beginning of the 20th century in the United States was a similar era of gigantic transformation. Many people felt disenfranchised because of this transformation. The farmers lost their livelihood because international competition brought down the prices of most crops and, as a result, they had a hard time making a living. What happened is a lot of farmers became workers in factories and that allowed the Industrial Revolution, the second Industrial Revolution, to take off and to produce enormous benefits for the United States overall. So, I think that there might be another sort of bonanza past this cusp. But, of course, this generation faces most of the cost, and that’s a reason why they’re so resentful.

Kate: I sort of don’t want to respond because I’m just going to be depressing, so maybe we should just end on that positive note.

In our second episode on pollution, investigative journalist Carey Gillam joins Kate and Luigi to discuss her new book "Whitewash: The Story of a Weed Killer, Cancer, and the Corruption of Science." Gillam reveals how pesticide companies secretly influence scientific research and avoid EPA regulations.

Kate: Hi, this is Kate Waldock from Georgetown University.

Luigi: And this is Luigi Zingales of the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Kate: The is the second part of a two-part episode on pollution and the deleterious effects that it can have on your health. Last week we talked about air pollution, and we talked also about a pollutant called C8 or PFOA, which can show up in the ground, as well as in the air.

On this week’s episode, we want to continue that conversation, and Luigi actually stumbled across a pretty cool NBER working paper that just came out, about the effect of kids living or going to school near highways. Luigi, do you want to tell us a little bit about that?

Luigi: Yes. This is a fascinating new study that exploits the different exposures that schools have to the pollution generated by traffic, and compares the achievement of students that are near highways versus the ones that are distant from the highways, and finds that the performance is significantly lower when they are close to a highway, because of—and this is what they claim—because of the pollution that they get.

Kate: Yeah, one thing that I thought was cool about this paper is that the way that they measure the effect of being close to a highway on academic achievement, is that they look within a certain range of distances away from a highway. So, let’s say you’re limiting yourselves to schools that are only exactly 100 feet away from a highway. Then, they compare not only the differences between academic achievements in those schools, but they compare kids who moved from one school to another.

And they’re also able to observe wind patterns of these highways. So, you’ve got two schools that are equidistant from the highway. One of them is getting a lot of pollutants being pushed to them from the wind, and the other is having the pollutants pushed in the opposite direction from the wind. When kids move from the school that’s in the opposite direction from the wind to the school that’s downwind from the highway, they actually end up doing worse, in terms of their test-taking abilities, as well as their presence at school.

Luigi: Of course, what Kate is saying is very important, because simply the closeness to highways could be a proxy for a lot of other conditions, including the socioeconomic status of the people going to school, and so, by itself, would not prove the link with pollution. But when you go and look at people who move, then you can determine better the directional causality.

Kate: Yeah, actually, I moved when I was a senior in high school, from an area that was super far away from a highway to an area that was right next to a highway. I was maybe 100 feet away from it, and I did a lot worse in school the year that I moved. But I think it was mostly because I was a senior in high school and mostly interested in partying, rather than going to school, so maybe that was the confounding factor.

By the way, that paper was by Heissel, Persico, and Simon, and is called “Does Pollution Drive Achievement? The Effect of Traffic Pollution on Academic Performance.”

Luigi: OK. Moving to today’s episode, we want to look at, number one, another form of pollution, the pollution that reaches the food we eat. But, most importantly, we want to expand the conversation about the research that is supposed to protect us against these potential toxic substances, and to what extent this research is doing a good job, to what extent it is not.

There is no better person to help us in this conversation than Carey Gillam. She’s an investigative journalist. She worked at Reuters for a long time, and she wrote a very topical and timely book, Whitewash: The Story of a Weed Killer, Cancer, and the Corruption of Science. Welcome to the show, Carey.

Carey Gillam: Thanks for having me.

Kate: Carey, do you want to start off by telling us what inspired you to write this book?

Carey Gillam: I was a reporter for Reuters for about 17 years. Reuters is an international news agency. Prior to my assignment to cover food and agriculture, I had covered the banking industry. But there was a lot going on in modern agriculture in the mid-1990s, and Reuters asked me to move to Kansas and start writing about the changes that were coming about with the introduction of genetically modified seeds and the pesticides that were used with them. Twenty years later, I’ve written Whitewash, which is a really sort of deep dive into what I call a pesticide-dependent food system, and what the science shows us that that is doing to our health and to the environment. I say it’s not a feel-good story, but it certainly is one I think is important for everyone to read.

Luigi: The regulation of pesticides in the United States is done by the EPA, right?

Carey Gillam: The Environmental Protection Agency, correct. There’s an Office of Pesticide Programs within the EPA that specifically their job is to regulate pesticides.

Luigi: If I am a chemical company, and I want to introduce a new product, what do I have to do to sell my product to the farmer in Kansas?

Carey Gillam: In the case of pesticides, the EPA asks for a whole assortment of different tests. Animal tests, toxicology tests, that look at dermal absorption, that look at how these chemicals impact your eyes, for instance, if they create eye irritation, skin irritation, if there are any acute dangers, hazards. There was one particular pesticide used in agriculture called paraquat, and we know that if you get a little bit on your tongue accidentally, if a little bit splashes up and you ingest that, you’re probably going to be dead in two or three weeks.

Luigi: In two or three weeks?

Carey Gillam: In two or three weeks, so these are the things that regulators want to know about. They rely very heavily on the companies to provide the data, the tests, that say whether these things are safe or not.

Kate: Why do you think the regulators rely so heavily on the companies? I mean, can the companies be trusted? Wouldn’t you expect the companies to say, “Oh, our product is good”?

Carey Gillam: A lot of people refer to this as the fox-in-the-henhouse type of situation. Yes, in a perfect world, we would love to have all of the money to plug into independent scientists who can do both short-term and long-term studies on all of these pesticides. But in the world we live in, that just doesn’t happen. The type of experiments that are done, the type of studies that are done, are very expensive, in many cases. What you really like to see is long-term studies. The companies are the ones that are going to be making the billions of dollars in revenue, so they’re the ones who are willing to put up the sometimes millions of dollars that it costs to do these studies in the first place. So, this is how it comes about. Our EPA, our government, does not provide the funding for the EPA to do studies. We rely on the companies to a large extent and then independent scientists as well.

Luigi: This is not that different from drugs, right? The FDA is requiring the pharmaceutical companies to do the studies, and then to decide whether this is safe and effective or not. It’s very different from the other chemical substances, because other toxic substances are introduced without any screening, unless they’ve proven otherwise.

Carey Gillam: Right. I mean, there are tens of thousands of chemicals that are in our environment, that we are exposed to on a daily basis, that really, there is very little testing that has been done on those.

Luigi: But one thing, at least I understood from your book, is that in many of these situations, the problem is not only or necessarily the substance per se, but also the interaction the substance has with other stuff in the environment. So, to what extent can these studies even be done? Because if this stuff is bad for everybody, it’s relatively easy to catch. But if it is bad in certain conditions, or in combination with certain soils that are impossible to detect—

Carey Gillam: Yeah. I mean, definitely, the acute reactions of course, like paraquat, as I mentioned earlier, that’s pretty easy to determine. And farmers use it. It is something that farmers use, but they’re aware of the risks. There are a lot of very detailed warnings and things like that, so farmers can be aware of that. But it’s this chronic sort of exposure that we really don’t seem to know very much about. And, as you said, the interactions with other chemicals and other classes of contaminants, and the multi-levels of exposure, because you have dermal exposure, inhalation exposure, but you also have dietary. So, you’re getting these chemicals in your food and in your drinking water.

Luigi: And here I would like to make a distinction, because very often it’s not done. And maybe I’m too much of an economist here, but there is the cost-benefit analysis from the point of view of the farmer. The farmer takes a risk in using various pesticides and makes profits by using these pesticides. But then this stuff ends up in our food, without any choice. So, I think that there is what we call in economics an externality, which is pretty big. This is where the government should intervene in evaluating that externality, because we were talking about C8 in the last episode. C8 is shown to reduce fertility in men. That’s a pretty severe issue.

Carey Gillam: It is. I mean, I focus a lot of the work I do on Monsanto and glyphosate. Glyphosate because it’s the most widely used herbicide in the world, and it’s so pervasive. But of course, as you pointed out, it’s by no means the only thing that we have to be concerned about out there: C8, PFOA. Chlorpyrifos is a very popular insecticide that has made a lot of money for Dow Chemical. Their science has shown it to be just fine. Independent science has shown that it causes neurodevelopmental damage to children who are exposed to it.

The science is so strong, and there’s such a consensus on this science among the independent science community, that it’s been banned from household use. They convinced the EPA to ban it. It was supposed to be banned from agriculture in 2017. They finally convinced the Obama administration, the weight of science, that this stuff that the government had told us was so safe for so long in our food and our water, now the weight of science has said, “Yeah, you know what? We were wrong.” So the government, the EPA, decided to go ahead and ban it.

Then the Trump administration came in, and Dow Chemical sat down with the new administration and gave $1 million to the Trump inaugural fund, and the ban went away. So, when you talk about science, you really do need to understand there’s so many different political ramifications, profit agendas, behind these things. It seems like public health and public good take a backseat quite often to these other issues.

Kate: I want to talk more about the role of big money in politics, big ag money. But first, I want to go back. So, last year Luigi and I did a podcast episode about the opioid crisis. We talked about the ways that big pharma was able to influence doctors by holding these very fancy conferences and giving away all of this swag, and making them feel wined and dined, and convincing them to prescribe their drugs. It sounds like there’s a lot of this going on in the ag industry as well.

Also, something that seems to happen is that if the carrot doesn’t work, there seems to be some of the stick. So, if farmers aren’t sold by marketing efforts of these big agriculture companies, then there’s actually cases of bullying and intense pressure put on them to use certain products. Can you tell us a little bit about how this works?

Carey Gillam: Well, one good example that we saw in the early 2000s was in the US, wheat farmers. Wheat farmers didn’t use a lot of Roundup. There is no genetically modified wheat like genetically altered corn and soybeans that are designed to be sprayed right over the top with Roundup. The same thing didn’t exist in wheat, and Monsanto really wanted to introduce a Roundup-ready wheat, so that they could sell a specialty patented seed to wheat farmers, and that the farmers would then spray the wheat with Monsanto’s Roundup.

I went to all of these meetings and watched this unfold, and they put a lot of pressure on them. They tried to apply funding to different groups and organizations, or take it away from others, and get their own people to head up wheat industry boards. Export markets were very upset and said, “We’re not going to buy wheat from the US if this gets rolled out.” It was a very, very big fight. Through it all, the farmers kept saying to Monsanto, “We don’t want it.” Monsanto kept saying, “Too bad, you’re going to get it.”

In the end, there was so much publicity about this that Monsanto did go ahead and say that it would shelve the company’s Roundup-ready wheat. So, it still hasn’t introduced it, but they tried awfully hard to shove it down the throats of farmers for a very long time.

Luigi: This is the part I would like to discuss now, because I think something that maybe as economists we’re less willing to accept or recognize is how much the process of research might be distorted by standard economic incentives, but in a way that makes it difficult to know the facts. Monsanto can be very politically influential and decide what is the right tradeoff. But at least if we had gotten the facts right, people could somehow object to it.

The problem is that, it seems to me, we don’t even know the facts. So, what I would like to discuss and would like to start with you, Carey, if you can sort of tell us what you learned in your research about how academic research is affected. Because the typical economist will say, “Look, there are two sides of every issue. There is a reward to tout each side. Why shouldn’t we expect that, on average, the truth prevails?”

Carey Gillam: I think what we’re seeing is that on average, money prevails. If you’re talking specifically about academics and professors, and scientists who are working at different universities and are doing research, and trying to share that with the public, what we’ve seen over many, many years is that, increasingly, big corporations are funneling money to these research programs, many millions of dollars in many cases. Even though it’s not supposed to affect the research, we do see them stepping in to sway or to direct the research. We know that there’s pressure, and we—

Luigi: Can you elaborate on this? Because even in economics, there are a lot of people that finance research. We think that they are kept at bay, they don’t have any influence, et cetera. So, what is your best evidence that, actually, this financing matters dramatically to the results?

Carey Gillam: Well, I guess there are many. There’s some laid out in the book. You can look at the University of Florida, for instance, or the University of Illinois, or the University of Nebraska, or around the United States, and they also engage in this activity, we know, in Europe. But again, I’m going back to Monsanto, this has been my main path that I’ve written about, is how they’ve done this. Funneling to a university, and identifying a particular professor who works in the area of science that is beneficial to them, and directing that professor to do this research or to make these policy statements. To go and hold classes or seminars or lectures, and in many cases Monsanto would provide the PowerPoints, provide the narrative, provide the talking points that this person is to deliver on their behalf.

Now, that’s a pretty extreme example, but it’s one that we saw in the documents that we obtained through Freedom of Information Act requests and state records requests. We’ve seen the correspondence, and we see the money flow, and you see how they talk about hiding the money flow. At the University of Nebraska, there was a professor who used to work at Monsanto, but he went to the University of Nebraska to run a food program that looked at the allergenicity of food, and to really study this, because, of course, so many people are afflicted with food allergies. But what we find in all the documents is that his program was being funded by the big corporations who wanted to make sure that he didn’t find any allergenicity problems in products that were connected to them. You see the correspondence, and you see him very worried about making sure he keeps them happy so he keeps funding to his research program. This is just repeated over and over and over.

Kate: Yeah, I would like to see, and I’m sure this exists, but I’m just not aware of it, a large-scale study across all different fields that observes the relationship between receiving funding from an organization and scientists’ findings that are in line with the view of that organization. It would just be interesting. If you did this across all fields, and then within the field, and then looked at different interactions and the extent that results were aligned. But anyway, one anecdote that I liked from your book, I think there was a story about a guy who was being funded for some research, and the company that was funding him, when referring to the research findings, said, “Oh, they’re going to say this,” before the research study was actually done. Am I . .  .did that happen?

Carey Gillam: Yeah. I mean, they know what they want it to say, and they’re going to direct that. We’ve seen that, again, in many cases. This gets also into ghostwriting. I mean, we saw in documents that were obtained through state record requests, professors at different universities who were lined up, and they were essentially assigned to write specific papers that would say specific things. They were given the assignments. They were given the points that were supposed to be covered in their papers. One of the main things was they didn’t want anybody to know the company was behind it, because these papers were going to promote, essentially, policies that would benefit this company. Every single one of the professors did as they were told, without stating the backing of these companies.

Luigi: I found something in your book that, to me, was even more offensive. Apparently, there is an email from one Monsanto executive that told colleagues in February 2015 that they could ghostwrite research material, and that certain independent scientists from outside the company would just edit and sign their names, so to speak, just as they had done it with a 2000 study.

Carey Gillam: Yeah. I mean, these are the things that have come out through Freedom of Information and through litigation discovery documents. We’re seeing, in particular with Monsanto, which has been in the news a lot, discussions internally in the company about how they ghostwrite papers, ghostwrite scientific literature. We know, for instance, in this email that you’re referring to, this illuminates us on two different papers. One, Monsanto refers in that email to ghostwriting a paper authored by scientists Williams, Kroes, and Munro in the year 2000. That paper found just complete safety, no reason to be concerned about glyphosate whatsoever, and that paper has been foundational to regulatory reviews around the world. The EPA and every regulator have cited this as evidence that we should not be concerned.

We now know that Monsanto considers that they ghostwrote that. They were talking about ghostwriting a new set of papers, and, in fact, those papers were published in Critical Reviews in Toxicology. The title of the papers was “A Review of Glyphosate by an Independent Panel.” In the declaration of interest, it said, “No Monsanto employee nor Monsanto attorney has reviewed these papers,” when, in fact, the emails show us a very in-depth discussion by Monsanto’s top scientists about what they’ve already written, what they’ve drafted, what they’re changing, what they’re editing. In their own internal emails, they’re trying to decide what independent scientist’s name is going to go on the paper that this Monsanto scientist has just written. Those papers got published, but this is just one example of things that we know have gone on for decades.

Luigi: So, let’s start to try to think about solutions. In your book, you mention a pretty straightforward one, which is to say, “Why don’t we tax the people who introduce pesticides, and with that money we fund independent research?”

Carey Gillam: Yeah, and actually that sort of idea and that movement is going forward to a certain degree. I think people would like to see more of that. They would like to see the companies really have to fund a very robust system of research that would, in fact, be truly independent. We’re not anywhere close to that at this point. But it’s something that people are talking about, and companies are having to kick in for the new requirements under the Toxic Substances Control Act, so we’ll see. That’s one idea.

Luigi: But that is a lovely idea, in my view. But it does raise the issue, who is really independent?

Carey Gillam: Again, yes.

Luigi: Because it’s very easy to determine if you work for Monsanto, you’re not independent. But if you work for an NGO that’s trying to fight pesticides, are you independent, not independent?

Carey Gillam: In theory, I mean, our government scientists should be independent. Our government scientists who work for the EPA are independent. They should be working for the public, so it would be ideal to have enough money and enough resources for these scientists to truly do the kind of work that would be revelatory. But what we’ve seen, as I said, in the past what we’ve seen is, even when they are analyzing research, if it doesn’t comport with what the chemical companies want, these scientists just get stomped on.

Kate: Carey, in the spirit of independent research and disclosure, I think we would be remiss if we didn’t ask you about the organizations that you’re affiliated with and the funding for those organizations. Could you tell us a little bit more about that?

Carey Gillam: I left Reuters at the end of 2015, and in early 2016 set about writing the book and also doing research for this nonprofit called US Right to Know. It formed, I think, in 2014. It’s very small, very new, very young. It was started with some seed money, no pun intended, I guess, or maybe, from the Organic Consumers Association, which, again, is another nonprofit and is a consumer group, not to be confused with the Organic Trade Association, which is made up of organic companies. Organic Consumers Association is aimed at trying to defend and uphold the integrity of the organic standard, and, of course, educate consumers. But they’re just one funder over time. The last time I checked, the largest donor this year was the Arnold Foundation, which supports a lot of other organizations that do research, including ProPublica, the Center for Media and Democracy.

What we do, what I do now in my job, is almost nothing but file Freedom of Information Act requests, trying to get data and documents. We share all these documents with the public through a database maintained by the University of California, San Francisco. So, reporters and lawyers and lawmakers and pretty much anybody who wants to can access all of these documents that otherwise would be really, really hard for them to find.

Kate: OK. I personally think that the biggest issue we need to address, pretty much agreed upon, is power and money and politics, and creating a separation between those things. Close the revolving door. I think there are ways that we can do that, that would actually benefit politicians. It’s like, “Well, if you can’t work for a large agricultural lobbying firm for two years after you’re done working for the EPA, then, in exchange, you’re going to paid more.” I think that there are people who would sign up for that, as long as they get paid enough more.

Luigi: But I think that rather than complaining about the political system, I think what we should do is try to fix the university system, because it seems that one of the big problems is academia. Number one, the lack of transparency. But even with transparency, I think that there is not enough censuring of people that get their stuff written by somebody else. I think that that is absolutely horrendous. It’s easy to say when it’s in a different field, but I fear we in economics are not exempt from that.

Kate: Absolutely. I would like to prefer the carrot over the stick, particularly when it comes to my own industry. But, unfortunately, I don’t think that it would work here. I think that we need harsher punishments for people who fabricate data and for people who find certain findings at the behest of their financial sponsors but don’t disclose those relationships.

I think that there should not only be career consequences, but there should also be financial consequences. But I also think that there are problems with the peer-review process. We tend to assume that when we hear the term “peer review” that everything is going to be OK. But I think that there is deep corruption in the peer-review process. It’s surprising to me that we don’t see, at least in economics or finance, we don’t see that many publications that are retracted or findings that are overturned. And if there is a debate, then usually that takes place in conference rooms. But you don’t see it publicly. I think that debate over findings is healthy and should be encouraged.

Luigi: So, in these two episodes we’re trying to look at pollution from a different point of view. All the attention these days is on CO2emissions. The traditional pollution of our water, our air, our food has kind of taken a backseat. But, number one, it’s problematic because this has a lot of costs. A lot of costs in terms of our health, and if you don’t care about health, in terms of our ability to produce successfully. Second, I think that people don’t fully understand how much this lack of interest for this type of pollution is the result of a political-economy equilibrium, where I think it’s easier to discuss CO2because we all produce it, and there is not a particular target. The cows produce a lot of CO2, so everybody is responsible for CO2.

When it comes to aerial pollution, where there is a clear company or a couple of companies that are the villains, nobody has the courage to go after those companies, because they are too influential: politically, on the media, in academia as well.

Carey Gillam: Well, and this ties the economics together with it. Our National Toxicology Program in 2016 issued a paper, very long and lengthy, looking at the economic costs of the toxic environment that we’re allowing. Basically saying, if you don’t care about the cancer and the infertility and the environmental pollution, the loss of biodiversity, if you don’t care about all of that sort of thing, let’s lay out the economics for you. So they laid out how much lost IQ points means to us, in terms of productivity in the future and that sort of thing.

I mean, that’s the larger message, is that we’re sort of being conditioned to just accept these toxins and pesticides and other chemicals and heavy metals in our food and our water. We’re being conditioned to think that that’s OK, and that’s normal, and that it’s OK to be sick, that we’re just accustomed to being sick. All the people who have cancer, they’re living longer, and that’s a success story, and we cheer that we can have body parts cut off. You can be radiated and pop pills, and yee-haw, because we’re living longer with cancer now. But this report laid it out and said, “Why don’t we start focusing on preventing these diseases to begin with?” And the first part of that is understanding the real risks and having transparency, and then going about setting policy.

In the first of a two-part series on pollution, Kate and Luigi discuss the health hazards and economic costs of air pollution and contaminated drinking water from the toxic chemical PFOA (C8) found in Teflon. How did DuPont skirt regulation and avoid corporate responsibility for so long?

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: This is Kate Waldock from Georgetown University.

Luigi: And this is Capitalisn’t.

Kate: A podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Speaking of what is not working, just before Christmas, I went to a conference in New Delhi, and when I landed, the air was unbreathable. I had been there 20 years ago, and it was bad, but this time, it was really, really bad, so I started to look at some numbers. One way you can measure pollution is by how much small particulates are in the air, and, generally, the healthy stuff is between one and 100. In California, when there were the fires, the big fires, it reached 200. That day I was in New Delhi, it was 450. I had to buy a mask just to survive.

Kate: Yeah, I mean, that’s insane, but I think another insane thing about that story is that, as an American, when I think about traveling to other countries, I’m automatically wary. I think, “Oh, I need to get a mask,” and, “Oh, I need to get water tablet pills,” to make sure that I don’t die of malaria or something, but I take for granted that here in the US, everything is clean. We don’t have those problems. Those are just foreign problems, when, in actuality, that’s not really the case.

Luigi: To be fair, our problems are much, much lighter than the one in India, but they do exist and not only with regards to the PMI index, which is this particulate matter, but other things we’re going to discuss in this episode.

Kate: Just as a disclaimer, when we talk about pollution or when you hear the word “pollution,” you might think that’s really a topic that concerns climate change and global warming. On this episode, we’re not going to talk about that sort of pollution. We’re going to focus on environmental health hazards like contaminants of your groundwater and your air quality. At a later time, we’d like to fully flesh out issues relating to climate change and capitalism, but we hope to discuss those issues in the future.

Luigi: Let’s start with one of the leading causes of death in the United States and in the world: small particles that are brought into the air by burning fossil fuels or by burning crops. They’re so small that they enter our lungs and they cause a number of respiratory diseases, but, most importantly, they are a primary cause of cancer.

Kate: Now, one of the challenges for economists and scientists is to try to figure out how bad these particles actually are. Of course, a natural thing to do would be to collect data about areas where there are lots of these particles, and then you collect data about deaths in those areas, or respiratory diseases or cancer, and then you come up with some sort of correlation between the two. People have done that, and there seem to be pretty high correlations between respiratory disease and particulate matter. However, that still doesn’t really address the issue of whether the particulate matter is causing the disease or the death, because there’s so much else going on in the environment that we don’t know or we can’t measure.

Luigi: Recently, as an economist, I resorted to a technique with a fancy name, but with a very simple idea. It’s called regression discontinuity, and let me try to explain the ideas in simple words. The example we’re going to use was used by a colleague to estimate how much the increase in this particulate matter increased death.

In medical science, if you want to see what generally cures a disease, you do what is called a controlled experiment. You have a treatment sample and you have an untreated sample. You make sure that the two samples look identical, and then the difference in results between the two gives you the impact, for example, of a new drug. Especially when it comes to pollution, you are not allowed, thank God, to randomly treat people and say, “To you, I give you a lot of pollution, and, to you, I don’t,” and see what happens. However, there are some policies that come pretty close to doing that.

In early communist China, Mao Zedong decided that everybody who lived north of the Wei River needed to be heated, and so they gave away coal to heat their houses. But if you were just south of the Wei River, it was warmer and you didn’t need to be heated, so the Communist Party would not give you any coal to heat. The people just north of that river were treated with a massive amount of pollution from coal, because everybody was heating their houses with coal, and coal is actually the biggest source of this particulate matter. As a result, data show that people living north of the river had a 46 percent higher level of this particulate matter in the air than people living south of it, and life expectancy was actually a year shorter just north of the river versus just south of the river.

Kate: I appreciate studies like this. I think that they are clever and I think that they help establish causality in environments where it’s really difficult to do so. I have a general criticism with this approach and the way of thinking of a lot of economists. I don’t think that they appreciate correlations enough, and I think that they put too much emphasis on these types of studies. If we have overwhelming evidence based on correlations, that should be enough for us to really get a good sense of how much this particulate matter coming from coal can impact life expectancy. OK?

Luigi: Actually, I recently discovered that the Nazis discovered that smoking kills you with a correlational study in 1939. As a result, Hitler prohibited everybody around him to smoke cigarettes, and he was actually proud that the fascist leaders were not smoking, Hitler, Mussolini and Franco, while the allies were all smoking, from Roosevelt to Churchill to Stalin.

Kate: Wow. That’s a super interesting fact.

Luigi: After the war, all this research was thrown away with all the Nazi research, and it took more than 10 years for the Americans to figure out that, actually, smoking kills you.

Kate: Hitler’s revenge.

Luigi: Anyway, this is to say that, you are right, sometimes correlation studies can be very useful in identifying a problem before you do these random treatments. But I think that these are useful in trying to get closer to the standard of causality that other sciences use, and, in economics, it’s more difficult to use it.

Kate: Yeah.

Luigi: Now, what is interesting is that Michael Greenstone, who is one of the authors of this study and a colleague here at Chicago, went farther than that. He actually used satellite data to measure the level of this PMI index in a lot of cities around the world. As a result, I can tell you, if you live in Los Angeles, you end up living one year less than the average. If you live in New Delhi, you end up living 10 years less than your life expectancy.

Kate: That’s crazy.

Luigi: It’s a pretty dangerous proposition to live there.

Kate: Yeah.

Luigi: The other thing which is quite interesting is that, until 2008, the worst place was probably Beijing. Now, Beijing has made a very concerted effort in trying to improve pollution. I think one aspect that is often ignored is that these studies are very useful in focusing people’s attention, because if you just have an idea, “Oh, yeah, pollution is bad,” that is one thing. If I tell you that you live 10 years less because of pollution, the government would pay attention, so I think that it’s certainly an important step in trying to create the demand for change.

Kate: Aside from just the underemphasis, I think, on pure correlational studies, another bone to pick that I have with this experimental design is that you have a cutoff, and you’re looking on one side of the cutoff versus the other side. In this case, the cutoff is people living above the river and people below the river.

In order to estimate the impact of pollution on, say, life expectancy, you want to see some difference in life expectancy around the cutoff. In order to do that, you’re collecting data on either side of the river, and what economists and data scientists often do is that they have to fit some function to either side of the cutoff. I have issues with the incentives that are in place in fitting those functions, because the incentive is to choose a function that will maximize the difference in outcomes.

You really want to say that there’s a big impact of pollution on life expectancy, and so you always see these graphs that make it look like the authors have absolutely tried to pick the function that makes it look like there’s the biggest jump in outcomes on life expectancy when, really, maybe there was a jump, but it wasn’t that huge. I would say that there’s some of that going on in this paper. I’m not sure that it really looks like there is a full year of difference here, but there is a difference, so I will grant them that.

Luigi: Also, I think, Kate, you’re right that there are these incentives. However, there’s a tension between saying nothing precisely or precisely nothing, and I think there’s a lot of value in having some estimates that might not be perfect. But if you just see an index that goes to 450, you can’t really relate it to your life. If they tell you that you’re losing 10 years of your life and you could only lose one if you move to LA, that makes a big difference, and maybe you’re losing between nine years and nine months, but it’s still a huge difference.

Kate: Maybe the air quality in the US isn’t quite as bad as it is in New Delhi, but there are still cities in the US where particulate matter is a problem—particularly in LA, for example—and one of the issues is that we’re not really moving in the right direction. The EPA under Trump is starting to roll back some of the measures that are designed to protect people and the health of their lungs rather than strengthening them, and I think part of the reason for that is because of the people we see leading the EPA.

You would expect someone who is head of the Environmental Protection Agency to actually be concerned with protecting the environment, but, in fact, we had . . . Formerly, there was Scott Pruitt, who was on the record saying that he wasn’t convinced that carbon dioxide was necessarily a contributor to global warming, and now we have Andrew Wheeler, acting head of the EPA, who has an established record as a lobbyist for big coal.

Luigi: This is very important because, of course, companies could use more efficiently and at a lower cost if they don’t have to worry about the externality they generate through pollution. Regulation does increase costs, but also, regulation has an impact on human lives.

The function of the EPA is to put rules in place so that companies can focus on producing, and know what they can and cannot do in terms of polluting the environment. The problem is that this regulation does not seem to be working very well, and Kate is absolutely right. One of the problems why this regulation does not work is a very intense revolving-door system. If you look at all the EPA administrators since the early ‘80s, most of them either became board members of major polluters, from chemical companies like Monsanto or DuPont to oil companies like Conoco. Others started consulting on environmental business, probably having these people as clients, if not going directly to work for those companies. I think that the revolving door is massive at the top, but it is massive even at the intermediate level.

The principal deputy on the Office of Chemical Safety and Pollution is a certain Nancy Beck, who for many years had been an executive of the American Chemistry Council, so she was basically a lobbyist for the chemical industry to reduce pollution, and she has been put in charge of the henhouse.

It’s not just a problem of incentives. As an economist, of course, I think incentives are very important, but it’s also a question of your way of thinking and, basically, a lifetime of research. If you are somebody who worked for the coal industry all his life, you probably think that coal is the greatest thing since sliced bread and that all the environmental issues are second-order.

Kate: I think we should talk about the DuPont case, because it’s a pretty good illustration of what’s broken in terms of environmental pollution and trying to protect citizens against it. For those of you who are not familiar, DuPont is a chemical company. By the way, it merged with Dow Chemical in 2017 to create DowDuPont, and it’s now the biggest chemical company in the world. One of its flagship products is Teflon, which you’re probably familiar with in terms of the liner of your pots and pans. It’s a nonstick product. DuPont has actually been making Teflon since the ‘40s, and one of the chemicals involved in making Teflon is called PFOA, or C8. It used this product in the manufacturing of Teflon for over five decades.

Luigi: For the record, the division that was producing Teflon has now been spun off by DuPont, and its name is Chemours, and it is separately traded on the NYSE, so all the information we’re describing today does not regard DuPont directly. However, what makes this case very interesting is that litigation brought up a vast number of internal documents that allowed people to make a calculation of what decisions were made back in 1984, when DuPont became aware of some problems, and, I will say in a second, pretty big problems of C8. It decided not to stop production, not to introduce a form of control or reduction of pollution, but actually to double production.

By the early ‘80s, DuPont either knew directly or was made aware by 3M, which was producing the C8, that C8 was a toxic product that needed to be handled with care. It also knew that, in mice, the exposure to C8 could lead to birth defects. After receiving this study, DuPont went and looked at all the women that were working in the plant that was producing Teflon. Of the seven women who had been pregnant, two had children with birth defects, and the same kind of birth defect identified in the mice, so much so that they decided to remove all women from the production of Teflon. But then, they also sent some employees to sample the water supply in the area in West Virginia where the plant was, and they found abnormal levels of PFOA in the water supply.

In spite of all this, they didn’t do anything. They didn’t report to the EPA. They didn’t do anything. They decided to double production of PFOA. Now, what’s interesting is, several years later, a farmer who happened to have a farm next to the plant started to see his cows die. They died with green eyes and very strange behavior. He immediately thought that the cause was a landfill by DuPont that was nearby. He tried to get some compensation from DuPont, and DuPont said, “Go away. You don’t know how to raise your cows.” He got lucky because he remembered that, when he was a kid, there was a guy playing with him that later became a lawyer in a major law firm in Cincinnati, so he reached out to him.

This lawyer, whose name is Robert Bilott, in spite of the fact that he was a top corporate lawyer, decided to take this plaintiff case just out of friendship. He understood from the internal documents of DuPont what PFOA was and started a major case. This case started in the late 1990s and the last settlement took place in 2017.

Kate: I also think it’s worth mentioning that this C8 didn’t just happen to get into the water supply. It wasn’t just an unfortunate accident. DuPont was just dumping the C8 into the Ohio River through tubes. They didn’t care. They were just like, “Let’s get rid of it. We don’t even want to bother securing it. We’re just going to dump into the river.” They were also creating these landfills that were unmarked, so they were intentionally trying to keep them secret. They were just burying the C8 and they were also emitting it through their smokestacks, so it was basically getting into the environment in the worst ways imaginable.

Luigi: To be fair, DuPont is not the only producer of C8 and is not the only one that polluted America, because I’m sorry to report that 99.7 percent of Americans have C8 in their blood. It also came from the 3M Scotchgard, from a lot of flame retardants, and it’s unfortunately used a lot by the military as anti-fire stuff, so I think that pollution is all over the place at levels that are quite dangerous.

Now, if it wasn’t for Robert Bilott, we’d never have discovered the effects of C8. Because C8 is a substance that is called biopersistent, which means that it’s not disintegrating in the environment and it accumulates in your body. Nobody really knew what that accumulation led to. Bilott had the brilliant idea to ask for an independent study. The problem with this independent study is where you get the data.

Bilott used some of the settlement money in one of the earlier cases to pay people in the affected area to donate blood. They went near Christmas with some trucks, asking people to donate their blood in exchange for $400. As you can imagine, $400, especially in West Virginia, especially next to Christmas, goes a long way. Out of the 70,000 people that were affected, he was able to collect 68,000 blood samples.

I don’t know whether you remember the movie Erin Brockovich, but, in that movie, there is a similar situation in which the main character is able to collect an enormous amount of data. We now know PFOA is responsible for an increase in the numbers of testicular cancer, kidney cancer, hypertension and another set of less lethal diseases.

Kate: Backing up a minute, I think it’s important to go through the thought process of the Tennant family. If you just realized that all your cows have died, and you’re trying to figure out what to do, what remedies do they have? Here, I think, there’s numerous ways in which the system just broke down for them. The way that they ended up getting DuPont is that they won based on a negligence suit. These types of lawsuits are in the realm of what’s called toxic torts. They were suing DuPont for being negligent, but, in order to do that, you have to prove a couple of things. First, you have to show the defendant was negligent and that they caused them harm.

In this case, it was up to the Tennant family to show that DuPont had caused the Tennant family’s cows to die. Now, what sort of information did they have at the time? Absolutely nothing. It’s, in fact, really hard to show proof. You have to know exactly what the chemical was that caused the harm and you have to be able to prove that chemical was directly responsible for the harm, and from the point of view of the Tennants back then, it was virtually impossible.

Luigi: Just to give you a sense, there are now roughly 85,000 substances, chemical substances, that have been used commercially, and every year, 1,500 are added. Unlike new drugs that go through a very lengthy process to establish that they are safe to use, basically, in the United States, new substances are considered safe for use unless proven otherwise. The burden of the proof is on the plaintiff or the people who are damaged or the EPA, who, as we said, is fairly cozy with the largest producers.

Kate: On top of that, there was another element to this case concerning the EPA, which was that, back in 1976, the EPA passed the Toxic Substances Control Act—which you might think, based on the title, would have allowed the EPA to regulate this sort of substance. The problem was, if materials or chemicals existed prior to 1976 when the act was passed, they were grandfathered in, as long as they weren’t already proven harmful at that point, which C8 wasn’t, because we just didn’t know enough about C8 and its health effects. And DuPont had no incentive to try to establish them, because, otherwise, it would have opened the chemical up to not being grandfathered in. The EPA at this point didn’t even really have the authority to try to test whether this was, in fact, a harmful substance.

Luigi: Recently, this regulation called TSCA has been revised. In fact, in a rare bipartisan move in 2016, a new TSCA law was passed in which, on the one hand, there would be more intervention by the EPA in terms of testing. On the other hand, there would more grandfathering and tolerance for the existing substances. Unfortunately, after the industry got in this nice spot, the administration changed, and the new EPA seems not so eager to do the tests they were supposed to do. So, while the regulation was meant to be at least a partial improvement, it might end up being a step back.

Kate: Another reason why this case, the Tennant case, was great that it won, but not the best example of an everyday pollution toxic tort case, was that the lawyer that you mentioned earlier, Luigi, Robert Bilott, wasn’t exactly your typical lawyer. In most cases like this, if you have enough people who have been harmed by environmental pollution, they would get together and form what’s called a class-action lawsuit to sue the company that was responsible for the damages. But the thing is that class-action lawsuits are expensive, and they take a long time, and they’re risky, and a lot of the financing for class-action lawsuits comes about through debt. That makes it such that the lawyers who are responsible for pursuing these types of cases tend to be risk-averse. They don’t necessarily want to go after cases where there is not much information and where the company has an established record of trying to hide that information. So, if this had been pretty much any other family without those sorts of connections, it would have been very unlikely that a class-action suit would have even been launched against DuPont.

Luigi: What is scary here is that DuPont is not your typical fly-by-night company that does pollute the environment and run away, et cetera. DuPont is probably the most blue-blooded corporate entity in America. It’s one of the oldest companies still in business and is praised for the way they’ve treated the environment, the research they have done on environmental risk for their employees. Even one of the CEOs during all this debacle, Charles Holliday, wrote a book called Walk the Talkdescribing how you can be a chemical company and be very good for the environment. Ironically, all these people, from the CEO to the directors to the people who made the decision in 1984, are either dead or retired, and they’re paying no reputational cost for what they have done.

Kate: Yeah. I think another interesting element of the reputational cost story is that DuPont is a chemical manufacturer. It’s not like I go to CVS and I buy DuPont goods all the time. When you think about reputational damage, for example, like Wells Fargo and their fake-accounts scandal, as a consumer, I might have the direct ability to change my bank, or I might have the direct ability to stop buying that good. But for a company like this, where what it produces is often an intermediary in the production of another good, the consumers don’t really have that much power to stop buying goods, because they’re not direct.

Luigi: Normally, in corporate finance, we think that what keeps companies at bay is a combination of legal liability, regulation, and reputation. Kate just explained to you why reputation does not seem to work. We discussed why regulation is not very effective, in part because of this revolving-door policy. Even legal liability does not seem to be that great.

In a study I’ve done of this DuPont case, we looked at . . . Imagine the company had known what the liability would be in the future. What was the probability of being caught that would make it optimal from a shareholder’s point of view to actually pollute? What we find is this probability is quite high, it’s 20 percent. So, if the risk of being caught is less than 20 percent, it was optimal for the company to pollute.

Kate: Another point related to this problem of information disclosure is that part of what allows them to protect this information is this idea that the chemicals that they’re manufacturing are trade secrets. If they were to release information to the EPA or to government regulators about even the name of the chemical, let alone its molecular compound, then that would jeopardize its competitive advantage. They wouldn’t be able to make profits from making that chemical anymore or using the chemical in its Teflon manufacturing process. And that, therefore, would disincentivize them from doing research and development.

I’m so sick of hearing this trade-secret story used to justify all of these corporate misdeeds. I mean, whether it’s from employment contracts and restricting labor mobility to just outright pollution, it’s ridiculous that this guise of trade secrets should allow us to protect corporations from revealing any information whatsoever.

Luigi: From an economic point of view, it’s important to understand that the optimal amount of pollution is not zero. Reducing pollution has a cost. We don’t want our house to be super safe at the cost of having no windows, because a house without windows would be safer, but it’s not a house we want to live in. In the same way, we don’t want to reduce pollution to zero, because the cost is prohibitive. However, it’s important to figure out what are the costs and benefits of pollution.

Kate: I’m glad you raised that point, because, I agree, it would be ridiculous to try to make pollution absolutely zero. But, at the end of the day, you can’t do a cost-benefit analysis if you don’t know what the pollutants are, and you don’t know what their costs are. I think that the real problem here isn’t necessarily the pollution itself, even though, obviously, excessive pollution can be a problem. It’s the fact that our institutions aren’t incentivizing these companies or aren’t requiring them to disclose enough information for us to be able to make that assessment.

Luigi: Absolutely. I think that, in an ideal world, the incentives provided by litigation, regulation, and reputation should make companies behave as if they were doing the cost-benefit analysis from a societal perspective. We need to think about how to realign these incentives. Unfortunately, this is not specific just to the particulate matter in the air or DuPont PFOA. It’s a more general problem, and to see another case of this in the next episode, we are going to interview Carey Gillam, an investigative journalist who has written a book, Whitewash, about Monsanto and a pesticide that is widely used around the world, Roundup. We’re going to discuss with her the possible solutions to these problems.

Kate: Before we go, I just wanted to insert a quick thank you to all of our listeners who responded to our feedback survey, some of whom got Capitalisn’t T-shirts. It really meant a lot to us, and it really helped us shape the direction of the show, so, again, thank you.

As Sen. Elizabeth Warren (D-Mass) jumps into the 2020 Presidential race, Kate and Luigi examine her legislative record and economic policy proposals, including several bold ideas to reform American capitalism.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

We just entered 2019, which promises to be the Democratic primaries year. Probably Trump will not receive a challenge—if he does, it will be interesting—but there are plenty of people willing to run for the Democratic primaries. What we’re interested in trying to figure out is whether any of those candidates have a response to the questions that we raise in this podcast.

Speaker 3: Breaking news, the highest-profile Democrat yet officially wading into presidential waters. In just the last half-hour, Senator Elizabeth Warren announced the launch of a 2020 presidential exploratory committee.

Luigi: So, in this spirit we’re going to start discussing the economic platform of Elizabeth Warren. Elizabeth Warren is a good example, not only because she’s the first one to start campaigning, but also because she’s written a lot and made a lot of proposals trying to deal with what she thinks is wrong with capitalism.

Kate: Don’t worry, we’re not going to do this on every single episode, so it’s not like the next 20 episodes are going to be us going through the Democratic slate. But we do think that Elizabeth Warren has an established record of her economic position. It’s not getting enough attention, and she is one of the big contenders.

Luigi: I think we should start by making a distinction between her and Bernie Sanders. Bernie Sanders has not declared that he will run, but I think that there is a profound difference in the approaches of the two candidates, even if some of the solutions might be similar and they’re often clumped together.

Kate: Well, I will say that I think one of the reasons they’re clumped together is because their overarching message is similar. I think their overarching similar message is that, A, they think inequality is a huge problem, so they really don’t like billionaires. And, B, they think that the stagnation of wages, particularly middle- and lower-class wages, is a huge problem. So, you’ll see them talking a lot about how big corporations are doing too well and they have too many advantages, whereas the little guys and the smaller companies have disadvantages. So, in that sense, I think very broadly they’re similar.

Luigi: Yes, but maybe, Kate, I’m old-fashioned, but I still give importance to words. Bernie Sanders calls himself, and probably is, a socialist, while Elizabeth Warren goes out of the way to say that she is a capitalist to her bones, that she loves competition. She is not a socialist at all.

Kate: I think that Bernie Sanders uses the term socialism as a rhetorical tool. I think the reason he throws it out there is because he thinks that too many people on the left are in the center-left and there needs to be some pull over further left. And so, by taking an extreme left position, he’s kind of putting himself further in the distribution, therefore making the average move over. Maybe I’m using too many statistical terms here, but I think that he himself would acknowledge that he doesn’t actually, truly believe in socialism in the central planning sense that most real socialists would. I just think that he’s way further left than many center-left candidates.

Luigi: Again, maybe it’s because I attribute too much importance to words, but Bernie Sanders comes from a socialist background. Elizabeth Warren, when she was younger, she was a Republican, and then she was confronted with some of the distortions in the marketplace and, particularly, how low-income people get screwed in the process, and she decided to do something about it. So, I think that this different history is quite important in understanding how different their approaches are to problems.

Kate: OK. So, let’s talk about Elizabeth Warren’s economic platform.

Luigi: Number one, there is one proposal that I have to say I love, and that is the Anti-Corruption and Public Integrity Act. I think it is a very elaborate proposal that she made in the Senate to overrule the current system of revolving doors in a way that is quite aggressive, but I think very much needed. The proposal goes from banning lobbying by former members of Congress for a lifetime to restricting lobbying by other federal employees for at least two years, but most likely six years, to a tax on lobbying above half a million dollars that is designed to finance a better staff for members of Congress.

I think that one of the justifications for lobbying is that members of Congress need to be informed, and lobbying provides information, and she said, why don’t we pay more people to collect information directly? I think that’s a pretty great idea. But I want to point out—and maybe this is because I’m an academic—but I want to point out an aspect of her proposal that is not very often discussed, but I think is fantastic, that requires disclosure of research, particularly research submitted to agencies. Many, many times you have lobbyists who buy research, even by famous people, and then they submit it to agencies as independent research. But the people that submit it don’t disclose where the money comes from, and it is not peer-reviewed.

Kate: Yeah, I think that’s a good point. I think I remember looking through one of Trump’s early economic plans, and, to be fair, I think this issue got a little bit better. But early on, if you looked through his citations . . . it was all research that was published by private companies or published in journals that economists have never heard of.

Luigi: Yeah, I don’t want to be too snobbish. I’m not saying that only stuff that comes from peer-reviewed journals or prestigious institutions is valid. I value ideas on the basis of the ideas themselves. However, when you come with empirical evidence, I think that the peer-review process is definitely a very good way to do that. I don’t expect it to be passed anytime soon, but I think it is not presented just as a flag. I think Elizabeth Warren believes that this is an important thing to do and is a first step in that direction.

Kate: The people that would have to pass it would be the ones who were directly harmed by it. So, it’s for that reason that it probably will never be signed into law.

Luigi: Yeah. It’s not easy to make turkeys vote for Thanksgiving, and so it’s not easy to have Congressmen vote for the fact that they will never get a job in the industry in the future. To be honest, I think there is a legitimate concern about the quality of the people in public administration. Whether we like it or not, having a job afterward is part of the career path of many politicians, and it is the only legal way that career politicians can make some money.

So, I like the fact that she is also considering, at least in part, not for the top politicians but for the staffers, ways to increase their salaries, because otherwise, the quality of the people involved will drop tremendously. There is a huge amount of uncertainty in political life, and if you don’t have any job afterward, only the desperate will take it, and that’s not the kind of political system we want.

So, Kate, do you want to talk about the Accountable Capitalism Act that is probably the boldest proposal that Elizabeth Warren made, and the one that has generated a lot of debate?

Kate: Sure. The Accountable Capitalism Act is a bill proposed by Elizabeth Warren that concerns corporations, the corporate decision-making process, as well as corporate boards of directors. There are several parts of this bill, but the main two parts have to do with how corporations make decisions. So, what are they maximizing? And, also, this idea that workers should be able to elect at least 40 percent of the board of directors.

In the Accountable Capitalism Act, the idea is that corporate decision makers, the CEOs, shouldn’t just be maximizing shareholder value, they should also be maximizing stakeholder value, where other stakeholders include employees, members of the community where that firm is operating, as well as customers. In order to make sure that corporations are maximizing stakeholder value rather than shareholder value, Warren proposes that, because companies need charters in order to operate, that large companies should have to get this federal charter that forces them to include the interests of these stakeholders. And if they don’t do that in their decision-making processes, then they can have that federal charter revoked.

The second part is a little bit more straightforward. Just this idea that the board of directors that typically oversees the CEO, the people who sit on it, at least 40 percent of them should be elected directly by the employees of the company.

I guess it’s worth mentioning that there’s another section that concerns political expenditures as well as political donations, and the idea behind this section is that if any corporation wants to make a political expenditure, it has to get at least 75 percent approval by all of its directors as well as all of its shareholders.

Luigi: I think it’s important for our listeners to understand that she proposes that all this should start when a company is above a certain size. I think, if I remember correctly, it is a billion in sales. So, if you are mom and pop and you open your little corporation to run your plumbing business, it’s not affecting you.

Now, this is a pretty strong intervention, because it is also sanctioned by another part of the legislation that says that the federal government can revoke this charter if the company is engaged in repeated and egregious illegal conduct. I don’t know how the two reconcile, but if illegal conduct is not to act in the interest of everybody, then this amounts to a death sentence in the hands of the US federal government, and that’s pretty strong stuff.

Kate: I agree. I also think that it’s easy to say, OK, all stakeholders should be considered when corporate decisions are being made, but if you actually want to maximize the welfare of all stakeholders, that’s an almost impossible decision to make. If you think about maximizing firm value, to say that that’s the same thing as maximizing stakeholder value, I don’t think that that’s true. Maximizing firm value is maximizing the value of your debt and maximizing the value of your equity. To the extent that bondholders and lenders can’t be exploited, it’s basically the same thing as maximizing shareholder value. And, of course, companies have to operate within certain constraints, and so they have to meet the law, and they have to make sure that they’re not polluting in any illegal way. And I think that there are a lot of laws and regulations that prevent negative externalities that companies impose on society.

But then to go the additional step and say, these companies need to be maximizing stakeholder value, which includes community and customer concerns, I do think that that really complicates their decision-making process.

Luigi: Wait, Kate, you have probably been a little bit too fast for most of our listeners, because what you said is correct, but you’re sneaking in a bunch of assumptions along the way that I think are useful—

Kate: Oh, yeah, like you never do that, Luigi.

Luigi: No, I never do that . . . are useful to unpack for our listeners. So, I think it is true that if all the markets for patrons of the firms—and patrons can be debtholders, can be customers, can be employees—if all these markets are perfectly competitive, then maximizing a firm’s value or maximizing shareholder value is the same thing as maximizing the welfare of all these parts together.

However, when some of these markets are not competitive, or when there are a lot of firm-specific investments, like if the workers have made some sacrifice in the past in order to work for this firm, then the story might be different. Then we have a situation in which you can maximize one at the expense of the others. I think that where Elizabeth Warren comes from is, she’s concerned that there is not enough competition in this market, and I disagree that the right threshold is a billion dollars, because you can be a billion-dollar firm with a lot of competition in all these markets, but I do envision situations in which you don’t have that competition, and then you do have to worry.

Kate: I agree that Elizabeth Warren is concerned about not just labor, but also the environment and climate change here, but I think it’s worth pointing out that she’s also in favor of a bill called the Climate Risk Disclosure Act, in which public companies would have to say exactly how they’re affecting the environment. To the extent that we would believe that that was true, that they were being completely honest about everything that they were doing to affect the environment and climate change, then to have the environment and just people living in the world be part of a CEO’s decision-making process, that, to me, it’s a little bit redundant with the other act, the Disclosure Act, and it adds a lot to the complexity of the decision-making process. It also opens up room, as you mentioned earlier, for the government to just attack any company that they think is not complying with the act in any way.

Let’s talk about the part of the proposed act that concerns labor relations directly. So, having 40 percent of the board, at least, be elected directly by workers at the company. What do you think about that?

Luigi: First of all, for our listeners, this is not such a new idea as the previous one, because this is what has taken place in Germany since World War II for the largest corporations. In fact, in Germany, they elect 50 percent of the directors, with the only caveat that in case of a 50-50 vote, the chairman’s vote counts for two votes, and the chairman is appointed by the shareholders. So, both systems leave the majority to the shareholders, but they give representation to workers. It’s called codetermination.

The evidence in Germany is that it was neither such a sort of fix for the problems nor a disaster like their enemies seemed to represent. I don’t think that really changed a lot, and now we know that industrial relations in Germany are, if you want, less conflicted than in the United States. I don’t know whether this is due to codetermination or due to the fact that the story in Germany is different. What I want to point out is, there’s a big difference between Germany and the United States. In Germany, people tend to have one job for life. The mobility in the labor market is fairly limited, and if you enter and work for Mercedes early on in your life, you stay there for most of your life. So, as such, having representation on a company board makes more sense. When you have a labor force that changes super-fast, that representation makes less sense.

Kate: Yeah, I think codetermination deserves an episode of its own, right? We could go through the literature that’s been relatively mixed on the success of codetermination. But I think it’s an important topic, and I think, if you’re interested as listeners, let us know, and maybe we can do another episode on that in particular.

Another thing I would add to what Luigi said about the differences between labor unions and labor representation between Germany and the US is that, who pays for the unions or who pays for the representation? In Germany, the laws are such that, if you have these committees set up within the corporation to help represent you on the board, then all the offices and everything those councils need in order to function are paid for by the company. Whereas in the US, if you’re part of a labor union, then, in a number of states, that labor union has the right to take a fraction of your wages as union dues. I think that that’s a huge part of why there are differences between the German system and the US system. A lot of US workers would support more representation, but they don’t like the idea of having to be forced to sacrifice part of their income to a labor union.

On top of that, in some regions and in certain occupations, there’s only one type of labor union that you can join. For example, when I was a grad student, I was part of GSOC-UAW, where the UAW part stands for United Auto Workers. Why am I, as a finance PhD student, part of a union with a bunch of autoworkers? I don’t know what their objective is. I don’t know if they have my best interests at heart. Whereas if I knew that . . . there was just a council within my own organization that was being paid for by the organization, I would maybe feel a little bit more comfortable with that. So, I think that there are huge changes that need to take place within the United States to help reform labor rights in general, but I still agree with the spirit of this suggestion.

Luigi: Kate, I never thought of you as an auto workers’ union member. That’s a new side of your personality that I’m discovering. But the more important point, and I know, we probably need to postpone it to the next episode, but in a world of multinationals, worker representation creates a huge problem. You’re going to represent all the workers? So, you are going to have some workers from the Philippines, some workers from Cambodia, some workers from the United States, and in many of the US corporations, probably there are more workers not from the United States than from the United States. So, they should have the majority on the board.

Kate: Yeah, that’s an interesting point that I honestly hadn’t thought about. If you have different types of employees, like if you’re talking about Google, if you have high-tech employees, as well as janitors, is there a different weighting in terms of who gets more power, or is it just the raw number of people who work in each position? I think that those are all difficult issues to grapple with.

Luigi: When you bring up Google and the power that employees of Google have in shaping the corporate policies of Google, this proves the point that you don’t need to have votes to have power. Talented employees that are in short supply have a huge amount of power and can shape the direction of Google. So, in a sense—and this is what the finance literature suggests—the reason that shareholders have votes is not because they are the most powerful. In fact, they have the votes because they are the least powerful. Once they put their capital into the firm, they have no say, and they can be easily expropriated by all the other constituencies. That’s the reason why their interests need to be protected by votes. The bondholders can withdraw their money by not renewing the bonds, the workers can withdraw their labor by leaving the firm, the customers can stop buying. Maybe the only ones who don’t have a lot of power are the community at large, but we know that the local mayor does have some influence on the way companies are run. So, I think that there is a pretty strong argument to give a primacy to the shareholders in most cases.

Kate: The last thing I want to say about the Accountable Capitalism Act is that I assigned an extra-credit assignment in the class that I taught last semester, where I had all of my undergraduate students write an essay on whether or not they agreed with the Accountable Capitalism Act. I was shocked. I mean, OK, so to be fair, these are all business-school students, and so, they were learning from me about maximizing profits and things like that. But I was pretty shocked to find that 60 percent of them, roughly, did not agree with her proposal. On top of that, the ones who did agree, I think they were very thoughtful, and they said, “OK, this part I think is better than that part, but on the whole, I think that I agree with her spirit.” But the ones who were against the act were vehemently against the act. They were like, “Oh, it’s a no-brainer that we shouldn’t pass something like this. This is going to sink the country into communism.” I thought that it was interesting that the rhetoric of the people who are on either side was different.

Luigi: It is interesting, because she received a lot of criticism from the right on this proposal, and many people have talked about socialism or transforming American capitalism into socialism, because you bring some workers on the board.

Given the experience of Germany, I doubt that’s the case. But it is a little bit funny, and I picked up on an article that Richard Epstein wrote about this. He said, if you want to apply this in general, why don’t you have the dean of the business school also appointed by the janitors? That’s part of the process. What about the unions being represented also by consumers? Where do you stop this representation of our constituencies? Why, as a consumer, can I not be represented in the union that decides whether they strike, making it impossible for me to travel by train or by plane?

Kate: The third major part of Elizabeth Warren’s platform that we want to talk about is affordable housing. In particular, she has called for almost half a trillion dollars of investment to be set aside over the course of the next 10 years to go towards affordable housing for the lowest-income members of society.

Luigi: But what is interesting is how the bill is designed, because, first of all, it works on two margins. One, it has some incentives to get rid of local zoning laws that restrict the supply of houses in many neighborhoods. This is very much something that even the right side of the political spectrum will agree with, and it is fighting the so-called NIMBY, not in my backyard, that is a major cause of the increase in house prices.

In that part it shows, in my view, the capitalist side of Elizabeth Warren that is trying to work through market forces, but then the other side is that she thinks it is also important to build more houses, and she proposes half a trillion dollars over 10 years in building new houses. You wonder, where does she get the money? Actually, she is planning to get the money by increasing the federal estate tax. There was even an independent paper showing that this will be a balanced budget proposal, which means that richer people will be taxed to the point of half a trillion in 10 years.

Kate: Yeah, she says explicitly that these tax changes would only affect about 10,000 families.

Luigi: It must be that those people are really squeezed a lot, because raising half a trillion out of 10,000 people, that’s a challenge.

Kate: Yeah, absolutely.

Luigi: But one piece that I admire is that she seems to have focused on what are, in my view, the biggest problems of our time. One is the fact that wages don’t rise enough. The second is that there are problems with the cost of housing that economists have shown can have a major impact on the ability of the country to grow, and the third one is political corruption.

So, those three pieces, again, I’m not necessarily buying all the parts of all these proposals, but the fact that she has identified what I think are the right problems, and she has some interesting proposals on those problems, I think speaks very highly.

Kate: I think that something else that Elizabeth Warren should be credited for, and also part of the reason that big business doesn’t like her, is the CFPB, the Consumer Financial Protection Bureau, which was really her brainchild. I think she proposed the idea behind the bureau in 2007.

This is an agency that has gone after scams, basically. It’s gone after companies that cheated victims of 9/11 out of the money they were owed. They’ve gone after exploitative payday lending. They’ve gone after retirement scams or scams that were created just to ensnare old people. They’ve also tried to put limits on debt-to-income ratios, in essence limiting exploitation in the housing market, which is part of what contributed to the financial crisis. But, unfortunately, the CFPB has since lost a lot of its powers.

I have maybe one additional criticism. Maybe you can consider this minor, just by virtue of the fact that it has to do with my background as a bankruptcy researcher, but amongst bankruptcy academics, some of her findings have stirred up a lot of controversy, particularly some of her research related to personal bankruptcy and what causes personal bankruptcy. She’s argued that somewhere in the realm of 50 percent to 60 percent of personal bankruptcies are due to injury and health-related causes. And this has been hotly contested within the bankruptcy community. Some have even made allegations that these findings were politically motivated. In any case, at the end of the day, I prefer her as a politician than I do as an academic.

Luigi: The point here is not whether you like her or not. The point is that she has interesting proposals that speak to the current problems in capitalism. They might not be the silver bullet, and certainly we have identified a lot of her shortcomings, but they are serious proposals for real problems, and in the spirit of not trying to overrule capitalism, but trying to make it work better.

Kate: As we mentioned earlier on, though, this episode was motivated by the many similarities between Elizabeth Warren’s economic platform and the issues that we try to grapple with on this podcast. As 2019 progresses and more candidates announce—and by the way, this could include right-wing candidates as well—we want to keep the conversation going.

So, if there are any presidential candidates whose economic platforms you think deserve serious consideration on this show, let us know.

Pulitzer Prize-winning journalist Steven Pearlstein drops by to talk about the incredible shrinking newspaper -- especially the business section -- and why that's bad for the economy. His new book "Can American Capitalism Survive?" argues that the mantra of 'maximizing shareholder value' ultimately caused Americans to lose faith in the free market.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Speaking about what is not working in capitalism, I think that the media plays quite an important role in trying to expose the many things that don’t work in capitalism. This is not a recent innovation. Going back in history, there was a very important role played by the press and particularly by a journalist, a woman journalist, Ida Tarbell, who exposed the problems with the Standard Oil monopoly and created the political demand for intervention.

Kate: But the last two decades have fundamentally altered business journalism, from the relationship between journalists and corporations, to the business models of publications themselves, to the public trust in the media. We’re very fortunate to have as our guest today someone who’s been a prominent business journalist throughout this transformation, Steve Pearlstein. Steve’s a Pulitzer Prize-winning journalist. He has a regular column at the Washington Post. He’s the Robinson Professor of Political and International Affairs at George Mason, and he recently came out with a book called Can American Capitalism Survive? Steve, welcome to the show.

Steve Pearlstein: Thanks for having me.

Kate: Steve, can you describe to us how the relationship between journalists and businesses was when you first started in your career?

Steve Pearlstein: I started, actually, at, seriously as a business journalist, at Inc. Magazine, which in the 1980s was a very fat book. If you dropped it on your foot, you would’ve broken your toe. The reason was because there were all these ads for this new thing called the personal computer. It was the beginning of Silicon Valley, and Inc. was the magazine of small business. I got a pretty good view of the entrepreneurial sector, but Inc. and a few other magazines, Entrepreneur, were the only ones that covered that. Covering business was covering big business. There was, frankly, a very close relationship between the business press and large, public companies. They all had vice presidents for, essentially what they then called press relations, and reporters were organized by beats. You were the defense industry reporter, or you were the retail reporter, or, at a place like the Wall Street Journal, you were the GE reporter. There were probably two GE reporters at the Wall Street Journal.

I eventually went to the Washington Post, and then I started covering the defense industry. When I became the defense industry reporter, I had a meeting at every one of these headquarters. I met this head of PR, but I also met several executives and the chief executive. They wanted to meet me, and I wanted to meet them. Now, this is the days of the telephone. You’d call them up, and they’d call you right back if they didn’t pick up the phone right away. They would do anything, really, to accommodate you, to answer your questions, to arrange for you to visit someplace, to talk to who you ever wanted to talk to. There were some exceptions to that, but by and large, that was the way things worked. There were several things going on there. First of all, we were very important to them, and so they needed us. They needed us to talk to the world, in the case of the defense industry, to talk to Washington. They needed us to talk to investors, and they needed us to talk to their customers.

We played the game in an honorable way. We didn’t do things to screw them. If we said it was off the record, it was off the record. They didn’t do things to mislead us because they knew if they misled us once, that it was not going to be good the next time we came around.

I want to contrast that with today. Today, businesses, particularly public companies, and private companies too, they don’t need us. They feel, anyway, they don’t need us. They feel they can communicate with their employees, with their customers, and with their investors through different channels. Social media has greatly changed that but also specialized blogs. So when someone like me calls up, who may not be a beat reporter—and there aren’t many beat reporters left, I’ll get to that in a minute—they may or may not respond. Mostly, they don’t give you their phone number on the website. You have to hunt for it, or you have to send an email to some drop box, and they may or may not respond to you.

The general rule is they’re not interested in talking to you. They’ll answer questions, written questions, by email, and that’s the end of it.

Half of this is our fault. The reason it’s our fault is because there are very many fewer business reporters, we’re not organized by beats, or the beats are very broad. You don’t have the knowledge and the relationships with the company. That’s a function of how journalism has changed and the economics of mainstream media have changed.

Kate: Can you give us an example of your favorite company to cover and the types of relationships you established in doing so?

Steve Pearlstein: Lockheed Martin was one I had a very close relationship with. The guy who was the chief flack, as we used to call them—and that was not a negative term—I mean, we had each other on the speed dials. I had his home number. He had my home number. We used to go out and have dinner together a couple of times a year just . . . He never lied to me, and he would never mislead me. If I really wanted something, if I really wanted to talk to the chairman, he’d get me the chairman. They wanted me to be well-informed and knowledgeable. It wasn’t a time . . . It’s not gotcha journalism. We didn’t do a lot of stories about people complaining about chief executives doing sexual harassment. I got to tell you, that was not . . . We were worried about profits, and mergers, and who was winning, and who was losing. The way I like to describe it is that in those days, we covered business the way sports reporters covered sports. There were various teams, and they were competing against each other for the World Series, and we covered it like that.

We covered the stars, that is the executives who, often, big profiles were done of them. They were on the front pages of magazines. When was the last time you saw a business executive on the front page of anything in a laudatory fashion? It just doesn’t happen anymore. The other thing about CEOs, particularly today, is they really like to control. You can’t control the press. You have to get comfortable with the idea that you don’t know how the story’s going to come out. They hate that. These guys, today, are control freaks, and they do not like dealing with the press, in part, because of that. We talk back to them. They’re not used to getting talked back to. They say they are. They say, “Oh, yeah, my people talk back to me all the time.” Let me tell you, that’s a load of crap.

This is another reason they don’t like the press, because we’re not, in their opinion, respectful. By the way, if you want to know where this goes back to, it goes back 20 years, 25 years, to the early ‘90s and the stories we used to write about their compensation. This where the trust, not between the PR people and us, but between the executives and the press broke down, because we kept writing these stories about nobody deserves to earn this amount of money. Of course, back in the ‘90s, they were pikers compared to today. Anyway, that’s where it started.

Luigi: I come from a country where big advertisers were few, and when they didn’t directly own a newspaper, they were still so influential that they could get their view of the world in a pretty dramatic way. Back then, was that the case in the United States?

Steve Pearlstein: No. It just wasn’t, Luigi, there was an absolute wall. I told you that I was the business editor of the Post for a few years. There was a guy who used to do all the selling for the Washington Postto the car dealers in the Washington area . . . There were several of them, but he was the chief one. One day, he came down to talk to the auto industry reporter. That became a big deal. The managing editor complained to the publisher. There was a big meeting about it, and those guys were told, “Don’t you ever come on the fifth floor.” That’s how much of a wall there was. No, they had . . . We used to write articles . . . The biggest advertisers were the department stores. We used to have this retail reporter who was always driving them nuts, and they would get the call. They called the publisher, and the publisher would just say, “Well, thank you for calling.” That was the end of it. We never heard of it.

Kate: What do you think was the mechanism that allowed the wall to exist? It wasn’t regulatory, right?

Steve Pearlstein: No, no, no. It was culture, and norms, and it was . . . We needed to protect our credibility. That was one way we protected our credibility. You see it even today in the Wall Street Journal. There’s a wall between the editorial department, which as you, if you read the Wall Street Journal, you’ll know is a very conservative editorial department, and the news department. Those guys, news people, play it absolutely straight, or at least they did before Murdoch took over. Their reporting was as unbiased as anyone else’s reporting at the Wall Street Journal. The editorial department had nothing, so it’s not just advertisers, but the editorial department were walled off. It was enforced this way: In the competition for good journalists, good journalists wouldn’t work for a place that allowed advertisers or the editorial department, or the publisher to affect your news coverage. Not only was it important for credibility for the public, but if you wanted to attract the best journalists, you had to have that wall.

Luigi: Can I try a different theory, maybe less romantic—

Steve Pearlstein: OK.

Luigi: I view the journals of yesteryear as a kind of oligopoly. They were making a lot of profits.

Steve Pearlstein: No doubt about that.

Luigi: We’re using journalists as people, now, as the fashion industry uses haute couture. It is like you use haute couture to attract the reputation, attract the big designers. Nobody actually buys haute couture. Haute couture is completely sort of a losing proposition—

Steve Pearlstein: Right.

Luigi: —but it is a good barrier to entry, a good way to create reputation, and a good way to attract talented designers. I think that the newsrooms of old newspapers were exactly that. The competition brought by online advertising and so on and so forth destroyed those monopoly rents. The news departments are going down the tube as the haute couture departments of fledging fashion houses.

Steve Pearlstein: Well, the analogy is apt except for one thing. A lot of people did wear our clothes. That is, we had millions of readers who did read us. That’s all we cared about. You’re right, having a quality journalistic product attracted the advertisers because it attracted the readers. We were the intermediary between the advertisers and the readers. The newsroom attracted the readers, and then the advertising department sold our product to the advertisers, and, effectively, the advertisers paid for the news. You did pay something for the newspaper, but what you really paid for was the printing and the delivery. The news, the gathering, and the writing, and the editing, and the display of the news were actually paid for by the advertisers. When there were less advertisers, there’s less news or less resource going to the news.

Luigi: Absolutely. Our listeners will remember when we discussed the multisided platform. Multisided platform is a new concept in economics, but it is not a new sort of a business model.

Steve Pearlstein: Right. No.

Luigi: The newspapers were exactly a multisided platform where the sides were the journalists, the readers, and the advertisers.

Steve Pearlstein:Like other multisided platforms, they have a tendency to winner-take-all competition because the advertisers want the place with the most readers, but it turns out the readers want the place with the most advertising. I’m not talking about the display ads. I’m talking about the classified ads. The reason that there was only one newspaper in every major metropolitan area until the 1990s, now there’s zero sometimes, but there was one, was because that was the paper that got ahead in the competition for classified advertising. That was a big source of revenue and much more profitable than other kinds of advertising. Once you got ahead in that, you basically won the game, because all the advertisers, classified wanted to go to the largest classified, and all the readers wanted to go to the largest classified. It’s like a natural monopoly.

Kate: Excuse my ignorance here—

Steve Pearlstein: Yeah.

Kate: —but who is mostly paying for the classified ads? Those weren’t necessarily personal ads. Right?

Steve Pearlstein: No, the people . . . No, well, they are. They were personal ads.

Kate: Really?

Steve Pearlstein: But they’re not personal ads like for dating. They were personal ads for selling—

Kate: That’s what I have in mind.

Steve Pearlstein: No, no, no. That was a small part, and we regulated those very, very, very heavily. No, it was for real estate, and used cars, and jobs. That’s how people, you forget, you’re too young. You forget that that’s how people got jobs. There was no online matches. It’s much more efficient now with cars, and real estate, and jobs. The online world . . . Craigslist ruined the newspaper business, basically. I mean, if you wanted to . . . it wasn’t Google. It was Craigslist that ruined the newspaper business as a business.

Luigi: Yeah, when I joined Chicago in 1992, and I looked for an apartment to stay, I bought the Chicago Tribune. I went through the classified ads of the Chicago Tribune. That’s the reason why I bought the newspaper, and the people who were renting apartments were paying to post their ads in the Chicago Tribune. That was really the focal point of the market at the time.

Steve Pearlstein: Yeah, and that was far and away the most profitable part of the advertising because people paid ... They only had these little things, and so they paid per line a very high amount compared to the number of lines you bought if you were a department store. But also, it was no sales cost involved. They called you. You didn’t have to call them.

Luigi: But I wonder to what extent, also, this brought a segmentation in the political views of the newspapers, because if you were the local newspaper, you were trying to cater to the largest possible market. You are naturally a moderate in position. You couldn’t be a radical on the left or the right because you wouldn’t get the market.

Steve Pearlstein: It was mass media, and so you had to be mass. They tended to be centrists. Sometimes editorial pages would go left or right, mostly right. Again, the editorial pages were separated from the newsroom, and there was a sort of professional attitude about how to cover the news objectively and fairly. People scoff at that now, but the truth is, there just was a way of doing things that we passed on from generation to generation. We didn’t, in our generation we didn’t go to journalism school, but it was learned on the job. One of the things you learned was how to be fair and balanced. We didn’t kid ourselves. Journalists, by sort of self-selection, tend to be liberal because they tend to be antiestablishment. They don’t get paid that much. They tended to be liberal, but we didn’t try to slant the news in one way or the other in terms of party or ideology. We were equal-opportunity assholes. Whoever has power, we tried to take them down a notch.

Luigi: So, how do we fix this problem, because I believe that the press was far from perfect in the past, but it was playing a very useful role. I think the business model allowed it to play this role. Now, that business model has been destroyed, and I don’t think it’s been substituted by an alternative so far.

Steve Pearlstein: It is being substituted, Luigi. The new business model, and we can see it in the Wall Street Journal, in the New York Times, and in the Washington Post, is now the readers will have to pay for the news. There was a time when the internet was fairly new, when there was a belief, and it came from Silicon Valley, that content ought to be free. Well, content, in the case of news, can’t be free. So, what’s happening now is, first of all, people who care about news and care about having edited news, curated news, quality news, factual news, are willing to pay for it. They’re willing to pay, I’m just throwing out a round number, a dollar a day to get a good newspaper—only it’s not a paper anymore—but to get a good news product. They’re willing to pay half of what they pay for a cup of Starbucks coffee, or a third, every day.

If you get a couple of million people, three or four million people willing to do that around the world, now you don’t have to worry just about your local area. You’re going to be able to put out a good global news product.  The Timesis well on its way to doing that. I think we at the Washington Postare on our way. The Wall Street Journaland the FThave an advantage, because the people who buy it actually are not people. They’re businesses that are buying, so they’re not that price-sensitive.

Luigi: I thought businesses were people, no?

Steve Pearlstein: Well, right. Anyway, so there is a new model, but what’s going to be the new model is there’s only going to be six or seven English-language, full-service, global news organizations around the world. They’re going to be print. They’re going to have video. They’re going to have podcasts. They’re going to have everything. They’re going to be global, and there’ll only be room for six or seven of those, because it’s only going to be a dollar a day, so you need several million. The loser in this is going to be local news coverage, because they can’t aggregate that number of paid readers. That’s going to suffer, but in terms of national and international news, and I would add sports news and global business news, there will be a product, and it is evolving. But remember, Luigi, that just at the height of the major newspaper era, there were something like, I’m guessing, 1,200 daily newspapers in the United States alone. That was so fragmented. You need consolidation, but with consolidation comes the neglect of local news.

Luigi: I would like you to elaborate, because I think it’s quite important. This generates a fragmentation, because if you are trying to please your customers, and especially if you’re trying to extract more of the surplus from your customers with higher prices, you’re going to cater to their ideological biases, and so the middle-of-the-road media that facilitated the common conversation in the United States are replaced by super-partisan media that make it more difficult for people to talk. I remember, you probably know the name, but there was somebody who said, “You are entitled to your opinion, but not to your own facts.”

Steve Pearlstein: Yeah, that was a senator named Daniel Patrick Moynihan.

Luigi: Yes, and so that, I think, used to represent what politics was. Today, politics has its own facts.

Steve Pearlstein: Well, I will say that there’s probably going to be a bifurcation. There is a market for straight, factual, smart news. Basically, upper-middle-class professionals want that. They do want the facts, and they do want smart, balanced analysis. They have the most money, and so there will always be one, or two, or maybe even three competitors who are trying to get them, because that’s where the money is. By the way, they’re also a good advertising audience. Advertising won’t drive this thing, but they are a good advertising audience. So, there will be them, and then there will be others who prefer a more biased news.

Just to give you an example, if you were running General Motors, you want to know what’s going on in the world, and you want a straight shot at the facts of what’s going on in the world. You’ll make your own opinions about it, but you don’t want your news tilted. There are still a lot of people, academics like yourselves, who are going to want that, and there’s a lot of people who want basically straight news. To have straight news doesn’t mean you can’t have commentary. You can either have slanted commentary or you could have a mix of commentary. Again, this audience that I just described probably wants to read a good conservative columnist and a good liberal columnist, as I do, and I suspect you do.

Kate: I’d like to talk a little bit about your book.

Steve Pearlstein: OK.

Kate: You focus on one important norm that changed at businesses, which is the idea of shareholder value maximization. What were CEOs maximizing prior to that idea, and what caused the shift?

Steve Pearlstein: Well, what they were maximizing was, perhaps, their own reputations, perhaps the size of their companies, and, putting it in the best face, they felt they had a number of stakeholders to which they had to pay attention. They saw their jobs as balancing the interests of these various stakeholders in order to maintain the long-run viability and success of the enterprise. In the 1950s and ‘60s, chief executives, top executives, had as much power as they do now, or more. Boards were actually more easy to sway. And no one would ever have considered paying himself what these guys pay themselves now. The reason was not only because their employees, whether they were unionized or not, would have not liked that. They would have seen these employees when they go out to the soccer game, or when they went downtown on Main Street to do shopping, or whatever, they ran into their employees, they wouldn’t have wanted to jeopardize those relationships. They didn’t want their employees to become unionized and socialist, so that’s another reason that they didn’t do it.

They wouldn’t, but here’s another reason they wouldn’t do it. They wouldn’t do it because when they went to the country club, one of them would have said to the other one, “Don’t do that. You’ll make us all look bad.” There was a sense, in those days, that they all had to stick to certain norms for the good of all business, so that business was well-regarded and trusted, so people didn’t join unions, so they didn’t vote socialist. There was also a period coming out of World War II, and there was a lot of shared sacrifice during World War II. Women went to work together in the same factories. Men served together of all different classes. There was a lot of sacrifice going on, in terms of people giving up certain consumer goods and rationing. So, coming out of World War II, that sort of thing would have been unseemly, the sort of individualistic “I’ve got mine, I don’t care whether you get yours” kind of thing. That would have seemed unseemly.

Now, obviously, as you get farther and farther from the war, that wore off, so that’s one reason the norms changed. The other reason was because of Wall Street. The period of the ‘70s was really a lost decade for investors. They made no money. If you invested in the broad stock market during the 1970s, on an inflation-adjusted basis, because we had pretty high inflation, you would have lost money. By the early ‘80s, Wall Street had pretty much had it. Here’s what happened: Big US companies used to earn rents in a closed economy, and they shared those rents with their employees and a little bit with their customers, but not really, but they shared it with their employees and their communities. Then global competition came, and they lost their rents. Their first instinct was actually not to take it away from their employees and their communities. They basically took it away from their shareholders, and that was the lost decade. After that, the shareholders said, “Hey, enough of that,” and you had this market for corporate control that developed during the 1980s, the hostile takeovers.

You had to change a lot of social norms in order to for that to happen. It used to be that white-shoe investment firms wouldn’t handle a hostile takeover, and that white-shoe legal firms wouldn’t handle one, and there was no bank that would finance it. So, there had to be a whole new system that developed, and it was out in California. It was Mike Milken and his company, Drexel Burnham Lambert. They provided the investment banking. They created junk bonds to finance it, and they went around the establishment system, so you had these corporate raiders who were considered low-life by the executives and the other people on Wall Street.

They started doing these things, and they basically revealed that a lot of these companies were not run with anything like the investors in mind. They said to investors, “Let us take over, and we’ll make you first.” They did that a few times, and then all of the sudden the norm was changed. Everyone felt that if they wanted to avoid a corporate takeover, they’d better run their companies that way. A lot of people in academics then jumped on and sort of came up with the economic and legal justification for maximizing shareholder value, and we’ve basically had shareholder capitalism ever since.

Luigi: But there’s one fact in your picture that you seem to ignore, which I think is equally important. Back in the days where people were not paid a very high salary, tax rates were 91 percent, so they changed the tax system, to some extent, to favor the emergence of some of those differences, because it’s not that the executives of the time were poor and were sacrificing their life.

Steve Pearlstein: I was a kid in the 1950s and early ‘60s, so I can’t say this from personal experience, but I have talked to people about this. First of all, nobody paid a 90 percent tax rate. There are liberals and conservatives who love to bring that up all the time. Nobody ever paid that, so unless you got this sort of windfall that you couldn’t arrange to avoid it, nobody paid it. For one thing, they could have paid themselves in stock, and that could have been taxed as capital gains, and that’s one way they did do it. That’s one way they still do it, so that’s the primary way in which you would increase your compensation if you were a chief executive, and that was still available at that time.

Kate: All right, so another trend that you talk about in your book is a shift in culture, and the shift in trust, and communication, and cooperation amongst citizens themselves. Do you think that that was part and parcel with the shifts in business attitudes towards maximizing shareholder value, or do you think there was something else going on at the same time?

Steve Pearlstein: A lot of what I consider to have gone wrong in American capitalism stems from maximizing shareholder value and that view of corporate purpose. I don’t think it’s a leap to say that one of the relationships that got strained badly was the relationship between workers and companies because of that. But there’s a second thing, which is the inequality question. The rise of income inequality has eroded social capital, has eroded the trust that we have in each other, and has resulted in things like a polarized politics, which makes our government dysfunctional. That, too, is not good for business. It’s not good for an economy if your government can’t respond in a timely fashion to changes in markets and changes in technology. Eventually, if your politics gets ossified, you’re not going to have a good economy.

Luigi: There are some key ideas in your book on how to sort of save capitalism or make capitalism survive. Can you summarize them for us?

Steve Pearlstein: Sure. Well, as I said, this all goes back to the 1980s when our economy had gotten uncompetitive, and we needed to do something to fix it. There was a real serious threat that Japan would overtake us, that Germany would overtake us. We had all these competitiveness panels and that sort of thing. I mean, it was a serious threat, and we needed to do something. And we did, but we did it by embracing a set of ideas, which at the time were quite useful. Ideas like the purpose of a corporation is to maximize shareholder value, or that greed was good. We needed people to be hungry in that way in order to have a competitive, entrepreneurial economy. Or, as things became more unequal, we said, “Look, don’t worry about income inequality. What matters is equality of opportunity, not income.” Or we had the idea that you could divide the pie more equally, but if you do that, you’re going to get a smaller pie.

There is some truth to all of those ideas, but when you push them as far as they have now been pushed in the last 30 years by the market fundamentalists, it turns out that they’re not true. If you come to realize that, then the solutions, it seemed to me, are a lot more apparent on what you can do and should do, which is not to have the pendulum go back to the 1960s and ‘70s. It’s not to become like socialist France, but maybe we have some things to learn from Germany, or Denmark, or Sweden. Maybe we have some things to learn from Japan. Maybe we have some things to learn from Chile, but our conversation about a lot of these things has gotten awful stale. Either you’re free market or you’re anti-free market. I haven’t found that, in recent years, to be a very satisfying conversation.

Luigi: And, by the way, countries like Sweden that are often indicated as socialist countries, they do have, of course, a higher level of distribution of income. But in terms of competition, in many dimensions, they’re more competitive than the United States. I was shocked to arrive at the Stockholm airport, and there are multiple cab companies competing one against the other.

Steve Pearlstein: Yes.

Luigi: You can make your price, and this is true not only, of course, in the cab companies, but in a lot of sectors. I think that the Swedish system, or even the Danish system, has tried to protect and push competition in a way that is not true in this country.

Steve Pearlstein: And particularly like that because there’s less regulation, but in order to do that, they have to have the safety net underneath people in order to do that, because you can’t have that kind of creative destruction that comes from that competition if everyone has so much on the line, that if I lose this, I don’t get health care. That’s exactly the kind of thing we have to talk about, but you can’t have that conversation today with most Republicans in Congress. Let’s do this tradeoff: less regulation with a better safety net. They will only have half the conversation. I wish we could have more of that kind of conversation, Luigi, because we would be a lot more fun, and much more productive, and it would be better for our economy.

Luigi: We certainly can have it in this podcast.

Kate: Steve Pearlstein, thanks for joining us on the show.

Steve Pearlstein: My pleasure.

Fahmi Quadir thinks short sellers get a bad rap. Known as the "financial assassin" for helping expose fraud and misconduct at Valeant, she tells Luigi that Tesla might be next. But Kate isn't convinced -- she thinks journalists and regulators are the real heroes.

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

For a capitalist system to work properly, we need information to be produced and disseminated. While there are a lot of mechanisms to collect and distribute good information, information that is positive and rewarding, it’s much less easy for negative information to be collected and distributed. So, who makes sure that fraud is identified and exposed? One crucial role in this is played by short sellers.

Kate: So, who are these short sellers, or what is short selling, exactly? It’s kind of like the opposite of buy low, sell high. You sell high first and then you buy low. There’s a question of how you do that, right? How can you actually sell high if you haven’t bought yet?

The mechanics of shorting involve you first borrowing a security, so let’s say borrowing a share of stock from somebody else. They have to be willing to let you borrow it, and so you have to talk to your broker, your broker talks to their broker, you make sure that everyone is on board with the borrowing agreement, but you borrow and then you sell it in the market immediately.

Then, later on, if the stock price falls, you buy it back from the open market, and then you return it to the person you borrowed it from. That way, if the stock price did indeed fall, you would make money on the amount by which it fell.

Luigi: Short selling is an extremely risky business for two reasons. Number one, the upside is limited. At best, the stock goes from the current price to zero. At worst, the stock price keeps rising and your loss is infinite.

Second, even if you have the right bet, but in the middle of your position, the person who lent you the shares decides that they don’t want to lend you the shares anymore, and they ask for it back, you are forced to buy back shares in the middle of the trade, and at a time where you might be in a situation where other short sellers are trying to do the same, and that pushes the prices up, making your losses even larger. That’s called, in jargon, a short squeeze.

Kate: I think this idea of unlimited downside is sort of a fiction, though. The reason that if you take a short position you usually need to post collateral is that eventually, if people are worried about your ability to repay the security, then, as you mentioned, they’ll either demand the security back or they’ll take whatever collateral you’ve put up in order to protect themselves.

At some point, if you’re losing enough money on a short position, it will be closed out. You’re not going to lose an infinite amount of money.

Luigi: You are right, but I think the reality is asymmetric, that there is more to be lost than to be gained. And remember, on average, stock prices go up, and so, on average, you lose money. So, you must be particularly good in identifying the bad stocks in order to live as just a short seller.

Kate: And precisely because of this, there aren’t that many funds that have a pure short strategy, which is to say that they only take short positions. There are a bunch of hedge funds that have long/short strategies, so they go long stocks and they go short stocks at the same time, or depending on market conditions.

But it’s tough to take a short-only strategy, because oftentimes, if you decide to buy stocks whose prices are falling, this is called trying to catch the falling knife, and that strategy, on average, is not going to make you money. And, as Luigi mentioned, for the most part, stock prices go up, so if you’re always just betting against the market, that’s not going to make you money.

To be a good short seller, you need to be able to identify companies whose stock prices are dropping, and they will be permanently dropping, and these tend to be companies that are either in industries that are just on the verge of death, or more likely, companies that are engaged in some sort of fraud, have some sort of scandal underlying them, or are right on the verge of failure.

Luigi: In a sense, this is an aspect of short selling I like, the idea of doing good and making money. If you are a good short seller, you expose fraud and you make money at the same time. It’s like a modern version of the bounty hunters that were going after criminals and making money.

Kate: To be fair, bounty hunters still exist. In fact, they make for very popular television.

Luigi: OK. Why don’t we meet a contemporary bounty hunter, Fahmi Quadir, who at the age of only 26 exposed Valeant, one famous pharmaceutical company, as an overhyped stock and made a fortune for the fund she was working for, and after that she walked away and created her own hedge fund, which is a short-only fund.

Kate: Unfortunately, I couldn’t make it to the interview because I was teaching all day, but I will chime in a little bit later, because I’ve got some thoughts about this interview.

Luigi: First of all, thank you for being on the show. This is a great opportunity for us to talk about a crucial aspect of capitalism that is not very much loved, which is shorting. Can you explain why this is such an important aspect of financial markets?

Fahmi Quadir: I think we live in a world where markets encourage companies to engage in varying levels of obfuscation, whether it’s at the corporate level or on their financial statements. So, short sellers are
. . . At least fundamental short sellers are really hoping to break through that obfuscation and provide some clarity as to what is really going on at a company, so there is ultimately true price discovery, and the stock price is more reflective of the true intrinsic value of that company.

Luigi: Can you explain to us what exactly is this dynamic between you and the companies?

Fahmi Quadir: One thing that we like to look for as short sellers are companies that complain about short sellers. Generally, if a company is focused on its operations and doing well and delivering to shareholders, then they will welcome short sellers, because it’s an opportunity for the share price to go higher, because at some point we have to buy those shares back.

But a company that has something to hide, they typically will act very negatively to the presence of short sellers. And it’s not just short sellers themselves. Sometimes, if there are skeptical Wall Street sell-side analysts—very rare I know, but they do exist—those analysts will be barred from asking questions on conference calls. They won’t be given access to management.

All of these behaviors . . . Even a toddler will tell you, it’s their attempts to hide something, to keep secrets and not be totally forthcoming. The only reason you can really ascribe to that is the fact they may be engaged in these same exact behaviors that short sellers are alleging.

Luigi: This is a little tip for a criminal CEO, don’t lose your temper and be nice with the short sellers, because otherwise you give away who you are.

Fahmi Quadir: Yeah. But fortunately for us, it seems that these guys can’t help themselves.

Luigi: Or they don’t listen to our podcast. That’s the problem. Most usually, I think that many people, in spite of the little explanation we gave now, see short selling as a bad activity. At some point a congressman said that short selling is un–American.

It seems like you are rooting for the other team. You are not only a contrarian, which is another side of that term, but you are antagonistic and hoping that things go badly. How can you respond to all this flurry of emotions?

Fahmi Quadir: If you are a believer in the free markets, then you should be a supporter of short sellers. We certainly play a role in keeping the markets efficient, as we discussed about price discovery.

But the way that I approach short selling, and the way we do at Safkhet, is we’re going after companies that are engaged in bad corporate practice, and that involves exploiting people, including exploiting Americans. Part of what we do is getting to the truth of what they’re doing and expose them so that they can at some point hopefully meet justice, so I don’t think there’s anything more American than that.

Luigi: So, you are making money by doing good?

Fahmi Quadir: I wouldn’t be doing it otherwise.

Luigi: Talking like a true millennial. Tell us a bit about probably the trade that made you most famous. Everybody has one high moment, and at least for the time being, your high moment is shorting Valeant. Can you tell our listeners how you first identified there was something wrong and what happened then?

Fahmi Quadir: Right. Valeant was the second short I ever put on in my entire life. I was first exposed to the company when I worked in pharmaceutical corporate intelligence. It was a company that there was an unspoken rule we’d never work with them, because they were known to be unethical. They were known to not pay their consultants, so they already had a bad reputation.

But the thing is, as a short seller, one thing we look for when a company is supposedly disrupting an industry, but it’s an established industry where there are certain norms that are adhered to, not just for purposes of convenience, but also for profitability.

With Valeant, we noticed that the business model was completely anomalous to the industry. The business model was to cut out R&D and to just raise prices. This didn’t really make sense, because the pharmaceutical industry itself is relatively profitable. It has better margins than most industries, so there wasn’t really much disrupting that needed to happen.

But what resonated so well with Wall Street was that it was very similar to a private-equity firm. It was all about managing costs and improving profits, and all the while taking on inordinate amounts of debt.

But I followed the progression of this, and it was only until I saw that the ability to access capital was basically cut off after they had acquired Salix that it became an attractive entry point for a short position, because the great thing about fraud is it can be incredibly profitable up to a point, and for me it seemed like that was the right point, because they couldn’t really keep the business model going with additional leverage.

So, I shorted it, and I continued pressing and building that short position on the way down as I investigated the company further and really tried to understand the nature of the fraud and how they were taking regulations that had been in place as far as reimbursement from private insurers and from the government and using that to enrich themselves.

All the while patients were getting hurt. The calls that we would get from whistleblowers and from patients who were taking these drugs still haunt me to this day. But, yes, it was, I guess, my first big short.

Luigi: Yes. But you are quite a character, because on the other side of the short, for people who don’t know, don’t remember, there was one of the most famous investors in Wall Street, Bill Ackman, who actually not only sort of invested in Valeant, but also defended the strategy of Valeant, so you kind of had a “high noon” moment and you won, so tell us about how.

Fahmi Quadir: Well, see, I’m not from the world of finance, so I didn’t really see it as so much of a duel against Bill. It was really, for me, with Valeant or with any other trade, I need to be right on the facts. I have to be able to justify to my investors why I’m taking on these positions.

Unlike Bill, on my side of the trade I have an infinite amount of risk. The stock price of Valeant or any other name that I’m short can go up forever, whereas on the other side, if I’m wrong it can only go to zero.

Luigi: This is an important point that most people don’t get, because they always think that shorters are very aggressive. In fact, in my view shorters are very timid and fearful, and they tend to only attack animals or companies that are really sort of close to death, because that makes it easier to actually profit.

Fahmi Quadir: I take issue with the word timid. I wouldn’t say we’re timid, we’re just very calculated.

Luigi: Prudent, I would say. They are prudent. OK.

Fahmi Quadir: Yes, prudent is a good word. To be a short seller, and because we’re up against those sorts of risks, you have to be right on the facts, so it’s about doing 10 times the work that the person on the other side of the trade is doing.

We saw the presentations that Bill had made. We saw that his justification for believing Valeant was not a fraud was because he asked Mike Pearson, the former CEO of Valeant, is Valeant a fraud? And Mike said no. So, that’s not a sufficient answer for me, so I had to go out and do proper due diligence and really investigate and prove my thesis.

That was compounded by the fact that this was my second trade of my career. I had no formal finance or accounting training, so I again had to prove myself, all the while proving my investment thesis. In the end, yes, I may have won, but it was never about Bill or anyone else on the other side of the trade. It was purely about the work that I had to do.

Luigi: What made you willing to take this bet that other people were not willing to take, and how is it possible . . . Maybe I’m talking too much like a Chicago professor here, but how is it possible that this information does not reach the market, that it needs you to reach the market?

Fahmi Quadir: Well, I think it starts with the questions that are asked of these companies. I think with something like Valeant, where the narrative was just that there was a lot of financial engineering, it was basically this private-equity type business model, and the stock was just . . . every year it was compounding and compounding and making lots of fund managers very wealthy, and the best performing funds all . . . what was their top holding? It was Valeant Pharmaceuticals.

It’s tough for an investment manager to take a stand against that. It’s not as tough for someone like me, who was an outsider and who really didn’t have to deal with those types of dynamics. I didn’t have any bridges that I potentially could burn. It was really just about asking the right questions and getting to the bottom of what was going on at the company.

Luigi: Generally, the first person saying that the emperor has no clothes gets shot, so how do you avoid getting shot in this situation?

Fahmi Quadir: Running a short-only fund, we’re taking bets against companies that are much larger than we are. They could go to any length to try to intimidate us out of our position. So, how do I keep this business model sustainable?

For us, part of that is just taking nonpublic positions, so we aren’t publishing research, we aren’t exposing ourselves to potential litigation damage, and we aren’t exposing ourselves to the attacks from these companies.

But even still, even though we aren’t making those public efforts, we have companies that are coming after us directly. Safkhet only started trading in January, but we’ve already faced very significant, orchestrated, sophisticated attacks on the cyber front as far as hacking, cyber surveillance, cyber intimidation. I even have to deal with physical surveillance, and it’s all because these companies don’t want us investigating their wrongdoing.

Luigi: You mentioned journalists earlier, and in order to make money, you not only need to make the right bet, you also need this right bet to be recognized by the marketplace. Basically, there are only two ways to do it. One is to have some journalist write about it, or to have the regulators go after the company. Which strategy do you prefer, and what are the plusses and minuses of the two strategies?

Fahmi Quadir: We try to keep all of those options in our toolkit. I think it really depends on the type of information that we’re trying to get out there. With every company that we do short, we will send our work to the regulators in due time, but that’s something that will take lots of time. Regulators require resources, and sometimes they won’t even direct any resources towards that particular company that we’ve been investigating.

With journalists, again, they’re also limited in resources, and even more so, I think, not enough support is going to our journalists. We live in a world where journalists are just killed for telling the truth, so it’s difficult for them to—

Luigi: Fortunately, not in this country yet.

Fahmi Quadir: I hope never. And it’s . . . From that point of view, journalists are also taking on very significant risks, and they are not getting the financial upside that short sellers get, but they play a crucial role in letting people know what goes on at these companies. But again, they have to be limited in the types of information that they get out there.

Luigi: You just said something a little bit earlier that was very interesting. You said that when you’re a shorter, you have to be doing your homework 10 times as hard as everybody else because it’s such hard work. Sometimes I hear this same expression, the same line vis-à-vis women, that in a man’s world they are forced to be 10 times as good in order to succeed. Is there a correlation within the two facts? How does your being a woman make you a short seller?

Fahmi Quadir: Well, being a woman and being in the fields that I’ve been in . . . I’ve never been in any sort of field where there have been a lot of women. It’s always been male-dominated, even when I went to college. At the time I went to Harvey Mudd, it was 70 percent men, and that wasn’t even that long ago.

For me, it’s more of, I won’t put up with BS. That’s why I’m here today, and I think women
generally . . . They have to put up with a lot of BS, but at some point, they shouldn’t.

Luigi: You have a nickname in your trade. What is it, and why?

Fahmi Quadir: So, I was named “The Assassin,” and just the backstory there, when I had started out, I would do my research and I would send it to other folks that were looking at these companies. Those folks would then ask, “Oh, who is this guy?” “Oh, it’s just The Assassin.” Then, eventually, people realized The Assassin was me, and I’m certainly not a dude.

Luigi: And you made the news with the fact that you shorted Tesla. Can you talk about this?

Fahmi Quadir: Well, yes. I can talk about Tesla. Again, we don’t really disclose positions, but journalists like the headline “Valeant Short Seller Now Shorts Tesla.” We’ve avoided shorting the company, because typically when there is mania and hype, mania and hype can continue for a significant period of time, and that means more losses and potentially business-ending losses if you’re a short-only fund, so we’ve avoided it. That being said, there’s so much that has been exposed—

Luigi: And we are looking forward to this “high noon” moment with Elon Musk. So, thank you very much for coming, and we look forward to seeing the next killing of The Assassin.

Fahmi Quadir: Thank you.

Luigi: Kate, now that you heard her interview, what do you think?

Kate: I think that Fahmi sounds like a smart and very capable and charismatic and well-spoken young woman. I think it’s great that she has made a name for herself in a male-dominated industry. But I take issue with the idea that we should be elevating hedge-fund managers, or anyone for that matter, who pursues a career of just making markets more efficient.

I don’t think that that’s something that we should be celebrating as a society. And I think that the reason for that is that there’s already so many young people flocking into the finance industry that it’s sucking up a lot of talent, and if we start celebrating these people as heroes, that’s only going to compound the problem.

People wouldn’t flock to finance if there weren’t money to be made, and I think that part of the reason that money is being made in the financial industry is because traders and hedge-fund managers make markets more efficient, so they take information and they incorporate that into prices.

I understand that that’s an important role that someone has to play in society, but I think that another reason, and maybe most of the reason why people make money in finance, has not so much to do with market efficiency, but to do with collusion between banks and local monopolies, or monopolies in certain types of securities, and the cozy relationship between Wall Street and DC, and all of these people justify their existence by saying, “Oh, yeah, we’re making markets more efficient.”

Luigi: Wow. What do you really think? Look, if you’re talking about a high-frequency trader who is making millions by quote-unquote making the market more efficient, I could be on your side. But in this case, I think it’s different. It’s not really just making the market more efficient. It is discovering fraud, preventing bad companies from wasting our money.

After all, you celebrate journalists when they write a piece like the Theranos piece exposing that the company was fake. What is wrong with celebrating somebody that exposes Valeant doing a strategy that is detrimental to American society, to people who are sick, and that without her work would be still there, doing that stuff?

I’m with you in saying we should not just celebrate finance people because they make money, but I think that we should not fall in the opposite direction and say we should criticize them all just because they make money.

Kate: I wasn’t criticizing them on the grounds of making money. And to your point about exposing fraud and exposing corruption, that’s not what her fund does. She explicitly said in the interview that they don’t disclose their positions publicly. They take a financial position, a short position, hoping that eventually later on people figure it out and the stock price falls.

But it’s not like they’re out there sounding the alarm. They’re just waiting privately for other people to discover that, for journalists to discover it and make that information public.

And also, Valeant in 2015 was being investigated by the SEC. It’s not like regulators were completely sleeping on the issue. And pretty soon thereafter, charges were brought and that led to the downfall of Valeant.

She talks about how regulators need more resources, and I totally agree. But if you’re on the side of exposing fraud, then go be one of those people who works for the SEC. Go work for one of the regulators. Don’t just work for a hedge fund where you take a short position and then keep your lips shut.

Luigi: I think you’re missing the fact that she diffuses the information, not under her name, not to be too much of a target. In fact, she was known as The Assassin during the Valeant case because her research was circulating, and as she said in the interview, she does pass information to the regulators and to the newspapers, and I bet money that the Valeant investigation in 2015 was caused by her research being given to the regulators.

Kate: It wasn’t.

Luigi: How do you know that?

Kate: Because they were aware of the situation before that.

Luigi: Look, I read in the paper about who blows the whistle on corporate fraud, and most of the time they are not the regulators. Most of the time, they are either employees talking to newspapers or short sellers. The regulators are late to the game, and very often even when they are told, they don’t act.

Like in Madoff, they went three times to the SEC saying that Madoff was a fraud, and nobody pursued that. If there was the ability to short sell Madoff, I think the Madoff scandal would have been discovered much earlier.

Kate: I agree with you that the SEC should act faster and that it needs more resources, but I don’t agree with you that just because the SEC acts slowly, that we should just rely on the short sellers as the heroes.

I thought your bounty hunter analogy was perfect, which is that bounty hunters from the perspective of society are not heroes. These are people who aren’t formally trained. They’re vigilantes. They don’t care about justice. They just care about making money.

If you actually cared about helping out the community and going after bad guys, you would be formally trained and you would work in formal law enforcement. It’s the people who don’t want to do that that are the bounty hunters.

Luigi: Wait a second. There are two things here that really get me the wrong way. The first one is, I don’t understand this “formally trained.” You can do a great job even without being formally trained. In fact, Bill Gates was not formally trained. He dropped out of Harvard, but I think he did a pretty good job. So, I don’t think that that’s the characteristic.

And second, I go back to Adam Smith. It’s not for the goodwill of the butcher and the baker that we get the meat and the fresh bread every morning. It is for their private interest.

I don’t see what the problem is in using private interests to reach the public good. That’s exactly what capitalism is about, good capitalism.

Kate: Sure. I agree with you, and we’re both in favor of a general capitalist society. But when I was in college, I hate to say it now, but I was in charge of two investment funds, these two student-run investment funds. Young college students, to them the idea of being able to make a ton of money just by being able to pick up on people’s personalities and having a good gut feeling about the market, that idea is like crack.

It’s worse than crack. It’s like fentanyl. It sucks them into the finance industry and it convinces them that they can make a ton of money without having to work hard or without actually having to have any experience or any specific knowledge, and I just think that it’s so dangerous to be disseminating ideas like that.

Luigi: But I think you are missing the bigger point here. I’m not saying that everybody should do what Fahmi does, and I don’t think in general that not having training is good. However, I recognize that training also brings distortions and brings some buy-in to a system that does not allow you to see the system from the outside.

I think that it is not a surprise that the biggest innovators tend to be outsiders who don’t fit into the system and see the system with a different pair of eyes. Do you want everybody to do that? Absolutely not. But do we need in society some people who do that? I think so, and Fahmi is one of those.

Kate: Sure. As I said initially, people need to make markets efficient, and if that means on the short side you need people with different perspectives, fine. I think that’s fine. I have no problem with the existence of short sellers, but I don’t think they’re any different than people who run long-only hedge funds, and they’re discovering positive information in order to make money. It’s all the same to me.

Luigi: Actually, I disagree here, because people who run long-only funds, they don’t get arrested, they don’t get hacked, they don’t get followed, they don’t get to be told they’re un–American and they are hated by people. I think it’s very hard to be a short seller, exactly like it’s very hard to bring bad news, and we need people who bring bad news.

The reason why there are stock market bubbles is there are not enough people who are willing to tell the bad news. I like to celebrate people who have the guts to do that, especially when they’re young, because you’re right that she only had one really big, successful short. But now we have a second test. Apparently she’s shorting Elon Musk and Tesla. Do you think she’s going to win on this one?

Kate: I mean, look, I’ll be the first person to make fun of Elon Musk. I actually dressed up as Elon Muskrat for Halloween. So, I have no problem with the position that she’s taking.

Luigi: What did your costume look like?

Kate: First, I wore a Tesla shirt, and then I got muskrat ears, or the closest I could find to it, and taped a rubber snake on top of it in the hopes that it would look like an eel, so, get it, eel on muskrat. And I had whiskers and claws and a tail, a rat tail and stuff. But then I also was carrying around a cigarillo that was meant to look like the blunt that he was smoking on that radio show.

Luigi: I think that people will flock to our Facebook page to see your picture impersonating Elon Musk.

Kate: I wish I hadn’t mentioned that.

In the second of a two-part look at global inequality Kate & Luigi talk about the downside of globalization. A listener's email sparks a conversation about what's driving the growing wage gap within the U.S. We survey the latest research on the lingering effects of the 'China Shock' and debate how to reverse the trend before the people revolt.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: We want to start out this episode with a note that we received from one of our listeners, Paul Driscoll, who wanted to hear us talk about globalization in technology. In his note, Paul described how he lost his IT job at HSBC Bank a couple of years ago, and it was under this internal slogan, “Moving IT to high-quality, low-cost locations,” which was just insulting. And after that, the next job he found was a pay cut from his prior job, and he said, “For me, this new liberalist viewpoint of most economists, treating people as mere widgets with none to little protection from the state, in my mind, no economics seems to have an answer.” And he blames a lot of this on globalization, automation and health care.

Luigi: Paul’s note is an excellent way to introduce our second episode on globalization. As our listeners remember, we started talking about populists, and then we moved to globalization because globalization is blamed for having created a lot of people who are disenfranchised—I suspect Paul is one of them—and who are very upset about what’s happening in the United States. And last episode, we looked at the positive aspects of globalization, the fact that billions of people were lifted out of poverty. Today, we’re going to look at the dark side of globalization, that is, an increase in income inequality in Western countries, and in particular, in the United States.

And, as Paul mentioned, it’s a bit difficult to separate globalization from automation or, generally, innovation. And the two, by the way, might combine to generate this phenomenon, but in today’s episode, we’re going to try to do our best to sort these things out.

Kate: Before we get into this, we should mention that what globalization means can be a complicated issue. So, it could refer to globalization of trade, to finance and capital markets, to immigration, to outsourcing of service jobs. Most economists focus on the trade element, and that’s what we’re going to talk about mostly today.

Luigi: And let’s start with the simplest example possible. Imagine that we have two countries, the United States and, let’s say, Cambodia, and those two countries don’t trade with each other in the beginning, and they both produce airplanes and T-shirts. And let’s assume that the United States is more technologically advanced, so they produce both T-shirts and planes better than Cambodia. But relatively, they are better at producing planes than T-shirts. Then, when the United States starts to trade with Cambodia, Cambodian T-shirts start to come into the United States, and they might be of slightly less quality, but they are much, much cheaper than the ones in the United States. And then, all of a sudden, the price of T-shirts in the United States drops, and as a result of this drop, the wages of low-skilled workers will go down, and the wage gap between high-skilled workers and low-skilled workers in the United States will most likely go up.

Now, let’s look at Cambodia. Cambodia, they probably are not going to import the T-shirts from the United States because they’re very expensive, but they love their US planes because they are much, much better than the Cambodian planes. And so, probably they even stop producing planes, but even if they do produce planes, the competition for planes would be quite harsh, and so prices of Cambodian planes will go down. And as a result, we should see, actually, a decrease in the wage gap in Cambodia, because the high-skilled workers working in the plane factory will get a wage cut, while the low-skilled workers working in textiles, because of the demand from the United States, will see prices go up, and so wages go up.

Now, what is interesting is if you look at the data, you do see the first phenomenon, you do see the fact that the wage gap in the United States goes up. You don’t see a similar phenomenon in Cambodia of the wage gap going down.

Kate: This is what’s known as the Stolper–Samuelson theorem. And the finding that Luigi just mentioned is part of why a lot of people in this literature, in this macro and international trade literature, they don’t think that globalization is what really is accounting for all of the increase in inequality within countries. Because, according to this theorem, we shouldn’t have seen inequality go up within countries like Cambodia. Instead, they think that automation and technology explain more of this increase in inequality, that machines and computers and robots are taking our jobs, and you don’t need as many people to make a T-shirt as you used to, because now we can automate that whole process.

Luigi: In general, it is very difficult to separate the impact of automation from the impact of globalization. And, in particular, from the impact of Chinese imports into the United States. And the interesting factoid is that until 2000, the number of jobs in manufacturing in the United States was fairly stable, and this was the result of two very different trends. On the one hand, the percentage of people working in manufacturing was dropping very fast. On the other hand, the quantity of manufacturing produced was going up, and the two things were conversating in a nice way, so that the total amount of workers was roughly the same. But then something happened dramatically in 2000, and between 2000 and 2007—so even before the financial crisis—we see a gigantic drop in the number of workers in manufacturing that goes from roughly 60 million to 12 million. And then, of course, with the financial crisis, there’s another drop from 12 million to 10 million.

Now, there is a paper, an economic paper that shows that the first drop, and maybe even the second, but certainly the first drop has been caused by a change in trade.

Kate: So, this change in trade was the result of what was called the permanent normal trade relations status. This is something that Bill Clinton pushed for a great deal towards the end of his presidency and was eventually passed in the late 1990s. And the whole idea behind this was that we wanted to normalize trade relations between the US and China. We wanted to give China this permanent status as a country that we could trade easily with. Eventually, he pressured Congress to pass this legislation, and it made it much easier for us to trade freely between the US and China, as well as move jobs over to China.

Luigi: Yeah. I think it’s useful to understand that before the passage of this law, China was considered a nonmarket economy, and so the possibility of trading freely between the United States and China was granted by Congress every year, at the beginning of the year. And while in the ‘80s, this was a no-brainer, after Tiananmen, there was a serious threat that the United States Congress would not renew this exemption. And so, the idea behind this paper is, up to 2000, when this law was passed, there was a lot of uncertainty about the long-term relationship between the United States and China, and so people were afraid, for example, to outsource a plant to China, because the next year you could stop trading. And in the same way, the Chinese were very much afraid to set up long-term relationships of exports to the United States for that reason.

And so, this paper looks at what happens to manufacturing, especially manufacturing that competes with China following that shock.

Kate: So, if you look at a chart that indicates the extent of imports and exports between China and the United States, what’s interesting is that you’ll see a gradual increase starting in the early 1990s, but this really takes off after 2000.

Luigi: The paper that we have been discussing has been written by Peter Schott at Yale and coauthors, and they have a follow-up paper that is pretty frightening, because they connect the increase in suicide rates at the country level with the decline in manufacturing caused by the opening of trade. And they find quite a remarkable effect, suggesting that the impact of globalization was not only a loss of income, but also some form of economic despair.

Kate: And in terms of the effects on inequality, there is a follow-up paper, a series of papers actually, by Autor, Dorn, and Hanson, and they pinned down the areas that were more exposed to trade with China, and the effect that that had on wages and labor force participation. And they found that in the counties exposed to the China shock, workers experienced lower lifetime income and had a really tough time readjusting their jobs and their skills. In some cases, it took more than a decade for people to transition into other industries.

Luigi: One aspect that is often forgotten is that in economics, it’s clear that trade improves overall welfare, but it’s not clear, in fact it’s clearly opposite, that trade increases the welfare of everybody. So, in economic theory, trade has winners and losers, and it does overall increase the size of the pie, but there are winners and losers, and these winners and losers need to be somewhat compensated in a political way, if we want trade to move ahead. And I think that part of what we have been seeing in the last 20 years is, we’ll push for more trade, ignoring the cost of the losers.

Kate: I think something that a lot of the macro literature on trade and inequality is missing is that for the most part they focus on the difference between low-skilled workers and high-skilled workers. So, people with no high school degree versus people with a college degree. That’s part of the inequality problem, but what’s really driving inequality at the high end isn’t all people with a college degree, it’s people in the top 1 percent. You could define that as income, but I think particularly wealth. And CEOs and top-paid executives are a big part of what’s driving within-country inequality.

There’s an interesting paper by Keller and Olney in 2016, and they showed this simple graph: if you look at exports from the 1950s to 2007, it’s a startling match for how much they went up versus how much executive compensation went up. Those two lines basically move in tandem. They don’t simply show one picture, they attempt to pin down the causal relationship between exports and CEO pay. But what they end up finding is, unsurprisingly, global trade did play a large role in increasing CEO salary, particularly for the top 50 companies.

Luigi: But I think this is a combination of expansion of markets, you can call it globalization, but the fact that now there is a global market, and technology. When I grew up, nobody was watching Italian soccer games except Italians. Today, there are people in China that regularly watch the Italian championship, because it’s better than the Chinese one. And I think that this expansion of the market, that is caused in part by technology, it is so much cheaper to transfer this information, and also by globalization, had an impact on wages and inequality that is independent of pure trade.

So, in my 2012 book, A Capitalism for the People, I used this example that I think is quite useful. Take golf tournaments, there’s no trade in golf tournaments. And take the best golf tournament in the United States, it’s the Masters, the Augusta Masters. Now, look at the prices that are paid for the winners. So, in 1948, the first prize was only $2,500. That, in 2008 numbers, is $22,000. In 2008, the first prize was $1,350,000. So, 60 times in real terms. Certainly, the wage of the people working at the field has not increased that much, but interestingly, even the second, third, or fifth prize did not increase that match.

So, even in prizes, there is an enormous increase in inequality, where the winner takes all. The winner is rewarded disproportionately, and why? Because people in Japan wake up in the morning to see Tiger Woods playing golf. They don’t want to see the number fifth or the number 20th.

My colleague Steve Kaplan and Josh Rauh from Stanford wrote an interesting paper trying to document how important are various categories in the famous top 1 percent, or top 0.5 percent, or even top 0.001 percent. And what you find is that, if you look at the 0.001 percent, the people that make at least $7 million, actually top celebrities are only 0.5 percent, professional athletes are 1.5 percent, and the Wall Street people are roughly 5 percent. So, there are a lot of other people who make it to that threshold, who don’t belong to the categories that we think normally are superstars.

And another colleague of mine, Eric Zwick with coauthors, is trying to identify who those guys are, and they tend to be doctors, dentists, and car dealers. Why car dealers? Apparently, car dealers are small entrepreneurs that make a lot of money.

Kate: Yeah, but you’re talking about the income distribution. And I don’t think that the same logic applies to the wealth distribution. To be in the top 1 percent of the income distribution on a household basis, you have to make over roughly $430,000 to $440,000 per year. That’s a lot. But to be in the top 1 percent of the wealth distribution in the United States, you have to have over $10.5 million of wealth. And I don’t think that there are that many doctors and car dealers who go from having nothing to having $10.5 million of wealth at the end of their lives. I think those people for the most part, to be fair, it’s harder to study the wealth distribution, and so we don’t have as good of a sense of who those people are with $10.5 million of wealth, but my hunch would be that they’re more ... People represented ... There’s more representation from the finance industry, and there’s just more inherited wealth in that top percent.

Luigi: Maybe we deal with different doctors. I think that there are quite a bit of doctors that at the end of their life have accumulated, at least at the end of their working life, have accumulated $10 million in total wealth.

Kate:Yeah. Maybe there’s a couple of brain surgeons and orthopedic surgeons out there, but also keep in mind that $10.5 million is the minimum cut-off. In terms of the average in that category, it’s much, much higher.

Luigi: The wealth has been tremendously affected by the internet, and now social media, and the stock market. I think that in order to make that kind of money, you need to basically succeed in the stock market.

The first artist who has become a billionaire is actually Jay-Z. And Jay-Z has an estimated wealth of north of a billion now, and most of it does not come from his phenomenal record deals. He had two deals. One in 2008, when he got $150 million, and another one recently for $210 million. So, he’s very good at dealing with this stuff, but where he made real money is that he created the Tidal streaming service in 2015. That now is valued close to a billion dollars. So, I think the real wealth is in the stock market.

Kate: And this goes back to Piketty’s point, it’s the owners of capital, who are able to have enough to save and put that in the stock market, whose wealth increases the most.

Luigi: That’s absolutely not true, because the capital that Piketty is talking about is land and housing, and neither Jay-Z nor any of the guys that made really a lot of money have made money from land and housing. I think that Zuckerberg is a billionaire, not because he’s saved a lot. Zuckerberg’s a billionaire because he had a clever idea and was able to appropriate a lot of future rents. And the same can be said for Bill Gates and for Jay-Z and for a lot of other people.

Kate: The reason that Piketty focused on land and housing was because most of the time series he was studying was in the 1700s and 1800s, but obviously, if you were to apply that same logic just to the past 20 years, he wouldn’t just be looking at land and housing, he would be looking at all capital, which, for the most part, what’s important is the stock market.

Luigi: Yeah. Little detail, he called his book, Capital in the Twenty-First Century, and he should have called it Capital in the 19th Century.

Kate: We’ve already been through this. If you want to hear more about this debate, you can go back and listen to our Piketty episode.

Should we talk about solutions?

Luigi: Please.

Kate: I think it’s a little disheartening to think about what the potential solutions are, because the solutions are things that we should have been thinking about in 2000, right? Coinciding with the permanent normal trade relations status of China in 2000, we should have also instituted labor retraining, labor mobility programs that would help out people who were working in manufacturing, and who lost their jobs because those jobs were exported to China. And we simply didn’t do that. We were assuming that everyone would be better off because we’d have cheaper goods, but we forgot about this huge swath of people who became unemployed.

And now, 20 years later, there’s the question of, is it too little, too late? Have those people permanently dropped out of the labor force? And what about the younger people in those areas, who are just entering the labor force? What can we do for them?

Luigi: Kate, you’re right, but I fear it’s even worse, because the issue should not have been thought of only in 2000. It should have been thought of even earlier. One reason why the American middle class is being so squeezed out by globalization is that it’s lost out in terms of relative education.

In 1950, high school graduates in the United States represented 35 percent of all the high school graduates in the world. And by 2000, they represented roughly only 5 percent. So, what this is saying is the world has caught up with the United States. The United States pioneered universal high school education in the early part of the 20th century, and since then, they have not pioneered universal college, but even worse, probably the quality of high school has gone down, while the rest of the world has understood the importance of education and has massively increased education, starting with the Asian tigers we were talking about last time, and most importantly, China.

Kate: And I think the answers are education, redistribution, and health care, but at this point I feel like, what’s the point of even talking about that, when we don’t have the political capital to really force through any of that legislation? Everyone knows that we need to solve these problems, but it’s depressing to talk about solutions.

Luigi: I think it’s important to explain to people that there was a negative effect of globalization, that this effect is not necessarily a reason to stop globalization, but it is a reason to join globalization with some other measures. And so, if you want to push for globalization, you need at the same time to think about some safety net to absorb some of the costs of globalization. If you want to go back, then you pay the cost of going back.

I think that, by and large, no one is proposing more globalization with better safety nets. You have people that say, more globalization, and people that say, no globalization, but the connection with the retraining, with the safety net, has been lost in many people’s view.

Kate: Sweden is a country that’s actually has done a pretty good job of that, though.

Luigi: Yeah. I think that they have a good safety net, and they are a very open economy. They’re just six million people. They can’t live just by themselves in a closed economy. So, they are very open. They favor markets. They also have some mechanism of a safety net that makes it difficult for people to fall behind.

Kate: The one thing I feel a little bit less depressed about is that I do think ... I mean, I’m sure there will be plenty of people on the right who would lobby hard against this, but I think one area where there’s probably some bipartisan consensus is that there needs to be less tax evasion, particularly on the part of the wealthy. And if we can do a better job of making sure that the wealthy pay their fair share of taxes, then that will help decrease the inequality problem.

Luigi: Except, though, the measures of inequality we look at are pretax. So, there’s no doubt that the after-tax measures can be improved with the redistribution, but at the moment, all the measures are pretax.

Kate: OK. That’s true. They probably won’t help the problem overnight, but over time, if there is more redistribution, then we should see wealth go up at the bottom.

Luigi: Yeah. But I fear that redistribution by itself is not the solution, because, of course, you need some safety net, but you can’t have people that live under it all their lives. I think there’s a human dignity aspect, which is at least as important as the income aspect. And I don’t want to demean the importance of support, but I think that people need to find a successful employment and meaning in life that is not just being paid off by the state.

Kate: So, going back to Paul, he said to us, “In my mind, no economics seems to have the answer.” And in a way, he’s sort of right. This goes back to the Rodrik dilemma, that you can’t have both economic globalization, and national sovereignty and democratic decision-making. And that’s kind of the point, that if you’re going to open up your country to globalization, then you’re going to end up having large swaths of the population who feel like they’ve been marginalized. And this inevitably, according to the Rodrik dilemma, will lead to trouble within our democratic system. And I think that that’s what we’ve been seeing with the rise of Trump and with the rise of populism.

Luigi: And it was easy for the United States to deride Latin American countries in the ‘60s, ‘70s, and ‘80s. They were very much affected by populism, but the reality is that those countries were much more exposed to global shocks than the United States was.

I remember as an undergrad student, I learned that whenever the United States sneezes, Canada catches a cold, because the United States was able to shock the rest of the world without being shocked. And today, the United States is shocked by the rest of the world. And if there is not a democratic response to that, people will revolt, and populism is a form of revolt.

Kate: So, Yascha Mounk was right. We’re all screwed.

Luigi: Join the worldwide movement against globalization. No, but the irony is, the worldwide movement against globalization.

Kate: The global movement against ... Yeah.

In the first of a two-part look at global inequality Kate & Luigi talk about the upside of globalization -- a decrease in income inequality between countries over the last few decades. How much of this can be attributed to China, and what was the secret to their success?

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: This is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

In the last two episodes, we discussed populists in Brazil with the victory of Bolsonaro, and with Yascha Mounk about populists all over the world. Yascha was one of the many people saying that the reason why we see this explosion of populists all over the world today is because of an increase in inequality.

What we want to do now is actually analyze how much truth there is in this allegation. In particular, what is the impact that globalization has on inequality?

Kate: There are many different ways in which you can think about globalization and inequality. One major distinction is between within-country inequality and across-country inequality. If a bunch of countries are converging to one another, poorer countries are being lifted out of poverty, you can think of that as a reduction in across-country inequality.

Luigi: The second thing we have to be aware of is that globalization is not necessarily a recent phenomenon. If we look at the last two centuries, there have been two major waves of globalization, one that took place between 1818 and World War I, and the second one that started in the 1980s and is continuing today. In both cases, we saw a similar pattern of increased inequality within the Western world. The difference is more what happens at the global level about inequality across countries.

What we’re going to do in these two episodes is focus on the recent wave of globalization, because, number one, it’s recent and more interesting, and, second, we have better data to analyze. But you have to keep in mind that some of the stuff that we say today has some historical background.

Kate: On today’s episode, we’re going to focus on the rosier side of the picture, which is how there’s some evidence that across countries, inequality has been improving, and, in particular, a lot of people have been lifted out of poverty as a result of globalization. But on the next episode, we’re going to focus on the darker side of the story, which is that within a lot of Western countries, there has been a big inequality problem.

I think part of the reason people are so mad about inequality is because of statistics like, just eight men in the world own the same amount of wealth as 3.6 billion people living in poverty, which is half the population of the planet.

Luigi: Are you angry because they’re men, or because there are only eight?

Kate: Both. A little bit more that there are only eight, but the fact that they’re men doesn’t thrill me either.

Luigi: This is not just a statistical issue. I think it is a philosophical issue. What do you care about? Why do we care about inequality?

I think that the reason why we care about inequality is because there is a tail of the distribution that is extremely poor. There is a tail that cannot arrive at the end of the month, cannot feed the kids, and so on, so forth. If that tail can improve dramatically, I think the world is a better place.

If the guy that used to buy a mansion can now buy two, that’s not a problem for me as long as more people can go to school, more people are not starving, more people are middle class. Definitely, we have seen that in the last 30 years.

Kate: Yeah, I do think there’s a distinction between talking about reductions in poverty and talking about changes in inequality. There have been reductions in poverty. I think at the global scale there’s no doubt about that.

But at the same time, there’s confounding factors there, too. Most of that is driven by China, for example. China’s poverty rate fell from 85 percent to 16 percent between 1980 and the mid-2000s. That was a huge driver of this reduction in poverty.

Also, another thing that confounds our measurement of global inequality is that rich people tend to not really report their incomes. If we’re not really counting how much richer rich people have gotten, then the numbers look rosier than, I think, the truth.

Luigi: Let’s put some structure to the discussion here. I think that the World Bank defines somebody as poor if the person can spend less than $1.90 a day and defines somebody as middle class if you can spend between $11 and $110 per day per person. Now, these dollars are adjusted for differences in what is called purchasing power, the ability to buy different goods in different places, and they are adjusted for time, so for inflation.

But, so, if you think about 2011 dollars that are not too different from 2018 dollars, in 1981, 42 percent of the world was poor. Now, it’s less than 10 percent.

You’re right, Kate, that much of this reduction took place in China. The number went from 660 million people to now 25 million, but, also, India, and part of the rest of the world. In addition, there has been an increase of people who consider themselves middle class.

I think that the other month there was a celebration that most of the world, slightly more than 50 percent of the world today, can be considered middle class by this standard. This is a remarkable success, and I think that globalization and capitalists are responsible for this success.

Kate: How do you measure inequality? If everyone’s wealth doubles, then, according to the Gini coefficient, inequality didn’t change. Also, if you’re looking at a poor person’s wealth doubling versus a rich person’s wealth doubling, I think that the rich person got better off, and, so, actually, inequality increased.

Luigi: I think this brings us to, why do we care about inequality? If the concern about inequality is envy, that you are jealous that some people make more than you and can buy more mansions than you can, I think that measuring on an absolute basis might be relevant.

But if we are concerned about people who are left behind, people who cannot afford a decent living, people who cannot send their kids to a decent school, I think what we care about is the fact that the lower tail of distribution is improving dramatically its standard of living. In that sense, a relative basis is fine and captures that very well.

Kate: I don’t think that the concern with rich people getting richer at the same time that poor people are getting poorer is just poor people being jealous of rich people. I think that the concern is that if rich people double their income at the same time that poor people double their income, that makes rich people relatively more able to influence the political system. It makes rich people relatively more able to distort the playing field in favor of their own children.

Yeah, I think the jealousy thing matters, too. It foments political unrest. I think there are reasons to be concerned about inequality on an absolute basis.

Luigi: I think that the point you’re raising about the influence in the political system is very important and should be taken very seriously. But if you keep that aside for a moment, and I’m not saying you should always keep it aside, but if you keep it aside for a moment, what we care mostly about is inequality of consumption. Inequality, if you want, of utility, of welfare.

We know that marginal utility of money is decreasing. If I go from making $1 a day to making $3 a day, my utility goes up tremendously. If I go from making $1 million a year to making $3 million a year, of course, my utility goes up, but not in any possible form or shape in the same degree.

I think that the standard measures that look at the relative distribution of income are useful measures, and, by those measures, the last 30 years have been very good years in terms of decreased inequality.

Kate: I don’t even agree with that. Even if we’re just looking at relative measures, one of the most popular studies of the decrease in global income inequality is by these two guys named Lakner and Milanovic, where Lakner is at the World Bank, Milanovic is at CUNY. They find that the global income Gini coefficient has fallen from 0.722 in 1988 to 0.705 in 2008.

First of all, 0.722 to 0.705 is not a massive decrease, and that still indicates a pretty high level of inequality. Then, also, here I think it’s important to talk about how much that increase in global income is attributable to just one country, China.

According to those same World Bank statistics, between 1981 and 2005, if we look at the number of people who are living below $2.50 per day, and we exclude China, then the number only dropped from 50 percent to 49 percent. Yeah, I’m bumping the number or the definition of poverty up by a little bit, you said $1.90, I’m saying $2.50. But really, I don’t think there’s a huge difference there. If we exclude China, there’s barely been any change.

It’s not to say that we should be sad about that, because there’s a huge number of people living in China, and they’ve become much better off. But I also don’t think that this necessarily tells us anything about global trends.

Luigi: First of all, it is not just China. Also, India did remarkably well—not as well as China, but I think it’s important. It is true that China is the big outlier. I think it’s worth understanding why China was able to make it.

I think that the turning point in China was the Deng Xiaoping reforms in the early ‘80s, when China de facto abandoned a communist regime, where even the land was in common, and started to recognize private property and allow some form of private enterprise. It was not initially very diffused. It was only in some economic areas. But then, this spread in a larger and larger part of the country.

The other major turning point is when China joined the World Trade Organization at the turn of the new century. This is really a turning point, because China accepted many rules of the economy, the world economy, and entered full term into the global economy in global trade. I think that it benefited tremendously from the transfer of technology and money coming in and being invested in China, foreign money coming in.

Kate: There’s this open question as to why did manufacturing jobs go to China and not South Africa or Indonesia. I think the answer to that is a difficult one, because there’s a couple of different potential solutions. One is that it has to do with government institutions. There’s a single party in China. Maybe there’s cooperation problems if you’re working with a democracy, where there’s changes in party control, and you’re not really sure what the next regime will be. For Western countries moving plants, for example, to other countries, it was easier for them to work within a single-party system. That’s one of the explanations.

Here, Amartya Sen, a Nobel Prize-winning economist, has weighed in on the issue, and he believes that it has much more to do with education and health. If you look at the educational statistics between China and India, for example, in 1990, only 45 percent of the adult Indian population was literate, whereas it was 80 percent for China. Life expectancy was also significantly higher in 1990.

This is why American manufacturing companies would want to relocate their factories to a place like China, where they knew that it was easier to train the population, because so many people were literate, and, also, they didn’t have to worry as much about low life expectancy, about having to deal with issues like disease and famine.

Luigi: But I think that I will divide the problem into two. There are the first 20 years of Chinese expansion from 1980 to 2000, and, then, there are the next 20 years, from 2000 to today.

In the first 20 years, I think that the secret is very simple. It is starting low. China was completely mismanaged. Agriculture was very, very low productivity, in part because there was no private ownership of land.

We have seen many countries having a very high level of growth succeeding in getting the agriculture from the Middle Ages to the 20th century. Even Italy after World War II had 20 years of 7 percent growth, which is hard to believe today, but it is a combination of a rapid movement from agriculture to industry.

Now, the more interesting question is, what happened in the next 20 years? Because, while it’s easy to go from a low-level agriculture to productive agriculture, it’s much more complicated to move from being a middle-income country to being a more-sophisticated country.

Here, I have to say, it’s not just China that did it. If you look at Korea, Taiwan, Singapore, Hong Kong, what we used to call the Asian Tigers, they all succeeded in this in a remarkable way.

They all share some common features. One is an emphasis on education, as you mentioned. The second was a pretty good rule of law, even if in China certainly much less than Hong Kong. I think that those two things are quite crucial to the success of the economy.

Kate: I think there’s an interesting debate to be had here about what we mean by good rule of law. There’s good rule of law for the people. That means democracy. That means voting rights. That means liberalism in the sense that there are civil liberties and people have free speech. But there’s also good institutions for business and capitalism.

I think the latter is really what united what you call the Asian Tigers. Even though China’s a communist country, at least de jure, it had a lot of the similar business-friendly institutions that Singapore and South Korea did.

Luigi: Yeah, I think it’s quite important especially to motivate foreign investments that if you set up a plant, this plant is not expropriated by the local authorities, or even if it’s not expropriated, if the working conditions, the regulation is changed ad hoc to make your life worse, or if they try to extract gigantic bribes for you to work there.

While Korea, China, and Taiwan are not in any way perfect from the corruption point of view, they are certainly better than Latin American countries or African countries or even India, for that matter.

Kate: I think that’s a huge point. I think it’s really the corruption problem at the local level and the everyday level that impedes business formation and growth.

Luigi: I think a point I would like to get across, because it’s often forgotten, is many economists or even policymakers think that if you just have markets, they will do wonders. But markets need infrastructure, legal infrastructure to work. The legal infrastructure must be supported by a competent state.

China has a long tradition of a competent state. I think that even Korea, et cetera, they do. I think in my view that helps forming a competent state to run a modern economy. In a lot of other countries, this tradition does not exist, and that makes it much more difficult.

What makes a country rich is not how much gold is there. It’s not how many buildings are there. It is the ability of the people working there to be very productive, to produce a lot per hour of work.

Labor productivity is what drives the wealth of nations in the long term. The fact that China increased tremendously the number of people out of poverty meant that China had a tremendous increase in labor productivity over this period.

Kate: I really hate to have to talk about this, because I don’t want to have to nerd out on this show, but it’s a little bit hard to talk about global growth without introducing this model called the Solow growth model, which is pretty important to understanding economic development. It’s named after Bob Solow, who won a Nobel Prize for this idea.

The two ideas behind the Solow growth model are that if you go from having just a little bit of capital—by capital I mean machines and plants and stuff—if you go from having just a little bit to more than just a little bit, that actually leads to a big increase in output, or a proportional increase in output. Whereas if you have a ton of machines and a ton of plants already, and then you increase them by that same amount, the relative increase in output is lower.

What I’m trying to explain is this idea of the declining marginal product of capital. Going from a low level to an intermediate level, you gain more than going from a high level to an even higher level.

One thing that’s a little bleak about the classical view of country growth is that once you reach what’s called a steady-state equilibrium, that’s just a point at which countries are basically stuck, the idea is that if you’re rich enough as you invest more in capital, you don’t actually get that much more output. In fact, you reach this point where the rate at which your factories and your tractors are depreciating is the same amount that you reinvest in them, and your output isn’t increasing at all. According to the classical model, once you’re a developed country, you just stop growing.

Luigi: You’re right, but this is in the classical model that ignores the importance of idea innovation. In fact, this year’s Nobel Prize winner, Paul Romer, got his prize precisely because he emphasized the importance that the spillover of ideas has increased the productivity of everybody.

This bleak view that we converge to a steady state, and we don’t grow from a steady state, is too negative a view and too old-fashioned a view. I think that innovation is important in increasing the famous Solow’s residual and in guaranteeing an increasing standard of living to everybody.

But this is the interesting part. China improved its productivity, not just importing capital or accumulating capital, but also importing technology and new ideas from the West. Globalization actually allowed China to do that and to do that very successfully.

Kate: Yeah, so you had mentioned this point earlier about how we allow other countries to experience the same sort of growth. I think it’s relevant to mention that if you look at the reduction in extreme poverty in some of the worst parts of the world, so, sub-Saharan Africa, and you look at the number of people living on less than $1.25 per day, that’s barely changed between 1990 and 2013.

Why is it that a country like China was increasing rapidly, whereas countries like those in sub-Saharan Africa didn’t benefit at all? The answer is mostly that it has to do with institutions. That you’ve got to give people property rights. You’ve got to create courts, and you’ve got to educate them at the elementary level and things like that. You have to have those basic institutions in order to really reap the benefits of technological improvements.

Luigi: This is where Africa starts at a major disadvantage, because it’s still affected by major fights and wars that are mostly a leftover of colonialists that divided Africa into countries that have very little to do with their ethnic origin, but more to do with which European power was grabbing what part of Africa.

War is the biggest enemy of development. The second biggest enemy is the lack of property rights. Africa is behind in creating these property rights, partly because, during wars, it’s difficult to maintain them.

But second, because you need a certain level of diffused education to do that. A friend of mine told me that when Tanzania became independent in 1961, there were 12 or 13 people with a college degree, 12 or 13 people in a country of 60 million people.

I think that the amount of human capital to start with was low, and, as a result, the ability to create courts and reliable systems is behind. But I think that, at least in parts of Africa, this is changing today.

Kate: Absolutely, I used to copy my math homework off of my Tanzanian roommate. She was brilliant. Thanks, Gloria.

Luigi: That’s not what I meant with the human capital, because, unfortunately, probably, your roommate will stay in the United States and will not help Tanzania develop, wouldn’t change—

Kate: Yeah, she actually lives in D.C., so, yup.

Luigi: Which is actually … a very important point that we’re raising is the level of brain drain that the United States is doing with respect to the rest of the world, and I am a case in point, is a problem for the rest of the world, because it is depriving the rest of the world of a lot of resources and making it more difficult for those countries to develop.

But now, Uganda, Rwanda, and Burundi are actually developing fast with a much better ruling class, much more educated ruling class, and I think the hopes of a turnaround of Africa are pretty significant.

Kate: I think another thing that’s good news for Africa is that Trump is making it harder and harder for people with high levels of human capital from other countries to stay in the United States. That’s good news for other countries, not great news for the US.

Luigi: In our podcast, we discuss so often what does not work in capitalism, but I think that in this episode, we can celebrate what does work. The success of China is a success of globalization and capitalism.

Remember that historically Western nations colonized other places, and this increased the poverty of those countries. Lenin famously said that colonialism was a way to exploit the monopoly power of Western nations over the rest of the world.

The globalization starting in the 1980s is the other way around. It is, in fact, the Western nations transferring technology to mostly China, but also India and some other countries were able to catch up, and this brought an enormous increase in the standard of living in a large part of the world. I think that we can celebrate a big success for capitalism in this episode.

Kate: Usually, I’m the one who’s positive about capitalism. I’m always the one who says, “What’s working in capitalism today.” But this time, I might feel a little bit more negative.

The huge success of China in the past couple of decades has led to an increase in the standard of living in China. But on the other side of it, there has been a lot of pain felt by Western democracies and, in particular, the United States. Many think that that was the flip side of the globalization that helped China out. This may have been what generated populist movements across Western democracies.

Luigi: I think you are absolutely right on the last point. But we have to remind ourselves that the failure of capitalism in this case is to be too egalitarian, because capitalism made it easier for the Chinese to catch up to the American standard of living and brought the standard of living of some Americans, at least, down in the process.

This is not something that capitalism is generally accused of. It’s accused of favoring inequalities, and, at least at the international level, it didn’t.

But you are right that it did create some losers. Globalization, in particular, created some losers in the United States. The big problem is that we vote on a national level, not on a global level, and so this legitimate concern was not addressed in any way politically, and that brought, too, a lot of disenfranchisement of a large part of the American population. I think that this is something that we need to analyze more.

Kate: On our next episode, we’re going to talk about how wealth inequality has changed over the past couple of decades within the United States, what the potential negative repercussions of that are, and we’re going to try to do it without sounding too much like nationalists or protectionists. I’m a little worried about that.

Yascha Mounk talks with Kate & Luigi about his new book "The People Vs. Democracy: Why Our Freedom Is in Danger and How to Save It." Recorded in front of a live audience, the conversation touches on recent populist uprisings and the extent to which they threaten liberal democracy.

Kate: Hi. I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales from the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: We are thrilled to have on our podcast today Yascha Mounk, who is a lecturer at Harvard, a senior fellow at New America, an executive director at the Tony Blair Institute for Global Change, and the host of The Good Fightpodcast, which I highly recommend. Welcome, Yascha.

Yascha Mounk: Thank you very much.

Kate: This is also our first live podcast episode. I am personally terrified. You can’t feel my palms right now, but they are just dripping with sweat. Luigi, you’re probably used to this. Are you terrified?

Luigi: I’m not terrified, no.

Kate: That’s what I thought.

Yascha Mounk: What about me? Nobody’s asking me if I’m terrified.

Kate: I just assumed that you’re good at this.

Yascha Mounk: I don’t know. We’ll see, we’ll see.

Kate: All right. So, we’re here to talk about your book entitled The People vs. Democracy, maybe more aptly titled Saving Liberal Democracy. So, to make sure we’re all on the same page, can you start out by telling us about what exactly is liberal democracy, and why is it worth saving?

Yascha Mounk: Sure. So, you know, we usually just talk about democracy. And so, we try to associate everything we like with democracy. But I think the problem is that when you expand one word so much that all of the good things sort of fall under it, you can’t draw careful, conceptual distinctions anymore. You can’t actually understand what’s going on in the world anymore.

So, I think it’s worth remembering with our political system is twofold. It’s a liberal democracy, which doesn’t have anything to do, obviously, with the sort of more political way in which we use the word liberal. So, in the way in which I’m talking about it, George W. Bush and Ronald Reagan are about as liberal as Bill Clinton or Barack Obama, right? This is not liberal/conservative. But what it means is that there’s two basic values which our political system tries to instantiate.

The first is individual freedom. That we ourselves decide what to say or not say. That we ourselves decide which gods to worship or whether to worship at all. That we decide how to lead our lives. And in order to have that, we don’t just need protections for various unpopular minorities. We also need the rule of law and the separation of powers, because if the president or prime minister can say, “Hey, I don’t like what you just said, I’m going to throw you in prison,” you’re not going to be free. That is the liberal element of our political system.

And then the second is the democratic element. That we want to collectively make our decisions together. That there isn’t a monarch or a military general or a priest who tells us what kind of laws we should have and where we should take our party. It’s all of us deciding those things together. So, to me, liberal democracy simply means a political system that strives and, to some extent, succeeds in instantiating these two basic values.

Luigi: Your book is also called The People vs. Democracy, as if there is an opposition between the two. Maybe it’s because I wasted five years of my young life in learning ancient Greek, but democracycomes from demos, people, so what is this tension? And you said that the notion of a democracy expands to everything that is good, but you seem to dump into populisteverything that is bad. If I may say, there is a bit of a populistic interpretation of the word populist.

Yascha Mounk: I have no idea what that means, but explain it to me down the line. Yes, why is it the people versus democracy? What does that mean? Well, I mean two things by that. One is relatively straightforward, one is a little bit deeper, perhaps. So, the straightforward bit is that back in the years in which everybody thought that democracies in places like Italy and the United States were obviously consolidated and obviously safe and obviously there wasn’t any particular reason to worry about it, I was a little skeptical of that narrative, because I saw lots of data points out there in the world point to various forms of trouble.

The fact that people have very low trust in institutions, that governments were really unpopular, that participation in elections kept going down, that especially in Europe, membership in political parties kept falling. And so, taking all of those things together, I thought that seems like reason to worry.

But most social scientists at the time, and at the time meaning three years ago, didn’t agree with me. And they drew this basic distinction between what we call government legitimacy and what we call regime legitimacy. So, they said, “Yeah, yeah, yeah. People are getting more critical of particular governments, but that’s a good thing. That’s healthy. That just means they’re becoming more ambitious when they demand more from the political system. That’s actually healthy. They’re becoming critical citizens. Regime legitimacy, the actual attachment to a political system, is as deep as it has always been.”

And so, I started to look at questions in surveys that actually got specifically at regime legitimacy. And what I found is that that regime legitimacy has been going down, in very worrying ways, quite rapidly. So, in the United States, for example, when you ask older people born in the 1930s and 1940s how important it is to them to live in a democracy, over two-thirds say absolutely important, 10 out of 10. Once you get to younger Americans born since 1980, relatively young Americans, less than ... Thanks for that slight chuckle.

Kate: When were you born?

Yascha Mounk: 1982. Exactly, that’s ... Yeah. Less than one-third of those say that it is absolutely essential to live in a democracy. So, that’s one thing. But there’s lots of other data points, right? So, even when you asked about as extreme an alternative to democracy like army rule, 20 years ago, one in 16 Americans said that was a good idea, and now it’s one in six. Among young and affluent Americans, it’s actually gone from 6 percent to 35 percent.

So, that’s one of the senses of the people versus democracy. The people, it turns out, are sort of turning against democracy. A majority still likes it in some kind of general way, but they don’t have a commitment to it that they once did.

There’s also a deeper sense which is important to understand, I think. So, you know, if you have these two core elements of our political system, liberalism and democracy, my fear is that these two things have been starting to come apart. And that on the one hand, for a long time, we’ve had what I call rights without democracy, undemocratic liberalism. So, a political system that’s reasonably good, not perfect, but reasonably good at ensuring individual rights, the rule of law, but that doesn’t do a great job of actually translating popular views into public policies.

And then on the other hand, you have the rise of what I would call illiberal democracy or democracy without rights. A bunch of populists ... We’ll get to that. A bunch of populists who come in and basically say, “The only reason why we have political problems is that this corrupt elite that wants to serve itself was in cahoots with those sort of minorities and outsiders and so on. And what we’ve got to do is for somebody like me who really speaks for ordinary people to come in. I alone am the true voice of the people. So, just give me a little bit more power, trust me a little bit, and I’m going to fix everything.” And what happens over the long run, as we’ve seen in countries like Hungary over the last eight or nine years, is that this person, first of all, establishes an illiberal democracy, which is to say that they scapegoat various minorities and restrict their rights and so on.

But once they have also attacked liberal institutions, once they have also put their own loyalists on the Supreme Court, once they have replaced the independence of law enforcement communities, once they have taken over state broadcasters and made it very difficult for private media outlets to do their job, once they control the electoral commission, it no longer is possible to replace a democratically elected government through democratic means. So, at that point, the champion of the people, the populist who claims to speak for the people, who initially might have been very popular, actually turns against democracy. And illiberal democracy slides into straight-out dictatorship.

But since he claims to represent the people, that’s the idea of a populist, and since people have actually voted him into office, there’s this sort of deeper sense in which the people turn against democracy.

Kate: OK. Let me try and reformulate Luigi’s question then. I wasn’t clear in your book what exactly populism meant. And in particular, the examples that you gave were, for the most part, far-right populists. What about people on the far left? So for example, Jeremy Corbyn, Bernie Sanders. Would you consider them populists?

Yascha Mounk: So, there are absolutely left-wing populists. I want to say two meanings of populist, right? So, sometimes in America, we just mean the sort of 19th-century agrarian populist and so on. That’s not the way in which I used the term. Right? The way in which, internationally, people use populist is a kind of style of politics, a kind of rhetoric of politics, and it’s precisely the claim to an exclusive representation of the people. That I stand for the real people and, by definition, everybody who disagrees with me does not. Everybody who disagrees with me is illegitimate.

And once you do that, you’re not going to accept the kinds of independent institutions we need to preserve liberal democracy over time. You’re not going to accept that you pass some law and the Supreme Court decides that it’s unconstitutional. That you commit a crime and the police might investigate you for it. That seems illegitimate to those kinds of populists. So that means that it’s not defined by public policy. If you just look at public policy, then populists seem not to have very much in common with each other. You may have noticed, for example, that our dear president, Donald Trump, does not appear to be, let’s say, overly fond of Muslims. When you look at someone like Recep Erdogan, the president of Turkey, he does not appear to be overly fond of anybody who’s not a Muslim.

There’s some populists like Donald Trump, actually in certain ways, who at least in the actions are readily right wing on the economy. Right? Giving tax cuts to billionaires and actually cutting some of the welfare state. There’s others, like Hugo Chavez, who are very left wing on the economy. So that’s not what defines somebody as a populist. What defines them as a populist is a rhetoric in which they say the whole political system is broken, it needs to be replaced. I alone truly represent the people and there’s no real legitimate limits on my power.

Absolutely, people like Hugo Chavez, who are left wing because of economic policies, left wing, fall into that and that’s why I call them populists.

Luigi: But when somebody says, “I’m the 99 percent. I am the people.” So, Bernie Sanders said, “I represent the 99 percent.” Why is he not a populist?

Yascha Mounk: Well, what he’s saying is that he is standing for the economic interests of 99 percent of the US population. I don’t particularly like that slogan for a number of reasons. For one, because if you actually want to do something about economic inequality in this country, it’s not just against the 1 percent that you have to go, but actually it’s the top 10, 20, 25 percent who have huge advantages over the rest of the population. So, as an actual prescription to the kind of policies you need, if you’re serious about remedying economic inequality in this country, I find that slogan quite unhelpful.

But I don’t see anything in Bernie Sanders’s rhetoric which goes beyond that, which actually says, I’m going to shut down media outlets. I think it’s unacceptable for people in the media to criticize me. I think that anyone who disagrees with me isn’t a true American. Those are all things that Donald Trump does all of the time. And those are all things that Hugo Chavez did all of the time. I haven’t seen Bernie Sanders do those things and so, that’s why I wouldn’t call him a populist on my terms.

But let’s talk about your country for a moment, Luigi. You know, how can you explain why in Greece, Cyprus is managing to rule with ANEL, a far-right populist party, and how can we explain that in Italy, the Five Star Movement, which very much has its roots on the political left, even if now it’s more politically amorphous, is able so far to be in a relatively stable government with the League, which is a far-right party? If you just look at the policy proposals, if you just look at where they come from on a left-right spectrum, this doesn’t make any sense.

But when you look at the fact that they’re both populists, that the main driving force behind them is precisely this deep opposition to the existing political system, and this claim that you’re either with us or you’re against us, then I think it starts to make sense. It’s the only way we can explain how these forces have ended up in coalitions and have ended up making it work.

Luigi: Actually, in Italy, it is very simple. It is because the only other alternative was to have a coalition with the Democratic Party. And the Democratic Party, run by Renzi, said, never ever. They preferred to be in bed with Berlusconi than to run with the Five Star. So, the Five Star had no alternative except this one. So, it was really, I think, the contempt of the traditional left that forced the Five Star into the hands of the League—

Yascha Mounk: But that might explain how they wound up in bed together. It doesn’t explain why they’re still in bed together and why—

Luigi: After two months?

Yascha Mounk: Seem to be going rather well and ... Well, that’s a long time for an Italian government—

Luigi: That’s true.

Yascha Mounk: By the way, it’s been half a year. So, I’m about to publish a study with a colleague, Jordan Kyle, which shows that, contrary to some expectations, it’s not true that populist governments tend to be less stable or in government for less long than “ordinary governments.” In fact, they’re in government for about twice as long as others on average, which is really striking and shocking.

Luigi: But let’s go back to the term populist. Again, you see everything negative, but even in the history of the United States, of course, Andrew Jackson had a lot of defects, but he did represent some change. For the first time, somebody not from the landed gentry became president, and the existing elite was indeed very corrupt. The people who were supporting the Second Bank of the United States were on the payroll of the Second Bank of the United States. And the United States survived after Andrew Jackson.

So, you have this view that if you have a populist president, necessarily you drift into disaster, but at least, if you look at the US history … and Italian and German history is very different. But if you look at the US history, it seems to be pretty positive.

Yascha Mounk: Look, I mean, the best way of looking at that is comparatively. And obviously, you know, it’s not easy to destroy democracy. And there’s plenty of cases where populists failed to do that. But on average, they do tremendous damage to democracies. Less than 50 percent of the time … A populist who is elected in democratic elections is removed from office through free and fair elections less than 50 percent of the time.

We see that if you want to look at times in which democracy is damaged by a democratically elected government, rather than foreign invasion or something like that, it is 14 times more likely to happen because you’ve elected a populist into office than any other kind of government. And when you look at many countries around the world, you see that economically, at the beginning, it can work relatively well, because the populists tend to be a little bit more immune from the ordinary sort of constraints of politics. And that can lead them to have effective management in the short run.

But in the long run, they tend to fail to modernize their economies. They tend to rely very strongly on short-term economic performance through fossil-fuel sales and so on. And they tend to hugely overspend. And so, in very many cases, 10 or so years into the rule, you get an economic disaster, as we’re seeing at the moment everywhere from Venezuela to Turkey, and so on.

So, sure, you can cherry-pick one particular example and say, “Well, there’s plenty of bad there, but perhaps there were some good things, too.” When you look at it systematically, it becomes very obvious that these governments do real damage.

Kate: Well, I’ll add in another example, which, to be fair, was not the president of the United States. But I think that the McCarthy era was also a period of populism in the sense that McCarthy was bringing to trials people who were considered outsiders and Communists. People who worked in the entertainment industry, people who were homosexual, and doing serious damage to their reputations and to their careers.

But that movement to some extent was diminished, if not completely eradicated, by due process and the rule of law. There were a number of Supreme Court cases that ruled against their unfair methods that pushed people back in the direction of the established rule of order. And I think that there are positive and optimistic lessons to be learned there, in the sense that we can do the same thing now.

For example, Trump was at his lowest point of popularity when the Supreme Court, or not necessarily the Supreme Court, but a number of courts were ruling against his travel ban. And now I think we’re making progress in terms of going after his emoluments or his financial interests. And there’s the case, I think, DC and Maryland have sued him for emoluments and that’s progressing. And I think a few months before that, the same case was dismissed.

And so, I guess what I’m trying to say is that I thought you were a little overly pessimistic about the use of the rule of law to overturn populism when there have been examples, including here in the US, of cases in which due process has made headway in overcoming populism.

Yascha Mounk: So, first of all, I just want to note that the line of attack on me has now shifted, which is good. I want all the lines of attack. So, it’s no longer—

Kate: Did you think we were going to play good cop, bad cop, because that’s not how—

Yascha Mounk: No, it’s bad cop, bad cop. But that’s fine. I’m, you know. Welcome to Chicago.

Kate: I’m not from Chicago.

Yascha Mounk: So, the sort of first line of attack was that populism might actually be good. Now, apparently at least for the moment, we’ve conceded that populism is bad. And the question is, but can’t we beat it in the end?

And look, I mean, you know, three years ago, I was going around to people trying to persuade them that our democracy may be under some amount of real threat because of the rise of populism around the world and various things that worried me in the United States. And people, to put it politely, looked at me like I was crazy. They kept calling me Cassandra, by the way, and I always wanted to say, “But Cassandra was right, dammit.”

And so, you know, my argument is not that we’re doomed. My argument is not that there is nothing we can do to defend our institutions, or that I’m swearing to you that two years from now, we’ll all be living under Generalissimo Donald Trump. My argument is that there’s a serious danger. And that when you look at the best historical analyses we have available, they’re imperfect, but the best we have, there’s very real reason to be concerned that often populists prove to be more effective at government, to do much more damage to the institutions, than elites tend to think. We think, that guy? He’s not going to beat us? What on Earth are you talking about?

So, to get to the question, I think some American institutions have been holding up, others have not. It’s striking to me to what extent the Republican Party has become a willing tool of Donald Trump’s latest whim. Whenever he says, “Jump,” and whichever hoop he holds out to them, they try to not to jump through, but jump above and do a little pirouette whilst they’re at it. That’s very concerning to me. People did not predict that two, three years ago. When you look at the extent to which he’s already managed to bring the FBI to heel, that’s very concerning. He has at this moment managed to fire the director of the FBI, the deputy director of the FBI, and three really leading instructing agents and so on.

When you look at the investigation of Brett Kavanaugh, I think there were real questions about whether that political context helped to limit what the FBI actually investigated. And I don’t think it is any longer impossible to believe that Rod Rosenstein will be removed and that the last sort of checks on how the FBI does its work are gone. And that in 2020, for example, you might have a politically motivated prosecution of a Democratic presidential candidate. I’m not saying that’s sure to happen, but I don’t think it’s unimaginable anymore.

When you look at the Supreme Court, I’m starting to worry as well that there is a deeper rot there than I would have anticipated two or three years ago. That’s partially because of the decisions we’ve seen over the course of the past year in which Congressional maps, where there’s evidence on email that they were used to weaken the Democratic Party and discriminate against African-Americans, were ruled to be constitutional. Where a highly dubious voter purge in Ohio was ruled to be constitutional. So that was business as usual though.

Now we have a stronger conservative majority on the court, and the circumstances where the pretense of nonpartisanship has gone out of a window in a really striking way during the Kavanaugh hearings. And in which the nature of conservative partisanship has ceased being a commitment to a set of values and has started to be loyalty to one person. So, you take all of that together and it worries me.

At the same time, you’re right, but certainly the media continue to be very active and that, in part, because we have such a decentralized country, elections for now remain, not entirely fair because of all of the problems of gerrymandering, and so on and so forth, but certainly robustly free.

And so, if the midterms go as some of the polls at least predict, and Democrats manage to regain control of at least one of the branches of government, and if Democrats run a sensible candidate in 2020 and manage to remove Donald Trump from office ... But yes, I think there’s a very good chance that we survive this kind of populist moment, at least in the short run. But we are in danger and we need to recognize that, because otherwise, we’re blind to mistakes we face.

Kate: So, can we briefly talk about some of the solutions that you propose in your book?

Yascha Mounk: Sure. So, look, I mean, I think the first thing to say is that wherever I go, people tell me these very local stories about what went wrong in their particular countries. And since we see the rise of populism across lots of different countries, I think we have to look for causes which are shared. Now I don’t think there’s any one cause that’s exactly the case and the same shape everywhere, but there’s a cluster of four or five causes. And a subsection of them, I think, is jointly sufficient to see the rise of populism.

So, anywhere we see three or four of those five or six causes, you wind up with strong populist movements. The three most important ones that I focus on the book is the stagnation of living standards for ordinary citizens. You know, in United States, from 1945 to 1960, the living standard of an average American doubles. From 1960 to 1985, it doubles again. Since 1985, it’s been roughly stagnant. The same in Europe, you had the Trente Gloriousesin France, the Wirtschaftswunderin Germany. These 20-, 30-year periods at the inception of democracy in many countries in which the living standard of people just fundamentally transformed. And now, for the last 30 or so years, people don’t feel like they’re getting something out of the local system. That fundamentally transforms what they think about politics, how they trust the political system.

The second big topic is culture, immigration, race. So, most democracies in the world upon their founding had a sort of mono-ethnic, monocultural conception of themselves. They said somebody who truly belongs in our country is somebody whose ancestors also came from this place. And we certainly are not from any ethnic minorities. We certainly do not come from other continents and so on and so forth. That has started to change over the last 40 or 50 years, there’s some real change in those self-conceptions. But there’s a big part of the population that isn’t on board with those changes and then rebels against it.

And the United States and Canada on that are both sort of similar and different. They’re similar in the sense that they, too ... They’re different in the sense that they’ve always been countries of immigration. They’ve always been multiethnic societies in a certain kind of way. They’re similar in the sense that they had a very clear racial and religious hierarchy, which gave a lot of advances to one group over others. Here, too, they’ve actually come a long way of overcoming that, but we certainly haven’t overcome it completely. And there’s a lot of people who are rebelling against the relative amount of equality that we’ve managed to achieve.

And then the third thing to me is the rise of digital technology, of the internet and of social media, which makes it harder for political and financial elites to control the Overton window, to control what can be said in politics. And that can be a positive thing. It can allow important formerly marginal voices to enter the political fray. But it can also be quite dangerous when it allows people who want to spread racial hatred, people who want to spread straightforward false information, to have a much bigger voice now in political discourse, particularly at a moment when people are already economically frustrated and a part of the population already is fearful of demographic and cultural change.

So, I think we need to confront those basic drivers. So, I think we need to have an economy that ensures that the fruits of economic growth and globalization actually go to ordinary citizens in a way that they currently don’t, but that also tries to accelerate productivity and economic growth, because we’ve seen that that’s one of the big reasons why living standards have stagnated. I think on the cultural piece, we should resist the temptation that a lot of people on the left have, and that I had for a long time in my life, of trying to leave patriotism and nationalism behind in the 20th century, which it so cruelly shaped.

If we do that, we ignore the fact that nationalism has tremendous force in the world, as the last 20 years have shown, remains the most powerful political motivator in most of our societies. And allow the political right and the worst part of the political right to dominate and exploit that motivating power. And so, instead, advocating fighting for an inclusive notion of patriotism in which we don’t leave that camp to the Steves, Bannon and Miller and so on, but fight to appropriate for it for ourselves. Arguing that, actually, nationalism historically has been a way of expanding the circle of human sympathy beyond our own village, our own family, our own ethnicity, our own religion, so we can feel real solidarity with people who might be 1,000 miles away from us, who might have a different skin color, who might have a different religion, but who we recognize as our fellow citizens.

And finally, on social media and the internet, I don’t think the solution is to censor, as some European governments are now doing. I think the solution is actually in a serious way to fight for our political values. From Plato to Aristotle, from Rousseau to the founding fathers, each set of political thinkers who have thought seriously about how to make a self-governing republic work emphasized the importance of passing our values on from one generation to the next.

I don’t think we take that seriously in the way we educate our children. I don’t think we take that seriously in primary and middle schools and high schools around the country. And I certainly don’t think we take that seriously as one of the core tasks that university professors and academics like us here on the stage have to do every day. And I think if we change that, hopefully it’ll make a little bit of a difference.

Luigi: Is the failure of the elite missing from here? Generally, populism arises, and we see now in Brazil with Bolsonaro, part of it is the economic failure. But part of it is the elite was deeply corrupt. And in the West, with a major failure like a war in Iraq that was fought for no reason, for misleading ... Leaders that misled the American and British people into a war that was a disaster, and I don’t use swear words, but you understand what kind of disaster.

You had a financial crisis. We had no executive going to jail in spite of the massive fraud of that financial crisis. We have an opioid crisis in the United States that is pushed very much by an industry that wants to make money on the face of people and is protected throughout the way and I can keep going.

Yascha Mounk: I mean, one of the things that I say is that when you look at the 2016 election, I think there was a choice between a moderate politics of the status quo and an extremist politics of change. And so, if people voted for Donald Trump, it’s not necessarily that all Americans are extremists, or even, you know, 46 percent or whatever voted for him are extremists, it’s that they really wanted change.

And the best way to fight against that is to create a plausible vision of how we can have quite radical change, of how we can actually shake up our political system and reform some of the ways in which it’s not delivering for people. But without being ideologically extreme, without giving up on the basic founding values of our country and the basic founding ideals of liberal democracy. So that’s the project I try to pursue.

Luigi: And with this, thank you very much. And thank you all for coming.

Kate: Thank you so much.

Populism strikes again as the world's 4th largest democracy is set to elect controversial right-wing politician Jair Bolsonaro as its next leader. Writer and lawyer Glenn Greenwald (now living in Brazil) tells Kate & Luigi how rampant corruption, violent crime and a struggling economy have given rise to yet another populist movement.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: For the past few months, we’ve been seeing populist movements pop up around the world, and the latest iteration of this is happening in Brazil, as we speak. This coming Sunday, the Brazilians are about to vote in the second round of a presidential election, which will almost certainly elect Jair Bolsonaro, who is a far-right-wing candidate.

Luigi: And some listeners might say, “What does this have to do with capitalists?” But, in fact, the interactions between capitalists and democracy are very important, and the degeneration that democracy is taking in many, many countries is problematic, not only from a political point of view, but also from an economic point of view.

Kate: So, on today’s episode, we’ve decided to invite Glenn Greenwald, who is a lawyer and journalist in the United States but has also been living in Brazil, and so he has a unique insight into what’s been going on with their political system and their institutions.

Luigi: In preparing this episode, we tried to reach out to both sides of the debate, and we tried to contact both Paulo Guedes, who is the economic advisor of Bolsonaro, and Greenwald, who, in spite of being a famous US journalist, actually lives in Brazil. We’re lucky to get Greenwald. Unfortunately, Guedes did not reply.

Kate: All right, so before we get to Glenn, we want to give you a little bit of context and background for what’s been going on in Brazil’s political history over the course past half-century. Brazil is no stranger to having its political parties overturned, the most salient of which took place in the 1960s, when the military took power and held onto power for 21 years. It was only relatively recently, in 1985, that democracy was restored. During that period, I think it’s important to note that Brazil actually experienced a great deal of economic growth, what some people call the Brazilian miracle.

Brazil’s a large exporter of natural resources, including oil, soybeans, agriculture, and its political cycle is very closely tied to what happens to commodities. So, in periods when commodities prices have been booming, Brazil’s political system has been more stable, but whenever there’s a downturn in commodity prices, it has tended to lead to overturning whoever was in power at the time.

Luigi: In 2002, Brazil elected the first left-wing president, Lula, a leader of the Workers’ Party, called PT in Brazil, and it was the beginning of this commodity cycle. So, at the early part of the Lula government Brazil did very well, and Lula left government after eight years with an 86 percent approval rating. Unfortunately, after that, the economic cycle turned south and Dilma, who was the first woman president elected after Lula, faced the difficulties of that downturn and eventually was even impeached, and Temer became president.

Now, the first thing we need to know about Brazil is the extent of political corruption. In the United States, we complain about campaign financing and how much money’s in campaign financing, but if you adjust for GDP in Brazil, just the legal donations are five times as much as the ones in the United States. That doesn’t count bribes and illegal donations. There is now an investigation going on where more than 16 large companies are involved. These are the best companies in the country. They all paid bribes in a systematic way to everybody who was in power. We’re talking about billions and billions of dollars of contracts and bribes paid.

Kate: The second thing that’s worth noting is that Brazil has been experiencing a serious recession for the past few years. Even though here in the US the economy has recovered ever since the financial crisis, from 2014 to 2017, Brazil has been going through one of the worst economic downturns in recent history. It’s been experiencing stagflation, so the economy, the GDP, was falling while inflation was high and also very high levels of unemployment, particularly among the young.

Luigi: This recession is actually a combination of the bad part of the commodity cycle and, actually, the result of the investigation by being so aggressive in a country that lives off corruption. If you are very harsh against corruption, you might freeze a lot of public work and a lot of work in general. The combination of the two has put Brazil in a very difficult situation.

Kate: All right, so now that you’ve heard a little history, let’s hear from Glenn Greenwald. Glenn is a lawyer, a Pulitzer Prize-winning journalist, and a best-selling author. He’s also a co-editor and co-founder of The Intercept. Glenn is also married to David Miranda, who is a city councilman for Rio de Janeiro. He is a member of the Socialism and Liberty Party, which is a left-wing party in Brazil. Glenn and his husband also have a program whereby they adopt dogs, and so, over the course of this interview, if you hear some dogs barking in the background, that’s why. Glenn, thank you for joining the show.

Glenn Greenwald: Thank you for having me. Happy to talk to you.

Kate: Let’s jump right into the Brazilian election that’s about to take place this Sunday. It’s almost certain that Jair Bolsonaro is going to win, and he is well known for speaking his mind about a number of pretty thorny social issues. Can we go through some of your favorites of the best-worst things that Bolsonaro has said, or what I like to call Bolson-uh-ohs?

Glenn Greenwald: Yeah, I mean, so I generally think of Bolsonaro in two different categories. One are the kinds of comments that he’s made that are inflammatory and offensive by design, similar to the ones that Trump has made, although they’re grounded in a much more serious ideology than Trump’s are. Secondly, the policies that Bolsonaro endorses that show that he really means the things he says. But kind of the highlight, or lowlight, reel of his comments begins with things like explicitly praising the torturers, the most notorious torturers of the military dictatorship. When he stood up on the floor to announce his vote to impeach Dilma, who herself was detained as a dissident under the military dictatorship and was tortured, he went out of his way to explicitly praise the military colonel who oversaw her torture.

He said they should’ve killed probably another 30,000 people. He said in 1989 that he didn’t think elections would ever fix any of the problems, that we needed to use … unfortunately, he said killing people who are a threat to the country, and at the time he even named the elected president, Fernando Henrique Cardoso, who was kind of a center-right figure, as somebody who should be killed. In 2014, he told a female colleague in Congress who had pointed out that he had a history of defending not just torture but rape that was used as a weapon by the military dictatorship. He told her, “Oh, you don’t need to worry. You’re too ugly to deserve my rape.”

Kate: Lovely.

Glenn Greenwald: When he was asked in an interview just about a year and a half ago about his history of anti-gay comments and how he would react if it turned out that his son was gay, he said that, “I couldn’t love a gay son. In fact, I’d rather learn that my son died in a car accident than learn that he was gay.” There’s a lot of racist comments as well. Things of those—

Kate: That’s disgusting.

Glenn Greenwald: Along those lines. He has not just a distant history, but a very recent history of saying all kinds of the most horrific things you could possibly think of.

Luigi: But the shocking thing is not only that people like this exist. Unfortunately, they do exist, but that the vast majority of Brazilians are ready to vote for somebody who explicitly says those things. How can you explain that?

Glenn Greenwald: I think that is the key question given that Brazil is a country, as we should recall, that in the last four national elections has voted for what is widely regarded as a left-wing party but is really more of a center-left-wing party, which is the Workers’ Party, founded by Lula da Silva, and also elected Dilma Rousseff, the first woman president. Why is there this radical shift in ideology all of a sudden?

I think the answer is the same one that explains the election of Donald Trump in the US, and Brexit in the UK, and the rise of extremist parties in places where we thought that it was previously unthinkable to see them in Western Europe, which is that once people conclude that the political establishment or the ruling class has so fundamentally failed them, they will run into the arms of anybody that they perceive is an enemy of that ruling class and is somebody who promises to burn it all down and destroy it. No matter what their own flaws are or their own faults are, the idea becomes, “Well, we have nothing else to lose. It can’t get any worse, and this person is hated by the very people that we blame for our plight.” That makes us think that he’s somebody we ought to dispatch as our agent or weapon against those who have spent the last two or three decades making our lives miserable. That’s a big part of the appeal of Bolsonaro.

Luigi: One of the potential causes of such an outrage is corruption. As people living in America, we are no stranger to corruption, but Brazil is at a different level. You have lived in both places. Can you explain to us how Brazil is so different?

Glenn Greenwald: Yeah, it’s an important point, because it is true that people in Western democracies, when they think about corruption, think about isolated cases of particular politicians who accept bribes in exchange for votes or contracts. Maybe even think about it now a little bit more systemically in terms of, say, corporations who donate large amounts of money to political campaigns or PACs in exchange for their agendas being served, but Brazil is in a completely different universe when we talk about corruption.

Every party in power, far more than ideology or political allegiance, essentially serves the interest of oligarchs who pour money not just into their party but into their secret Swiss bank accounts in exchange for contracts of enormous magnitude. This has been going on for a long time with total impunity, and it was just sort of the way that things worked in Brazil and have always worked in Brazil. It was just assumed that’s how Brazil was governed, and the only thing that changed is that there was this sort of young team of prosecutors who kind of stumbled by accident into a narrow corruption case that opened up this much broader window into this sweeping corruption scandal that has now exposed every major political party, the nation’s leading plutocrats, and exactly how they have engaged in corruption. A lot of them have been hauled off into prison. A lot of them are on the verge of going to jail, and that has obviously destroyed public faith and confidence in all Brazilian institutions except for its military.

Kate: What does it feel like to be a Brazilian on a day-to-day basis? Do you encounter corruption in your regular life? When you come across the police, for example, do you have to pay them off or is it something that’s more removed?

Glenn Greenwald: Corruption is definitely ingrained into every fabric of Brazilian life. It’s just accepted that if you want bureaucracies to move quickly you need to bribe bureaucrats. If you get stopped for a speeding ticket or a traffic infraction, almost every police officer encourages you to pay them some bribe in order to let you go without a ticket or without points on your license. That’s definitely just a natural part of all aspects of Brazilian culture that date back to the dictatorship and the way that it ran. Because bureaucracy is something that dictatorships use to control populations, and there is a massive residual bureaucracy that’s extremely slow moving and almost impossible to get anything done. Yeah, it’s well known that even petty corruption and bribery is just a daily part of Brazilian life no matter who you are.

Kate: Taking a step back and taking a broader look at Brazilian politics, if corruption is so deeply ingrained, how is anyone ever going to root it out and still maintain democracy?

Glenn Greenwald: Well, that’s an open question whether or not that can really happen. The reality is that, although, as I’ve indicated, this corruption scandal has exposed essentially every political party and every major corporation, in a very fundamental way, only a small fraction of the people who have been implicated have actually gone to prison. In large part because the members of Brazil’s Congress, both the lower house and the Senate, enjoy this kind of legal privilege where they’re immunized from being prosecuted for any crimes while they’re in office, except for prosecutions that are conducted by the Supreme Court, the highest court of the country. You could imagine what that would mean in the US, for example, where the Supreme Court is nine judges and has a very full docket. They can’t really oversee criminal cases, and so that immunity means that they’re essentially fully immunized.

Recently, just to give you a sense for how corrupt this mechanism is protecting people, the right-wing candidate who ran against Dilma Rousseff in 2014 for president, Aécio Neves, with the center-right, establishment-backed party called PSDB, was a senator, and he has now been exposed as not just a corrupt politician who accepts bribes, but he got caught on tape talking about murdering witnesses, including his own cousin, to hide evidence of his corruption. Yet he is still in Congress, and just this year the polls showed that he had no chance of being re-elected to the Senate, so he decided instead to humiliate himself and run for a seat in the lower house just in order to keep his legal privilege and stay out of jail, and just through name recognition he ended up winning.

There is a real question about whether or not the systemic corruption is actually going to really be dented by what had looked like this really monumental investigation. Of course, a big part of Bolsonaro’s appeal is that he hasn’t been implicated by this scandal and intends to clean out all of Brasilia. A dubious promise, but one that definitely has a lot of political appeal.

Luigi: What is funny for me as an Italian is that this Operation Car Wash is almost identical to Operation Clean Hands that took place in Italy in 1992, ‘93. The irony of this is that in Italy, Berlusconi, but all the center-right, was blaming the prosecutors for being communist and claiming that all the investigations of Operation Clean Hands were, in fact, a political agenda to get rid of the center-right and put in a leftist government. In Brazil, it seems sort of the other way around, that all the allegations are that the judges are right-wing. Is there some sort of truth to that claim or not?

Glenn Greenwald: There is some truth to that claim, but I think we have to be a little bit careful about it. It is definitely true that the results of the investigation have disproportionately punished left-wing politicians while right-wing politicians have gone largely unscathed. If you speak to the prosecutors and confront them with that allegation, as I’ve done, what they will say is that, “Well, of course that’s the case, because it’s the left that has been in power for the last 16 years.” Since 2002, the Workers’ Party was occupying the presidency through two terms of Lula and then one-and-a-half terms of Dilma. Dilma herself was chairman of the board of Petrobras, where a lot of the corruption was centered, and so their argument is, “Of course, the politicians who are actually in power are more likely to be involved in corruption, because they’re the ones who can get things done.”

There’s a little bit of truth to that, but the much bigger truth is that even though the Workers’ Party occupied the presidency for those 14 years, they relied on parties in the center and the center-right as coalitions in Congress in order to get things done, and those parties wielded great influence. As I indicated earlier, Dilma’s right-wing partner, Aécio Neves, has been caught on tape ordering bribes and murdering witnesses. The president that they installed once they impeached Dilma, Michel Temer, who is part of this kind of centrist transactional party, PMDB, also got caught on tape that the whole country heard, ordering bribes to silence witnesses, and none of them have gone to prison.

There is this very valid left-wing critique of the prosecutors that they seem to be much more interested in going after left-wing politicians. If you think about Brazilian society, that’s not surprising because the society is so stratified that the people who become prosecutors, who become lawyers, who become judges, come from rich families, and there’s lots of things that these judges have done that, we can go into detail if you want and I can give you examples, but that do suggest a very politicized bias where they’re far more interested in punishing politicians and others on the left than they have been on the right.

Kate: When we think about moneyed interests in the United States, most people are concerned about Wall Street and the big banks, to some extent there is concern about pharma and big oil. Who are the moneyed interests in Brazil? I mean, in the case of the Workers’ Party it seems like a lot of the corruption scandals revolve around Petrobras, the state-owned oil company. Are there different interests backing Bolsonaro, or is it the same set of oligarchs as you mentioned earlier?

Glenn Greenwald: Well, obviously, oil is a major industry, and Petrobras is one of the world’s major oil companies and is a state-owned oil company that has funded a lot of other social programs and has lifted people out of poverty under Lula’s presidency. But they have a lot of construction companies that are adjacent to Petrobras that do a lot of the building of the infrastructure that Petrobras uses but also that the country uses.

Then, there’s a very large financial and banking industry that’s linked to hedge funds and international capital. For a long time, those interests were very skeptical and wary of Bolsonaro. Much like the kind of classic Wall Street, Silicon Valley billionaires and plutocratic class in the US supported Jeb Bush or Marco Rubio and most certainly not Donald Trump, because they perceived Trump as this kind of anti-establishment outsider who was going to bring instability. Eventually, what Bolsonaro did that was actually quite shrewd was he hired as his kind of economic guru Paulo Guedes, who is kind of one of the classical neoliberal privatizing economists.

Kate: He was trained at the University of Chicago.

Glenn Greenwald: Out of the University of Chicago school. Exactly. In the most notorious sense, the kind that ran Chile under Pinochet, and Bolsonaro just came out and said, “I know nothing about economic policy. That’s not my interest. I’m an army captain. I’m going to focus on cleaning Brazil up and getting rid of its criminal elements and getting rid of its left-wing communists, and I’m going to turn over economic policy to Paulo Guedes.”

Kate: Can you compare and contrast the economic plans of Bolsonaro and his rival Haddad?

Glenn Greenwald: One of the really interesting things about Bolsonaro’s economic policy is that he, in his 30 years in office, has never really demonstrated any real interest in economic policy, and to the extent that he ever opined on it, it was as an interventionist, as somebody who believed that the state should play a significant role in regulating the economy. In order to kind of lure Brazil’s oligarchical class and financiers that wield a great amount of power, Bolsonaro has basically said, “I’m going to have very little to do with the economy and economic policy. I’m going to just simply turn it over to Paulo Guedes, who’s going to implement this kind of libertarian, right-wing, highly privatized, focused economic approach that will eliminate state-owned industry, sell off all of our assets, and make certain that businesses are freed of regulation.”

On the other hand, you have Haddad that comes from ... He actually got his PhD in Marxist economics, although he’s now regarded as a kind of technocrat and moderate. He governed as mayor of São Paulo for four years, the largest city in Latin America, and really was not even a left-wing figure. He was just sort of this kind of Hillary Clinton-type centrist. Probably not nearly as moderate as she. I mean, he was definitely still a Workers’ Party candidate, but definitely in the Workers’ Party universe, he’s kind of a moderate. But the Workers’ Party has always had its origins, as its name indicates, as shifting resources away from the richest to the poorest. There is a very stark contrast in economic policy between the two, but because Bolsonaro is just such a kind of singular, aberrational figure in Brazilian politics, much like Donald Trump was, the election really hasn’t focused very much on things like economic policy and instead has been very Bolsonaro-centric. Just like the 2016 election was all about Donald Trump.

But the economic programs and ideologies that they would usher in really couldn’t be more starkly different. I mean, I should say that the Workers’ Party, despite how it likes to market itself, actually was very closely aligned with the nation’s oligarchical class during the rule of Lula and Dilma. They did very, very well and got very comfortable with the Workers’ Party. That was part of their strategy for staying in power. They definitely moderated their economic ideology, but compared to the ideology of Paulo Guedes, the difference is quite vast.

Kate: They both want to invest in infrastructure. That’s the one thing they have in common.

Glenn Greenwald: Yeah, sort of like Bernie Sanders and Donald Trump both had that in common, but other than that it’s very difficult to find commonalities.

Luigi: Whether we like it or not, we are all part of the elite and in some way of the establishment. What can we do to avoid this deterioration in Brazil, in the United States, around the world?

Glenn Greenwald: I think that there’s one very important requirement to prevent more Marine Le Pens, or Brexits, or Bolsonaros, which is that people who have been a part of the ruling class for the last 20 to 30 years need to engage in a serious self-critique and self-reckoning about what the effects of things like globalization and other free-trade policies have been or the cultural rift that has emerged in Western democracies that has made a huge portion of the country feel as though they have zero investment in what happens in distant capitals that rule their lives. Because until that happens, until there’s some sense of responsibility assumed by the establishment of the world’s leading democracies, the resentment and the anger, a lot of which is valid, that is now bubbling to the surface and being exploited by demagogues is only going to intensify. That will only result in the empowerment of exactly the people who are best able to exploit our worst human instincts, because once people conclude that their futures are grim and that they have no hope, they’re willing to roll the dice on anything that is new and different.

Kate: Bringing this back to the United States, where are we in this process of recognition and soul searching, looking for a candidate who will fix everything? Is Brazil trailing the US or is the US trailing Brazil at this point?

Glenn Greenwald: I think there’s been this attempt by Western media to understand Brazil with reference to the US, because that’s the way that Western journalists can think about things and call Bolsonaro Brazil’s Trump. As we’ve discussed, I think that Bolsonaro is a far more extremist figure and his election is far more dangerous, in part because Brazil’s democracy is so much younger and its institutions much more fragile. But I do think there are similarities in the dynamic.

In particular, just as is true of Bolsonaro, there are some elements of Trump’s electorate that voted for him because of the racism, and the misogyny, and the xenophobia that he spewed, but a large number of people voted for him despite all of that, because they watched their manufacturing jobs and their opportunities to stay in the middle class disappear over the last 20 to 30 years, as both parties presided over policies that destroyed the economic security and the future of a huge portion of the country with utter and seemingly aggressive indifference towards their plight. That’s why there are a lot of people, despite the media narrative, who voted first for Obama when he promised the ideology of change, to go and change who Washington works for, and then who also voted for Trump because they were just looking for anyone who seemed like an outsider figure, somebody who was going to go and be an enemy of Washington and the factions that rule it.

I think the same dynamic that’s driving Bolsonaro largely, which isn’t his racism and homophobia and misogyny ... That’s a big part of it but not the biggest part. The biggest part is this anti-establishment anger that has a lot of legitimacy and validity to it is also driving a lot of the political currents in the US. What you’re seeing actually, what you saw in Brazil in this last election, is the disappearance of the center.

Kate: I have a personal question for you. We started out the episode talking about Bolsonaro’s support of torture and his praise of the use of murder extrajudicially. This is a man who is nostalgic of a time when there was military rule, has hearkened back to it, wants to reinstate it, and this military rule was extremely oppressive of free speech. As a lawyer and a journalist, when Bolsonaro is elected president, as he is almost certainly going to be in a few days, are you thinking about leaving?

Glenn Greenwald: Well, I mean, I guess I would add to that the fact that obviously given my work as a journalist and my husband’s work as an elected official in the same left-wing party that Bolsonaro blames for his near-fatal stabbing a month ago ... Bolsonaro attacked me personally on Twitter about six months ago when he used an epithet for gay people against me on Twitter. My husband is currently demanding the removal of Bolsonaro’s son from the city council, where they serve together, because he posted some pictures that were intended to glorify torture and threaten protestors with murder. We’re definitely a pretty high-profile target for Bolsonaro and his movement.

I’d be lying if I said that we didn’t actively think about the risk that we might face, but at the same time, we’ve adopted two children here who are Brazilian. We consider Brazil our country. No, I don’t intend to just run away the minute that things get a little bit difficult, or risky, or dangerous. I don’t intend to engage in pointless self-sacrifice, but I think there’s going to be a substantial resistance because even though the democracy is young, there is a whole generation of people who have spent the last 30 years inculcated with the idea that democratic values matter. I think there’s going to be a lot of resistance to any steps that he intends to take to reinstitute the kinds of oppressive measures that were seen during military rule, and I intend to participate to the best extent that I can using my public platform as best I can as part of that effort.

Kate: Glenn Greenwald, I wish you the best of luck. I hope for your safety and the safety of your family, and thank you for joining us on the show.

Glenn Greenwald: Thank you for having me. I really enjoyed the conversation.

In our third and final episode on the 2008 financial crisis, Kate & Luigi look at recent volatility in the markets and try to predict the cause of the next financial crash with help from prominent economists Robert Shiller and Lawrence Summers.

Speaker 1: Do you worry about another crisis?

Speaker 2: Well, there will be one some time.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On today’s episode, we’re going to be doing economists’ favorite thing, which is to predict when the next crisis is going to hit.

Luigi: The running joke about economists is that predicting is hard, especially about the future.

Kate: Yeah. In order to minimize the amount of opining that Luigi and I would have to do in this episode, we went out, and we made a couple of calls to prominent scholars who perhaps are better equipped—or at least more willing to talk about—this issue of where the next crisis will come from.

Luigi: We reached out to Bob Shiller, who not only has a Nobel Prize but also has the privilege of having called the recent real-estate bubble before it burst, so he has some claim to fame in terms of predictive ability.

Kate: We also called Larry Summers, who is the former secretary of the treasury of the US, also president emeritus of Harvard, and who’s also spent a lot of time working in the policy world, particularly as a key advisor to Obama during the financial crisis.

Robert Shiller: “Where the Next Crisis Will Come from and Why,” by Robert Shiller. It’s hard enough to answer where previous crises came from, let alone do that for the next crisis. Part of the problem is that the big crises are the result of a confluence of factors. Little fluctuations in the economy become big if 10 or 12 small factors become big and important all at once. So, there is not a good tellable story of the cause. The explanation of the crisis has to take the form of a list of factors.

Many of these factors typically involve new narratives that become contagious and go viral. The concept of a housing bubble went viral starting around 2005, and this eventually crashed the housing market. Nicola Gennaioli and Andrei Shleifer have a brand-new book, A Crisis of Beliefs, that attributes the financial crisis to a change in fundamental beliefs. I would say they are right, but would add that the change in beliefs is mediated by newly viral narratives.

The next crisis is inherently difficult to describe, since there are so many new directions future narratives could take. Combinatorics, working with lists of relevant subjects and words—bubble, bank run, oil crisis, trade war, and on and on—suggest an astronomical number of possible mutations of our existing narratives. These will be experimented with by countless people, and something new and different will emerge as contagious.

Kate: Can I just say that Bob Shiller has the warmest voice of anyone that I’ve ever heard?

Luigi: Can I say that he punted the question a bit?

Kate: I mean, yeah. He didn’t give the most direct answer to the question, but whenever I hear Bob Shiller’s voice, I want him to be my grandpa. I want to make gingerbread for him at Thanksgiving and just listen to him talk around the fireplace. He’s just got such a nice voice. I don’t even know how to make gingerbread. All right.

Luigi: More seriously, there are two, I think, powerful insights here. The first one, which is maybe kind of obvious but important, is that you don’t know where the next crisis is going to come from, because if you knew, you could to some extent avoid it. So, there is this element of unpredictability that’s inherent to a crisis. And—

Kate: Can I just step in there?

Luigi: Sure.

Kate: I mean, yes, obviously, that’s true for markets. The market can’t predict a market crisis, because then the crisis would have happened already, but individuals can predict crises just as long as enough people don’t listen to them.

Luigi: Yeah, so it’s possible that somebody might sort of spot it, but it’s hard for the system overall to spot it, because if it does, it does not unfold as a crisis.

Kate: OK, sure.

Luigi: The second important point is that there is an element of irrational beliefs in crises. I think that one of, in my view, limitations that classical economics and the dominant paradigm, until the crisis, are responsible for is to have eliminated completely what in jargon goes as a Hyman Minsky moment, from an economist who died in 1996 who was very much into the history of crises and what causes crises. He was emphasizing the rational component of crises, and, as a result, became a sort of non-grata basically in mainstream economics.

If you go and look at the textbooks of macro until the crisis, nobody was citing Minsky, and today everybody does cite him because of that.

Kate: Yeah. I would characterize it . . . I agree with him, but I think most of the irrationality comes before the crisis. It’s that people get irrationally exuberant about things and then it’s only when they wake up because the system has become so bloated that, actually, that’s when they become rational, and that’s what sets off the crisis. I think it’s two sides of the same coin.

Luigi: I actually disagree here. I think that there is a moment of rationalizing the crisis itself. Kindleberger, who cites Minsky, was an economics professor at MIT and wrote a famous book about manias, panics, and crashes. Actually, he uses a German term, which is Tür schlosspanic, which means “door shut” panic. Basically, what happens in a . . .

Kate: I love the German terms.

Luigi: In a room when you try to get out, and you fear that the door is going to close, and then everybody panics. I think that represents very well what happens at the peak of a crisis. Another description I heard, which I think is very funny, is the Minsky moment. It’s like Wile E. Coyote and the Road Runner when they chase each other, and at some point they go off the cliff, and they keep going for a little while off the cliff, until they realize they are off the cliff. Then, they start to precipitate. I think that crises have this element that you are . . . Of the euphoria before, the euphoria that pushes you off the cliff, and then there is the moment you realize you’re off the cliff. That’s what is called in jargon the Minsky moment, and that is when you have the opposite, which is the panic.

Kate: All right, next up let’s hear from Larry Summers.

Larry Summers: I’m Larry Summers. I’m the president emeritus of Harvard, and the former secretary of the treasury. I think a main lesson of history is that important aspects of the next crisis are likely to be things that we don’t anticipate, and that we don’t foresee right now, because if we foresaw a crisis there’d be selling pressures, there’d be various mechanisms that would be either accelerating the crisis or forestalling it.

As I think about the risks in the current global environment, I would highlight the risk that central banks overtighten, because they’re not fully internalizing the lags between tighter monetary policies and its impact on the economy, and that that leads to an economic downturn with important financial consequences.

The second risk would be the risk that we saw too often with the internet bubble, with the housing bubble, that complacency becomes a self-denying prophecy, that after a period of tranquility, after a period of rising markets, people come to think that it’s safe to borrow in order to invest. They come to invest less in reliance on the fundamentals of an asset, and more in reliance on their ability to sell it to someone else at a higher price. At some point, the music stops and matters unwind.

A third risk is what will happen in China and in emerging markets, which have accumulated, in some cases, very substantial quantities of leverage. In the case of some emerging markets, very substantial quantities of dollar debt, and therefore are at risk of an economic downturn.

The last risk, which I think is very real, is the geopolitical risk at a time when we’re seeing substantial emergence of what used to be called great-power rivalry between the United States, Russia, and China. A time of substantial, potential instability in the Middle East, on the Korean peninsula, and so, political and security developments could also be a source of uncertainty and risk to financial stability.

Kate: Maybe I’m a little biased, but I agree with everything that Larry said. I think he actually pinpointed certain areas of the economy that we should be worried about. In particular, I completely agree with him about his concern about overtightening.

I want to share a little bit of the history of recessions in the US. The recession in 1949 followed monetary tightening. The one in ‘53 followed monetary tightening. The recession in 1957 followed monetary tightening. In ‘60 it followed monetary tightening, and in 1969 it followed fiscal and monetary tightening. Then there was the recession in 1973. It partially followed monetary tightening, but it was mostly about the oil shock. There was a brief recession in 1980 that was really followed by monetary tightening. The one in ‘81 was a mixture of the oil crisis and monetary tightening. 1990, there was an oil shock, we had accumulated a lot of debt, but it also followed monetary tightening.

And then, the more recent ones have been a little bit different. The 2001 recession was the bursting of the dot-com bubble combined with 9/11, and then, obviously, the more recent financial crisis had more to do with the subprime mortgage market, but I think there is enough of a history there that we should be a little concerned about actions of the Fed, and whether Jerome Powell is going to raise interest rates too quickly when the fundamentals of our economy actually aren’t strong enough to support that.

Luigi: But I would like to distinguish between the normal business cycle and real crises. For instance, the one you describe . . . Most of the ones you describe are recessions in the post-World War II period that did not really have the aspect of a major economic and financial crisis. They were just business-cycle fluctuations, which, I agree, most of them were caused by a tightening of the Fed, which was trying to prevent a rise in inflation. But when we look at big crises, the 1929 crisis, the financial crisis in Japan in 1990, and in east Asia in 1997 and ‘98, then we look at the last financial crisis in 2007, 2008, these are kind of different in nature from your normal business-cycle recessions.

Kate: Yeah. I totally agree. I think what I had in mind for this episode is where the next recession is going to come from, not necessarily the next major crisis.

Luigi: I think that it’s more interesting to try to speculate what the major crisis is going to come from, because here, even if we are unable to tell exactly where it’s coming from, I think using some of the insights that Larry Summers gave us, which are very much in line with what Hyman Minsky gave us, we can trace some characteristics that will help us spot the beginning of the next crisis.

Hyman Minsky has this view that everything starts with what’s called displacement. A moment where you create some enormous profit opportunities that change the way people invest normally. That tends to generate a lot of excitement and a lot of lending in that direction. Think about the dot-com bubble, where a lot of people lent for new telecommunications, or the real-estate bubble, where there was a lot of lending related to real estate. This is the moment where you start by lending on fundamentals, as Larry Summers said, and then you start to stop lending just on fundamentals and lend against expectations of future increases in prices.

This is where the Wile E. Coyote moment comes, because you lend against future increases, and as long as those future increases come and everybody expects them, you can keep going. But then, there is the moment in which you start to doubt that they’re going to come, and once you doubt, you don’t want to lend, and that makes those doubts reality.

Kate: So, do you think there’s evidence that we should be worried about this right now?

Luigi: Not necessarily yet, but I think that we need to watch out for this kind of phenomenon. Certainly, there was this phenomenon in the bitcoin market until recently, but I don’t think it’s big enough to create a major crisis.

Kate: I think that this is something we should be worried about right now, particularly in the leveraged loan market. The term leveraged loan, or leveraged lending, refers to loans that are made by banks or groups of financial institutions, to borrowers that have pretty bad credit ratings, particularly below double B. This market has been taking off ever since the financial crisis. According to CVC Credit Partners, it’s doubled since 2011 globally. I think it’s worth over a trillion dollars, and that’s in terms of loans that have been made to already very highly levered, risky borrowers.

I think that part of what’s been driving this is, well, at least in the past couple years, is the Trump tax cut. I think, if anything, that should make us really worried, because what you would expect from the tax cut is sort of the opposite of what happened. Part of the reason that debt is attractive relative to equity is that there’s a tax benefit from it, and so, if the marginal tax rate is really high for corporations, then relative to equity, debt seems pretty attractive.

When Trump cut the marginal tax rate for corporations from 36 percent to 21 percent, it should have made debt relatively less attractive. But what it did was that it infused companies with a ton of cash. Some of that they paid out to investors, so it infused investors with some cash, and some of that they held on for themselves. I don’t think that the investment opportunities were as plentiful as Trump made it sound like they would be.

Instead, all that cash rushed into the buyout market, where companies were trying to acquire one another, or make deals with one another, and they’re just sitting on all this, what they call, dry powder. I think that that has been ramping up deal activity, I think it’s been pushing down yields, I think it’s been leading to an influx of money lent to a pretty dangerous sector, and I think that we should absolutely be worried about this.

Luigi: You’re right, Kate, but the big question in my view is to what extent a crash in the leveraged loan markets becomes a major financial crisis. I think this is the aspect that neither Larry nor Bob analyzed. To be fair, we didn’t ask them to analyze it, but what they didn’t stress are the mechanics through which a relatively small hit becomes a major source of instability. After all, ironically, if you look at the real-estate market, particularly the subprime real-estate market, in 2008, it was a relatively small sector. We’re talking about $1.5 trillion, which, of course, is a lot of money, but even a major loss in that market shouldn’t, in a normal situation, lead to a financial crisis.

After all, when the dot-com bubble exploded, there were a lot of people who lost money, but there wasn’t really a major financial crisis afterward. I think the loss was bigger in terms of magnitude than the loss in the real-estate market in 2008. So, the mechanics that lead from a small loss to a big financial crisis is actually debt, and, in particular, short-term debt. There is a colleague of mine, Doug Diamond, who stated that financial crises are everywhere and always the problem of short-term debt. This, of course, is a bit of playing with a famous sentence by Milton Friedman that said, “Inflation is always and everywhere a monetary phenomenon,” and I think that he’s by and large right. Short-term debt plays a crucial role, because in the moment in which . . . In the Wile E. Coyote moment in which you are panicking, if you are locked in with long-term debt, or with equity, there’s nothing you can do. But if you have the chance of having some short-term debt, what you do is try to get out, to get to the famous door, as fast as possible. That’s where the crisis starts, because everybody tries to get through the door, and not everybody can.

Kate: Yeah, and to reiterate the role of short-term debt in the past crises, the past major crises we’ve seen of this century. During the Great Depression, it was bank deposits. You and me having our money in a bank and being able to pull it out right away. As we discussed on the first episode of this series, the nature of short-term debt for the most recent financial crisis was a little bit different. It was more about banks lending on a short-term basis to one another in what’s called the wholesale funding market, which is a little bit more opaque than a typical bank deposit, but, in a way, it was just as risky and susceptible to runs as the typical deposit was in the 1920s.

Luigi: And, in most international financial crises, actually international creditors, short-term international creditors, try to pull out of the country, and when they all try to pull out of the country at the same time, what you generally have is a major devaluation of the currency and a financial crisis. That’s what Argentina is going through as we speak.

Kate: Yeah, I have to admit in terms of the short-term funding perspective, I don’t think that we have any serious problems. I think that a lot of the issues with wholesale funding that were present in 2006, 2007, have been remedied since the crisis. I think that banks are fundamentally safer. I don’t think that we have a major crisis or depression looming. I do think that there are elements of our economy that could trigger a recession in the next year or two, but I don’t think that it will be anywhere near as bad as the financial crisis.

Luigi: I’m not an expert of China, but as Larry said, I think that the Chinese financial system is a system that is probably likely to experience a major financial crisis in the near future. Part of the reason is because there’s a lot of short-term funding, and the other reason is because there is a huge amount of opacity.

The other aspect of a crisis, the Wile E. Coyote moment, is also when you realize that the system is not as safe, or is not following the rules you expected the system to follow. In the 2008 financial crisis in the United States, I think people realized that, actually, mortgages were not made as they thought they were made, and that led to a panic—what else is there? In Wall Street, there is this famous story of the cockroach theory. For people who live in high-rises in New York, they know when you see a cockroach, there are many more to come. So, when you see something problematic, then you start wondering what is the next shoe to drop.

Kate: What’s tough to predict about China is that the state has its hands in everything in China. They might not exactly know what’s going on in the shadows, but they have the power to step in and bail anyone, or anything, out if they wanted. I don’t think the concern about moral hazard that existed here in the US during the financial crisis is as strong in China, because, by definition, they are supposed to be involved in everything. They’re supposed to own everything. I do think that if there were a short-term funding panic in China, then the government would step in, it would bail out whoever needed bailing out, and then it would probably engage in the slow and lengthy process of trying to reform the system, which I do think that it has been trying to do. They’ve at least been working on reforming the bankruptcy system to get rid of some of the zombie state-owned enterprises that are basically defunct, but are still on banks’ balance sheets. It’s hard to predict how much of a panic could ensue in China, because the government could prevent the panic from happening.

Luigi: You raise an excellent point that I would like to return toward the end of this episode, because I think we need to think about not just where the next crisis is going to come from, but also what can be done to prevent the next crisis to unfold. I think that you suggest that if you have a very capable and very powerful government that intervenes very massively, it might be able to stop a crisis, with some other consequences. I’m not saying that this necessarily is a panacea, but I think it’s—

Kate: I was going to say, Luigi, are you calling for a very capable government to intervene in all financial situations? All distressed situations?

Luigi: Not necessarily, but I think that in the situation of panics, having a government that is capable, and with deep pockets and credibility, I think is a big issue. I speak as an Italian who has a government who is not very powerful from that point of view, because there’s not a deep pocket, it cannot even issue its own currency, because only the European Central Bank can. So, it is potentially subject to a run, in terms of the banking system could be subject to a run. I think that if I have to predict the next financial crisis, I think that the euro system seems like the most likely one, and Italy probably the culprit.

Kate: OK, but going back to the United States, something that has captured a lot of attention in the past few years is that student-loan debt has skyrocketed in the past decade. In particular, since 2004, it’s more than tripled in the US. Do you think that this a potential source of concern?

Luigi: Yes and no. I think that there is indeed an overlending in this direction. I think that, to some extent, an overlending that is very similar to what happened in the real-estate crisis, because at the time you had very aggressive lenders that didn’t particularly care about the ability of the borrower to repay. In a sense, that’s exactly what student debt is about, because the lenders know that the debt cannot be restructured in bankruptcy, so they push this onto the students as much as possible. For many students, the cost really exceeds the benefits they receive, especially in a world that is becoming more and more unequal.

The median student does not get enough from the future income after college to pay for the debt. Is there a possibility of major losses in that market? Absolutely. Whether this will transform itself into a financial crisis, I think that’s less likely to be the case.

Kate: I basically agree with you on this one. I think that student-loan debt is certainly concerning, and I think that it may lead to issues in the future. I don’t think that those issues will necessarily turn into crises, because student loan debt isn’t as systemically risky as, let’s say, subprime mortgage debt. I do think, though, that student loan debt will have adverse consequences on the economy from an aggregate demand perspective. 2004 was really the inflection point when we saw the total amount of student-loan debt really start to balloon. If you think about it, if you were starting college in 2004, you are just turning 32 right around now. Thirty-two is the average age of the first-time homebuyer. I don’t think we’ve really seen the effects of student-loan debt yet, I think that we’re just starting.

Luigi: I think you’re right. I think, in part, we’re already observing this as we speak. People are getting married less, and home ownership is down, and I think that the demand for some durables is down. Some of the effects are already in place today, and, as you said, they might have macroeconomic consequences that slow down growth. Whether this is transforming itself into a major crisis, I don’t see it coming, but it certainly will impact the economy in a negative way for a long time to come.

Can I try something quite different in terms of potential risk?

Kate: Sure.

Luigi: If you wake up in the morning and you realize that a major bank, or a major securities house, etc., has been hacked, and you’re not sure that you can get your money back, I think that everybody will try to reach out to their online account and try to get their money in some safe place. The question is, what is safe at that point? That could be indeed a major financial panic.

Kate: All right. What about the trade war? This has also been discussed widely in the news. Do you think that that’s going to have a significant drain on our economy?

Luigi: I think that it potentially could, if it really is pushed to the limit. I think it has the appearance of being a lot of noise, with very little substance, in the sense that, after denouncing NAFTA as the worst deal on the face of American history, the history of America, President Trump seems to have agreed to the renewal of NAFTA. That, of course, cannot be called a renewal, but is a completely new agreement, that is not that far off, with some marginal improvement, by the way. I think that there were some marginal improvements, but . . . I think he barks more than he bites. That’s my impression. I’m much more concerned about a political deterioration in terms of a military confrontation or a cyberwar than I am about a trade war.

Kate: I agree with you on this one, too. Particularly that Trump’s bark is worse than his bite, but I also think that trade between the US and China is not as big as people make it out to be. It’s only 3.2 percent of world exports. Yeah, the trade war will lead to slight increases in prices for the US consumer. I don’t think it’s necessarily going to trigger a recession.

Luigi: So, Kate, I think that everybody says that a financial crisis is hard to spot in advance. So, what can be done at a government level, or even at the individual level, or the corporate level, to prepare, to make sure that the next shock that inevitably will come, will not transform itself into a major financial crisis like the one we experienced 10 years ago?

Kate: I think in terms of preventing a financial crisis, it’s incumbent on the government to make sure that it knows what’s going on, and that deposits or short-term funding are relatively stable. In that regard, I think that we’ve made improvements since the financial crisis. We’ve got the Financial Stability Oversight Council, and a lot of the provisions of Basel III, which are new provisions that regulate banks and investment banks, have made the funding and liquidity of investment banks more stable.

Having said that, I think another thing we should have learned from the financial crisis is that new types of engineering, or new types of financial securities, that we didn’t even know existed maybe five, 10 years ago, are something that the government should be worried about. I think there is some of this going on in the corporate loan market. I think that we should be careful to make sure that the financial sector can’t just dodge the regulations we have in place by coming up with new types of vehicles that exist in the shadows.

What about you?

Luigi: I think that central bankers have been trying to develop tools to face new crises that go under the name of macroprudential regulation. The idea is all these major crises started with an explosion of debt, so if we monitor what leads to this explosion of debt, and we have instruments to prevent that explosion, or moderate that explosion, then we can prevent or deal with the new financial crisis.

I think there is some element of truth in that. However, as we discussed in a previous episode with Paul Tucker, there are also some dangers, because if the macroprudential regulation leads to determine who can borrow and who cannot, it becomes, really, a centrally planned economy. So, to what extent can you change the requirement for lending against . . . For a house, for example, and can you change the down payment based on the cycle and based on the location? So, if I say that in your neighborhood of Washington, all houses should be purchased with a 60 percent down payment, that’s quite intrusive. This is what, actually, has been going on in New Zealand, they’ve started to put some requirements first on the country overall, then on just the capital, Auckland. They didn’t go down to the quarter level, but you can imagine they might. I think that that’s a serious concern.

Kate: So, just out of curiosity, have you changed the composition of your wealth, or your investments, in any way to reflect your views on whether there will be a crisis or a recession coming in the next couple years?

Luigi: No. I have not, but I don’t want to give advice. I am a terrible investor and I don’t think people should learn from it. You know the expression that the children of cobblers don’t have shoes, that’s exactly my model of investing, so I don’t think that I want to give listeners any investment advice.

The second in a 3-part series on the 2008 financial crisis. In the weeks after the crash Luigi remembers petitioning the government for a better bank bailout. Looking back, he and Kate review everything from TARP to Dodd-Frank to see how we averted a worse recession. But did some CEOs get away with fraud?

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, the podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On the last episode, we discussed the lead-up to the financial crisis, and I shared some of my maybe sort of embarrassing stories about how I worked for Lehman, lost all my summer internship money, and then ended up dropping out of school and hitchhiking around. Luigi, I’m assuming that you were making a more productive use of time around the end of 2008.

Luigi: I’m not so sure that it was more productive, but I do remember I was in my office looking at the news. I was outraged when I heard that the secretary of the treasury, Hank Paulson, wanted to ask Congress for $700 billion to be used to buy assets from the failing banks. I remember that I was sitting in my office. I said, “That can’t be. That is really the end of capitalism as I know it, because this is the fact that when a business fails, it fails. When small banks fail, they fail. But when big banks fail, or are about to fail, the government comes in and socializes the losses.”

A system where you prioritize profits and socialize losses is the worst possible system on Earth. Actually, I remember at the time, and I already mentioned in the last episode about Allan Meltzer, Allan Meltzer was saying that capitalism without bankruptcy is like religion without sin, it doesn’t work.

I didn’t know about that sentence at the time, but I wrote a little piece with the very subtle title of “Why Paulson is Wrong,” and I started circulating it, and I got a lot of attention on that. Then, the next week, early in the week, I was so outraged that I started … At the time, Paola Sapienza was visiting Chicago. I was discussing with her, “We need to do something.” So, with her and then John Cochrane, who was my colleague at the time, we started a collection of signatures of economists against that version of TARP.

We quickly reached 300 signatures of major economists, including a few Nobel Prize winners, and I remember that during the debate Senator Shelby actually showed on camera the list of economists against TARP.

Kate: Is this something you frequently refer to as a mechanism to combat the government, is that you start petitions?

Luigi: Maybe this is my Italian background. In Italy, you petition all the time. I don’t believe in abusing those, but I thought that, in that particular case, that was important, because this was a topic that was pretty obscure to most people. I think that this reverse socialism where you socialize the losses is the worst kind of socialism.

Kate: So, did it work at all? Did your petition actually have any influence on what the government did?

Luigi: Actually, I think I would be a bit too full of myself saying that that was the fact, that made things change. But I have to say that there was enough opposition that, number one, the version of TARP that later was approved by Congress was modified. Now, it was still a bit of a gift to the major banks, in particular Citigroup. But the investment by the government came with a restriction, a restriction on executive pay. Surprise, surprise, when you restrict the executive pay, the executives really wanted to buy back those stocks as fast as possible. They did in June of 2009. So, I think in that sense, it was very successful.

Kate: TARP wasn’t just for the banks, though. TARP also involved the big automakers, and it also had a component to help support homeowners who may have gone through foreclosure. To put some numbers on the magnitude of the crisis that unfolded, the GDP shortfall ... So, in terms of the path that US GDP was on prior to the financial crisis and the amount that we lost by not staying on that path, is estimated to be about five or six trillion dollars. That’s relative to the roughly one trillion that was spent in stimulus. The unemployment rate went up to 10 percent in 2009. Then, finally, the median family experienced a household drop in income of about 8 percent. That’s on real terms, so in terms of how much they could buy.

Luigi: One of the things that was particularly scary at that time is the speed at which companies fired workers. It’s normal in a recession to have a reduction in employment. But the reduction in employment that came at the time of the Great Recession was abnormal by any standard, even by the standard of the large drop in GDP.

Economists are still wondering why that was the case. But the results were pretty dramatic, because unemployment, as you said, Kate, reached 10 percent. The possibility of finding a job for many people became a distant prospect. That was pretty devastating in a large part of the country.

The other thing that was very devastating is it took a long time for this unemployment to be reabsorbed. In a typical recession, you have that the sharpest is the downturn, the fastest is the recovery. However, when there is a recession due to a financial crisis, the recovery is actually quite slow.

What was very painful for the US economy overall is that the recovery, in spite of TARP, in spite of the stimulus package, in spite of the other monetary interventions we’re going to discuss in a second, was much slower than we’ve seen historically. So, a lot of people remained unemployed for a long period of time.

One thing that we know as economists is that long terms of unemployment tend to have permanent effects. People lose their skills, lose their willingness to go and look for a job, lose even their ability to work on a regular job at a regular time. So, it’s not that easy to reabsorb those people in the labor force after them being unemployed for six, nine months, or even a year.

Kate: Unemployment benefits and their extension were a component of the stimulus act, but it was a relatively small fraction of the funds dedicated. It was much smaller than the outright tax assistance. I think that there should have been, given the fact that unemployment rose to 10 percent, I think that some of that tax assistance should have been shifted over to the increase in unemployment benefits.

Luigi: But, to be fair, if you compare the United States to the euro area, they both were hit by a crisis in 2008. The United States recovered faster than the European Union. So, the other factor, and I think this is the right time to bring it into the picture, the other factor that delayed the recovery in Europe is the European Central Bank was slower in doing any form of quantitative easing. Kate, can you explain to our listeners what quantitative easing is, because everybody talks about it, but what actually is it?

Kate: Sure, so I think before we explain quantitative easing, we have to explain that the Fed cut interest rates to virtually zero, shortly after the panic ensued of the financial crisis. Cutting interest rates to zero is the Fed’s main lever of monetary policy. Those interest rates that I’m referring to, by the way, are pretty short-term interest rates.

Now, how much can the Fed actually do to help stimulate the economy once interest rates are already zero? In the traditional sense, the answer is not that much. So, this is where quantitative easing comes in. It’s sort of a form of the Fed also trying to push down interest rates. But not just in short-term securities, but in long-term securities. So, they purchase assets, typically longer-term government bonds. This purchasing is being done by the government. When there’s more demand for long-term bonds, the yields on those bonds go down, and that typically boosts the stock market. So, it’s another way of central banks trying to keep down yields and bonds.

Another thing that it does is that it helps prevent deflation. Deflation is really dangerous, potentially, because if prices are going down, and if interest rates are already zero, then people are incentivized to just hoard cash, right, because they’re not going to put it in the bank, because they’re not going to earn any interest on it. They’re also not going to spend it, because prices are going to keep going down.

Even though we haven’t actually experienced much of this sort of deflationary trap in the United States, there was a concern that it might happen shortly after the financial crisis. So, by buying longer-term bonds, the government through quantitative easing was trying to boost asset prices and prevent us from entering into this deflationary trap.

Luigi: Now, many people thought that quantitative easing was an extraordinary measure of monetary policy that was unprecedented, and even some people attacked the Fed as being kind of revolutionary and unjustified. In reality, as Kate said, this is just a continuation of ordinary monetary policy in a different way.

When you choose to keep inflation only at 2 percent, you find it hard to bring the level of real interest rates negative, because basically what happens is there is a demand and a supply of savings. The demand and supply of savings should lead to an equilibrium price of interest rates. However, if the demand of savings, i.e., the investments, are very low, it might be that the clearing price for this market is a negative real interest rate. How do you get negative real interest rates when you have low inflation? You have to have negative nominal interest rates.

The negative nominal interest rate is difficult to administer, because, as Kate said, people have an easy arbitrage. They can hold onto the cash and get the benefit of that.

Kate: Then, finally, we come to Dodd-Frank, which was the legislative branch’s approach to changing regulation after the financial crisis, and preventing a similar crisis from taking place in the future. The component of Dodd-Frank that people are most familiar with is the Volcker Rule, which prohibited investment banks from proprietary trading, or trying to make money on their own behalf, rather than on behalf of their clients.

The Volcker Rule effectively made most investment banks have to spin off or eliminate the proprietary trading components of their operations. There was also an entirely new government agency created, the Financial Stability Oversight Council, with a research arm that was part of it, which is dedicated to just making sure that huge crises, whether in the form of subprime mortgages or anything else, financially engineered products, didn’t happen again. It’s like a group of people who are just keeping their finger on the pulse of the economy, making sure there aren’t big systemic risks building up in ways that regulators don’t see.

Luigi: Two things. First of all, the Dodd-Frank Act is extremely large and has so many provisions that we can’t possibly do justice to them all. There are some that are definitely very beneficial, like, for example, the movement of most derivatives onto organized exchanges to make the system more stable. There are others that are more controversial. In particular, what I find very controversial is the Volcker Rule. The Volcker Rule is an attempt of the Obama administration to please the popular demand for the separation between investment banking and commercial banking. What goes under the name of an old law passed during the Great Depression, the Glass-Steagall Act, and the demand of banks to keep doing the same.

My interpretation of it, and you might disagree, Kate, but my interpretation is Geithner was very clever, trying to have the cake and eat it, too. He had a rule that was named after an impeccable person like Volcker, that in some sense gives the impression of catering to the people who want the separation between the two, but de facto does not do much, because it’s very hard to implement, because you’re right in saying that the Volcker Rule prohibits proprietary trading. The question is, what is proprietary trading? If I trade with my clients in mind, even if my clients did not give me an order, is that proprietary trading? The Volcker Rule will say no. So, in order to implement the rule, we really need to look at the intent of the trader, something very hard to do.

Kate: I think there’s two points to discuss about the Volcker Rule. One, whether it was actually effective. Two, whether it had anything to do with the financial crisis. In terms of effectiveness, I do think that the outright prop desks, the outright groups within investment banks whose sole purpose was to just make money for the investment banks, for the most part those disappeared, or they were no longer part of the investment bank. To your point about whether an individual trader can actually make any money for his or her own desk, even if trading on behalf of a client, yeah, sure. I do think that there are ways for them to make money. But I still think that compliance departments within investment banks were pretty careful to make sure that they weren’t at least explicitly violating the Volcker Rule.

I do think that the Volcker Rule was pretty effective in mitigating how much banks were trading on their own behalf, even if not completely effective. But I think the bigger question is, did it have anything to do with the financial crisis? The parts within investment banks that were responsible for financial engineering and subprime securitization weren’t really the proprietary desks of these banks. They were the desks that were devoted to purchasing these bad mortgages, bundling them together, and then selling them off to investors. Those weren’t necessarily those groups that were later eliminated. So, I don’t think that the design of the Volcker Rule necessarily had that much to do with preventing future similar crises.

Luigi: One of the causes of the crisis, according to many economists, was lack of regulation, or at least lax regulation, and regulation that was not apt to stand up with a change in the economy. However, the Financial Crisis Inquiry Commission came up with seven names of people that, in their view, had committed fraud. Two of these people were indicted, or potentially indictable, on two grounds. Those two people are Robert Rubin and Chuck Prince, both from Citigroup. The attorney general under Obama, Eric Holder, did not proceed against any of them, but in particular did not proceed against any of these two.

Kate: I think the question of whether fraud occurred at the level of the mortgage originators is much easier to handle. It’s sort of like with a drug ring. The guys on the ground who are selling the illicit drugs, it’s easier to prove that they are directly doing something wrong. In the case of the mortgage originators, I think that the fraud is easier to prove. There are some people involved in the process who absolutely should have been convicted and put in jail. At the higher level, at the financial institutions, it’s … in some sense they bore a bigger burden.

But it’s also harder to prove that they necessarily violated any particular law, because I think that their actions that were detrimental to the entire system were, in some sense, not explicitly illegal. They were creating these financially engineered securities that were dangerous and amplified risks. But everyone was doing it, and there was no ... I think there was also large fault on the part of the regulators who allowed this to happen. So, how can we really say, “Oh, it’s really their fault”?

Now, in the case of a couple people, Rubin and Prince, I’m not sure exactly what the Financial Crisis Inquiry Commission pinpointed as their exact fault. I mean, I get the sense that it was that they had a feeling that the market was about to turn. They still continued in their financially engineered securitization process. In some cases, they even took positions betting against what they were creating. That is immoral. But how can we necessarily throw someone in jail for doing something immoral that’s still legal?

Luigi: I think you’re too generous. I think that what the Financial Crisis Inquiry Commission found were violations of the law. If you refer somebody to a prosecutor for indictment, it means that you have a strong suspicion that there is ground for indictment. The fact the attorney general dropped the case without even trying, I think is worrisome. Just to make sure that we’re not picking only on those, there are a lot of other cases. For example, a whistleblower came out saying that Jamie Dimon, at the time and even today CEO of JP Morgan, knew perfectly well that some of the packages of securities that were done contained a lot of fraudulent mortgages. This was settled with a large fine to JP Morgan, but no particular indictment against Jamie Dimon.

I think there was a concerted effort of letting these things go. At the beginning, you can even understand that, because you are afraid that this might create more panic. But the fact that this was done even later I think was a disaster. I think that there is a big difference between the way Roosevelt dealt with the problem led by the financial crisis in 1929, and the way Obama dealt with the leftovers of the financial crisis 10 years ago. I think that the backlash that we have observed, the lack of trust in institutions, the lack of trust that justice applies equally to everybody, is a consequence, a direct consequence, of the fact that homeowners were forced out of their houses. Some of them even paid for the fraud they did when they had the application for their mortgage. Nobody else did.

By the way, I remember that in the fall of 2008, the beginning of 2009, I wrote an explicit piece to Geithner saying, “Look, we have saved the banks. Why don’t we try to do the same thing with homeowners?” After all, if I am a guy in Las Vegas who bought a house, and because I’m getting married, and because I have a new kid, because of whatever, and all of a sudden prices drop 50 or 60 percent, am I really a bad guy because I don’t pay the mortgage anymore? Or is it that I got hit by a tsunami, and honestly, I am not responsible for that tsunami? I should be helped in the same way, or even more, than the banks were helped.

The asymmetry that you help the banks but you don’t help people who generally ... not speculators who are buying five houses, but ordinary Americans who are buying the place where they’re living, and found themselves hit by a tsunami, the lack of support for them is what, in my view, created all this resentment.

Kate: I think that there should have been, and this is maybe an unpopular opinion, but I think that there should have been some foreclosures, to the extent that there was overheating in the housing market. There was too much subprime lending. People who bought McMansions with no jobs, no income and no family, for that matter, I mean, I think that there is some natural adjustment that should have taken place.

Now, for people who really needed homes, for people who were using those subprime mortgages to buy a primary residence, and for people who had jobs and a family, I think that there should have been assistance that went directly to them, and there was. I mean, there were programs that were designed for that. I just don’t think that they were designed well enough. I don’t think that there was enough funding set aside for them. But I do think that there was some political will for it.

Luigi: Yeah, at the end there was a little bit of help. It was, as you said, little, designed in a way not to make it easy, and did not work very well. I am the first one to say you need bankruptcy. You need bankruptcy for big banks. You need bankruptcy for individuals when they make a mistake. However, I don’t understand why, when it comes to banks, you say, “Oh, it’s better to intervene when there is a big crisis, because bankruptcy is so inefficient than we can benefit by fixing it.” The same is true for individuals. Bankruptcy isn’t efficient. When you foreclose on a house, you lose a lot of value in the process. When the fault, if you want, I know I use a moral term, but when the fault is not of the individual, when the individual has bought a house in Las Vegas and that house now is worth half what was owned before, and he has a mortgage that will basically waste his money for the rest of his life, why don’t you want to help getting this person out of it in a decent way?

Kate: I think we agree that they should have, and the government should have. I mean, I think we’re on the same page here. But I want to go back to an earlier point that you made about the Financial Crisis Inquiry Commission actually finding that people like Rubin and Prince had violated laws. What were the laws that they violated? What law says that Jamie Dimon is committing a crime if he knew that some of the loans that were going into the securitized products that he was issuing to investors, some of those loans had faulty documentation?

Luigi: That’s called fraud. If you know that you’re selling something that is sort of defective, and you don’t tell people, that’s called fraud.

Kate: But the people who were committing the fraud were the ones that were writing the faulty documentation. Right? They were committing fraud. Then, they were selling bad products to the investment banks. The investment banks were just the intermediaries who sold those bad products onto other people. So, if the investment banks had a vague notion that there was some fraud going on at a lower level of the chain, is that also fraud? I mean, I’m sort of playing the devil’s advocate here, but I think it’s a hard question. I think that we can’t just throw people in jail based on vague definitions of the law.

Luigi: If you know that you’re selling crap, even if you’re not the one producing it, but if you are repackaging fraudulent mortgages and you don’t tell people that these are fraudulent mortgages, you are committing fraud. Whether you are an intermediary, you are still an intermediary of fraud. Or when you mislead investors, you don’t reveal stuff to investors, that’s a fraud. I think that there are laws against that.

I’m not a lawyer. I did not do the investigation. But what I read is that there was enough evidence that in normal cases, you would have proceeded. But they did not want to proceed, in order to protect the stability of the financial system.

Kate: My position is that we should amend the laws to make them stricter.

Luigi: Yeah, but that’s a different question, because if you change the law, you cannot prosecute people after you changed the law, because you cannot prosecute for a law that was not in place at the time.

Kate: Exactly. I think that it was primarily the fault of our regulators and the legal system that existed earlier. I don’t think that we can look back on that and be like, “Oh, well, shoot, we should have had those laws in place that would have protected investors, and protected consumers, and we didn’t. So now, let’s just throw people in jail, even though it was really our fault for not putting those investor protections in place.” But there’s the deeper question of whether Dodd-Frank was effective in preventing another crisis.

Luigi: Yeah, I think that this is indeed the bigger question. Even more importantly, do we fear another financial crisis? Is any bubble leading to a financial crisis of the type we experienced 10 years ago? Or do we have a more resilient financial system that can withstand some shocks? Because the only thing that we can be sure of is there will be other shocks. As we said in the first episode, at the end of the day, these shocks were not that big to begin with. But they were amplified by a number of factors. So, the question is whether these factors are still in place, and whether there is a risk that a relatively small shock might lead to a big crisis like the one we experienced 10 years ago.

Kate: I think we haven’t yet talked about what’s potentially the biggest result of the crisis, or the biggest response to the crisis, which is that despite lack of regulation in this area, a lot of the products that led to the crisis completely ceased to exist. In terms of subprime mortgage origination, for example, I mean, it still exists, because some borrowers who have low FICO scores still should be able to get houses if they have an income. But the market fell from about $600 billion in 2005, to around $60 billion now.

I think that the order of magnitude shrinkage in the subprime mortgage origination market is something that I’m comfortable with. Maybe more importantly, the types of mortgage-backed securities that were being created by non-GSE, or non-Fannie-Freddie institutions, fell from over a trillion dollars to only $14 billion now. That market completely disappeared. So did these financially engineered products like the crap CDO-Squared and synthetic products that we talked about in the first episode. For the most part, they’ll all gone.

Those were not due to government intervention, but they were just because investors realized that those products were not fundamentally sound, and so the demand for them disappeared. But I don’t think that we’ve put in place sufficient regulation to prevent banks from engaging in similar, even though not identical, types of financial engineering in the future.

Luigi: I agree, and that’s the reason why, in the next episode, we’re going to try to explore where the next crisis is going to come from.

The first in a 3-part series on the 2008 financial crisis. Kate tells Luigi about being an intern at Lehman Brothers when it collapsed and then we debate the causes including subprime mortgages, investor fraud and an ill-advised speech from former President George W. Bush.

Speaker 1: Mark your calendars, because this is the 10-year anniversary of Lehman Brothers’ collapse.

Kate: Hi. I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Speaking about what isn’t working in capitalism, today is the 10th anniversary of the last day in which Lehman was trading as an independent company.

Kate: It’s a death day.

Luigi: Yeah, it is a death day. And where were you, Kate, at the time?

Kate: I think that I was in my dorm room. I was back from my junior internship, which was at Lehman, that summer, the summer of 2008. By September, I was out of my internship for two weeks, back at school, watching the stock price fall.

Luigi: Now I understand why you have so much interest in bankruptcy, because you started experiencing bankruptcy from day one.

Kate: Yeah, it’s weird. When I started my PhD, I was like, I’m interested in shadow banking and bankruptcy, but I don’t know why.

Luigi: So, Kate, you had unique insight. You were in Lehman just before the collapse. How was life on the verge of death?

Kate: I guess I have to say that I don’t have a tremendous amount of insight into what was frantically going on in the background, because I was just an intern. I was only there at the very end. But I will say that I was on the fixed-income trading floor, and they had ... at the top of the floor, the center of the room, Lehman’s stock price with the LEH sticker in front of it. It had been blinking green for the most part for the past 10 years, and that summer it was just blinking red, every day. I mean, that weighed pretty heavily on people’s moods.

Even though my desk was reasonably secure—I was on the government bonds desk, so everyone always needs that sort of trading desk in an investment bank—moods were high, tensions were high. I think the managing director threw the phone against the wall once.

Luigi: And did you lose any money?

Kate: OK. I don’t know if this qualifies as insider trading. I don’t think it does, because I didn’t have any special information, but everyone on my desk was convinced that Lehman would be OK. They were convinced that either they would survive through the weekend, or they would be purchased, like acquired by another bank for a reasonable amount, and that their jobs would remain.

Just based on that vague information alone, based on everyone’s optimism, the weekend before Lehman failed, I used all my summer internship money to buy Lehman’s stock. And then on Monday morning—

Luigi: Wow. That was a good trade.

Kate: Yeah, it was a great trade. On Monday morning, I woke up right after my summer internship and had no money left.

Luigi: So that’s the reason why you became a professor.

Kate: Exactly. Extremely risk averse now.

Luigi: Let’s now try to go back to what led to the Lehman weekend and to that disaster. I think that your position is interesting, because a lot of people back then, and a lot of people even today, are wondering, should Lehman have failed? But, before entering this discussion, let’s give our listeners a short recap of how we arrived at that dramatic weekend of 10 years ago.

Kate: In celebration of the 10-year death day of Lehman, we’re going to be doing a three-part series. This first episode we’re going to talk mostly about the causes of the financial crisis. On the next episode, we’re going to talk about the aftermath, and then, on our last episode, we’re going to talk about whether there’s a crisis brewing in the future.

Luigi: Yes, but let’s start with history, which is easier, and let’s go to ... In your view, what caused the crisis? How did it start?

Kate: All right. So, we’re standing in 2007. There had been a real-estate bubble in the United States. So, to give you some sense of that, house prices had risen 91 percent between 1995 and 2003. And then, between 2004 and mid-2006, they rose another 36 percent.

Luigi: But not just in the United States, they went up everywhere. They went up in the UK, went up in Spain, went up in Australia. In all these places, by a bigger factor than in the United States. So, yes, there was a dramatic rise in real estate, but it’s not like there was a gigantic real-estate bubble. I think that the problem was that a lot of people bought in very highly levered positions, and the second is there was a lot, in my view, a lot of fraud, but this is something that we can discuss later.

Kate: Yeah, absolutely. So, to your point about household debt, between 2001 and 2007, US mortgage debt basically doubled, and so households had a lot more debt than they did in the beginning of the century.

Luigi: Yes, but this can explain why, in 2008 and 2009, we see families cutting down consumption because of the high leverage. However, what generated, really, the financial crisis was not so much the leverage of their households, it is the fact that many households started to default, and many financial institutions were heavily exposed to the risk of this default.

Kate: Right, so when you talk about risk, a lot of that was coming about through this popular word, “subprime,” that entered everyone’s vernacular around 2007. Subprime mortgage origination had always been about 10 percent of all mortgage origination in the late ‘90s, and by 2006 it was almost a quarter of all mortgage originations. The types of housing loans that were being made had gotten a lot worse in quality throughout the early 2000s, and that was a big part of why, at least in the United States, the bubble started to deflate around 2006.

Luigi: Yes, because traditionally mortgages were issued by banks and then were sold by two government-sponsored entities, Fannie and Freddie, that were repackaging these mortgages into what are called mortgage-backed securities, and selling them to the financial markets. So, historically, these repackaged mortgages were relatively safe because they were issued under strict guidelines, but in the early 2000s, the playbook was thrown out, and many mortgages were issued without strict guidelines and with the understanding that the market will take the risk.

Not only were there so many of these mortgages being sold, but these mortgages were further repackaged and sliced in different tranches, giving different degrees of priority to investors. The frenziedness was such that this operation took place many, many times and, in fact, some investment banks started to bet on those mortgages even if those mortgages were not issued—what is called, in jargon, synthetic mortgages.

Kate: Yeah, so around mid-2007, people started to get really worried about this. In particular, in between April and June, Bear Stearns had a bunch of hedge funds that it sponsored. One, in particular, had been doing gangbusters. In 2004, it earned 17 percent for investors, in 2005, it earned 10 percent, and so they started another, similar fund, both of these heavily exposed to these risky mortgages, and there was $18 billion of capital invested in these hedge funds by 2006. And yet, by June of 2007, these hedge funds failed and Bear Stearns had to bail them out.

After this, it set off a bit of a panic in financial markets. People typically say that the financial crisis started around August or late summer of 2007, when financial markets really started to react to the fact that these two large mortgage-exposed hedge funds had failed.

Luigi: However, to be fair, the stock market peaked in the fall of 2007, so, in spite of the early warnings in 2007, the market as a whole was going up, and the first really big wakeup call was in March 2008, when Bear Stearns, which was an investment bank, basically was rescued at the last minute in an operation joined by the Fed and JPMorgan.

Kate: So, why did they need rescuing? This has to do with the fragile nature of the way that investment banks are set up. If you’re an investment bank, you probably have a portfolio of securities called a security inventory, and, oddly enough, these securities are financed on a very short-term basis. If Bear Stearns held, for example, a bunch of mortgage-backed securities in its inventory, it was financing those mortgage-backed securities not by owning them outright, but by borrowing money to buy them and then having to reborrow that money every single day.

It was essentially borrowing on a very short-term basis where each loan was due the next day, and it was just expecting these loans to be rolled over every single day. In March of 2008, that stopped. It couldn’t borrow anymore against these securities that it held in its inventory, and so that’s why it needed a bailout.

Luigi: What is interesting is that, number one, in a matter of a week they lost tens of billions of dollars of liquidity. So, at the beginning of the week, they still had plenty of liquidity in their portfolio, and by the end of the week, actually by Thursday, they had to get special loans from the Fed in order to be able to operate on Friday. And then they were rescued during the weekend. One thing that surprised the market is that not only did they find it difficult to borrow against these mortgage-backed securities, they found it difficult to borrow even against Treasurys.

This is the stuff that surprised everybody, because Treasurys are super safe, and you expect that everybody is willing to lend you money against Treasurys as collateral. However, when people perceive you might not be around tomorrow, they don’t want to take the risk, even to have the inconvenience to be stuck with some Treasurys or some securities they don’t want to hold.

Kate: To highlight how exposed Bear Stearns was to this really short-term repo financing, I like an example that was provided by the Financial Crisis Inquiry Commission in a special report that they did, which is to say that Bear Stearns’ leverage and their exposure to short-term financing was about the equivalent of a small business with $50,000 in equity borrowing $1.6 million overall and having about $300,000 of that due every single day. So, having to rely on refinancing your loan, your $300,000 loan, every single day, even if you only have $50,000 in equity. That’s how much Bear Stearns was exposed, and one day that liquidity just dried up and they had to be bailed out.

Luigi: Let’s actually discuss for a second how it was bailed out, because it’s interesting. So, normally, in normal times, the Federal Reserve makes loans only to depository institutions, normal commercial banks. However, in the Fed statute, there was an article that has been modified slightly in 2010, but there was an article called 13(3) that says that under unusual and exigent circumstances, then the Fed can lend to other institutions that are not depository institutions. What is interesting is Bear Stearns asked for this possibility and this possibility was denied, but then, immediately after the failure, or the quasi-failure, of Bear Stearns, the Federal Reserve opened a particular kind of facility called the primary dealer facility that extended the access to loans to primary dealers including Bear Stearns and Lehman.

Kate: But it was kind of too little, too late, because I think it was either on the same day that the Fed announced this, or the next day, Bear Stearns was downgraded way below junk status by Moody’s. That was enough to scare the market, so even though Bear Stearns had access to this financing, its liquidity dried up anyway, because its credit rating was downgraded.

Luigi: And the result for Bear Stearns was that the Fed made a loan to JPMorgan, and JPMorgan bought out Bear Stearns at a very low price and, by doing so, also guaranteed the liabilities of Bear Stearns. Nobody lost money except the shareholders of Bear Stearns, so the market got spooked a bit afterward, and people started to worry about who was going to be next after Bear Stearns, but the market continued operating rather normally until, basically, the summer.

Kate: Yeah, so then, six months later, a similar type of panic happens for Lehman Brothers. Lehman was highly exposed to real estate. At that point, it was clear that the US was experiencing a full-fledged mortgage-backed-security, subprime-mortgage-backed-security crisis. Because of Lehman’s exposure to these types of securities, there was a similar liquidity run on Lehman. They also used a lot of short-term financing that was really susceptible to drying up overnight.

Luigi: Now, what is interesting is that Lehman, at the beginning of the week that ends with September 13, they had $41 billion in liquidity. By the end of the week they had $1.4 billion. This is literally a bank run of the type that we have seen in movies like “It’s a Wonderful Life,” but a bank run where the runners are not the depositors, but are the institutions that lend to Lehman in this repo transaction.

Kate: So, this time, Lehman was not bailed out, and some people argue that this is part of why the financial crisis was so bad, because there was a little bit of inconsistency in terms of what the government was doing. It brokered a deal so that Bear Stearns could be acquired by JPMorgan, it brokered a deal so that Merrill Lynch could be acquired by Bank of America, but it didn’t really facilitate a deal for Lehman to be acquired by another bank. Even though there—

Luigi: A little bit of inconsistency? I think you might be … There was a gigantic inconsistency.

Kate: OK, I don’t want to be too harsh on Geithner or Bernanke—

Luigi: Let me quote David Swensen, a legendary investor who runs the portfolio of the Yale endowment. He said that you have to try hard to have the kind of inconsistency that was shown in the 2008 approach to the problem. Every time there was a new approach that was designed ex novoand then caught the investors by surprise.

Kate: To be fair, though, I think the reasoning on the part of the federal government was that they didn’t want to just bail out every single bank, because that would send a message to markets that banks could take a lot of risk and then be reasonably assured that they would be bailed out later on, so that would create a moral hazard problem.

Luigi: It’s true, but remember, the reason why the Federal Reserve was created was to intervene in situations of panics. The Fed was created in 1913 in response to the 1907 panic, where the financial markets were cornered by the only provider of liquidity at the time, that was JP Morgan. Not just the bank, but the person.

Kate: The individual.

Luigi: And so, what is a bit strange is, over the years, this notion of the Fed has kind of gone by the wayside. If you look in macroeconomic textbooks, between the late ‘80s and the financial crisis, they only talk about inflation as the main job of the Fed. The Fed was not created to control inflation, the Fed was created to control panics in financial crises. The article I mentioned, the 13(3), of unusual and exigent circumstances, is precisely the article that says, in those situations, the Fed should intervene by lending, against good collateral but lending freely against, or generously against, good collateral. That’s the part that, in my view, but we can come back later, the Fed did not do.

Kate: Look, I’m not trying to say that I’m defending Tim Geithner, I’m defending Ben Bernanke, but part of the reason why they didn’t necessarily want to bail out all the banks was because of this moral hazard issue.

Luigi: I, at the time, was against a bailout, too. But part of the problem, in my view, is part of the way economics thinks about this issue. To what extent you have panics, to what extent you have a liquidity crisis, to what extend you have a solvency crisis. One of the big issues, and we’re going to return to that, but one of the big issues is, was Lehman insolvent at the time, and could the Fed have lent to Lehman or not? Ben Bernanke came out saying that he could not have lent to Lehman, because it was too risky. A macroeconomist, Larry Ball, came out with a book recently showing, in excruciating detail, that is actually false. That the Fed could, and, in his view, should have lent to Lehman.

Kate: Well, I think another part of why the Fed was reluctant was because they simply didn’t know how exposed Lehman was to the global markets. The way that banks were structured then, and still are now, except there’s more transparency now, is that they finance a lot of their inventory on a very short-term basis, and it’s not just like a mortgage-backed security is being financed overnight by one company. It’s that that company that provides the overnight financing then also gets a loan to be able to do that, and whoever they got the loan from is also getting a loan to be able to provide the loan provider with the financing.

So, there were these long chains of interconnectedness, some of which had to do with derivative exposure that was all very opaque. It was not all reported to the government, and so, it was hard for the government to know exactly how systemically risky Lehman Brothers was.

Luigi: To be fair, until March 2008, the Fed was not supervising Lehman at all, because Lehman was an investment bank, like Bear Stearns, and they should have been supervised. They were supervised by the Securities and Exchange Commission, who wasn’t particularly aggressive in doing so. However, when they opened the primary dealer facility, the Fed started to have some people at Lehman overseeing what Lehman was doing. So, there was a team from the New York Fed inside Lehman during the summer you were working there and at the time Lehman fell.

Kate: I didn’t see them. Yeah, but again, it was sort of too little, too late. In Lehman’s bankruptcy, it took years to unravel and at least figure out who owed who what. Having six months over the summer in the middle of a panic just wasn’t enough time for the government to really get up to speed on what was going on within Lehman.

Luigi: OK, but the day after Lehman fell, the Fed got another phone call saying that AIG was in trouble. Now, full disclosure, I testified on behalf of AIG in a case that involved an AIG owner against the US government, but the only thing I testified was that there was a taking by the US government, which was proven in court.

Kate: And, full disclosure, I did some research on the other side, on the side of the US government arguing against Luigi’s position.

Luigi: Good. So, I think that overall, we are not biased.

Kate: We’re balanced.

Luigi: AIG found itself in a major liquidity crisis due to the fact that it was insuring a lot of those mortgage-backed securities that were failing. It was insuring them not in a traditional insurance form, but through this instrument that goes under the name of credit default swap, which is the factor in insurance that repays you in full in case a bond defaults.

Kate: So, credit default swaps written by AIG, I think, covered over $440 billion in bonds that day that it needed to be bailed out. The government decided in the case of AIG, it was too risky to just let it collapse, because all this insurance that it had provided to other financial institutions, it would have disappeared. And then, those bonds failing would have meant that those financial institutions would have then collapsed, and so, it would have been a huge house of cards. The government decided to rescue AIG by essentially purchasing it outright.

Luigi: They were in the process of dropping in value. The cash needs of AIG were not to pay for defaulted bonds but were as collateral, because they were providing this insurance as collateral for people that were insured with AIG that, in case things went badly, they would be able to pay. Interestingly, among the institutions that were asking very aggressively for more and more collateral was, on the other side, Goldman Sachs. Goldman Sachs was valuing the insurance that was provided by AIG at a very low price and was demanding from AIG a lot of collateral, and, as a result, AIG needed some liquidity. It went to the Fed and asked to be accepted in the primary dealer facility or some form of facility like that facility.

The Fed denied that but made a very special loan at a very high rate with also some warrant that would allow the Fed, basically, to control AIG. In fact, the CEO of AIG resigned, and who did they put as CEO of AIG? They put a board member of Goldman Sachs, who was actually on the risk committee of Goldman Sachs. The weekend of the 19th and 20th of September, he was both participating in the meetings of the risk committee of Goldman Sachs and deciding what to do for AIG, which was a counterparty to Goldman Sachs.

Kate: That’s a little bit shady. I didn’t know about that.

Luigi: But anyway, the important part for our listeners is that the Fed did rescue AIG, issuing very large loans, but financial markets got even worse because the default of Lehman caused major losses in money market funds, and money market funds have, or used to have, this promise to redeem the investors always at par, 100 cents on the dollar. Some of these funds, in particular one fund, the Reserve Primary Fund, had invested so much in Lehman bonds, and that caused, basically, a run on the money market funds that created a panic in the entire money market industry.

However, big crises, of course, are not caused by one factor alone, but if you were to go retrospectively, in your view, Kate, what is the main cause, or the main causes, of the crisis?

Kate: In my mind, I like to frame this as a supply and demand issue. On the demand side, there was global demand for very safe assets that could be a sure store of wealth. This is coming from emerging markets, it was coming from China, it was coming from countries where there was a lot of saving. It was also coming from government institutions. Fannie and Freddie, which we’ve talked about as these safe, government-sponsored entities, were investing heavily in these subprime mortgages that were being securitized by the private sector.

So, there was this significant demand coming from all over the world for these very safe securities that had to be created through this bundling and securitization process that made it very lucrative for investment banks to put whatever they could possibly find in these pools of mortgages and that, in turn, spread down to mortgage originators who were willing to push basically junk, crap mortgages, on whoever was willing to take them out and buy a new house. Even if they couldn’t afford it. Even if they didn’t have a job.

I think there was kind of this pull coming from a lot of different participants, international and domestic, but there was also the supply of terrible mortgages that was aggravated by the fact that ... As you mentioned earlier, there was fraud going on, the incentives of the investment banks and the mortgage originators were so perverse that people who absolutely had no business buying mansions were buying multiple mansions. On top of that, there was very lax oversight of this whole system, and, sitting in the middle, were the ratings agencies that said everything was OK.

So, I think I just listed 50 different causes, but—

Luigi: You put it very nicely. I will be more rough. And I would say that, in my view, the real problem was the pervasiveness of fraud and the inability of institutions to weed out that fraud. In fact, they probably wanted to encourage and push that fraud throughout the system. It’s true that there is demand for stuff, but if you cannot supply that stuff and you fake it, I don’t call it demand and supply. I call that fraud. I think institutions who were supposed to lend with the prospect of repayment in mind violated those conditions simply because there were some willing buyers on the other side, and they faked much of the documentation. Now, there are papers documenting that there were double liens that were not reported, the fact that you were an investor rather than a homeowner, so that you had multiple properties, was not reported properly, and so on and so forth.

There was a laissez-faire attitude that really cultivated, in a moment of market euphoria, the possibility for vast fraud. Once the market stopped going up, the US stock market stopped going up, people started to realize that the mortgages were much, much worse than they expected. There was a gigantic uncertainty of who would bear the losses and how big those losses were. I think that that is what created a situation of frozen markets. In this difficult situation, the Fed behaved in a very inconsistent way. A great economist, Allan Meltzer, who studied the history of the Federal Reserve, wrote extensively about the fact that the Fed never developed a policy of lender of last resort.

Kate: I completely agree with you that there was rampant fraud in the mortgage market in the early 2000s, particularly in subprime mortgages. I completely agree with you that the inconsistency of the government’s actions was part of what amplified the crisis, but I belabor this point about the demand side, the global capital being invested in safe US securities, because there were housing bubbles as well in France, Australia, Italy, Spain, and they also, at least some of them, experienced significant housing drops around the same time.

A lot of European banks failed as well, and this happened in countries that didn’t have the same sort of securitization process that we have here. They didn’t have investment banks going out and pooling together subprime loans, and yet they also experienced significant drops in housing prices and bank failures. So even though I completely agree with you that what happened in the United States, the rampant fraud that we experienced, was a big part of the crisis here, I think that the story about global capital being invested in Europe and the US, therefore pushing down long-term interest rates, therefore increasing housing prices, I don’t think that that gets enough attention.

Luigi: Certainly, there were enabling conditions, and these conditions can be different. So, for example, in Europe, there wasn’t a huge influx of foreign money, but in some parts of Europe, there was a huge influx of German money coming down. So, in Ireland and Spain, there was a huge amount of loans made by German banks to Spanish banks, and the influx of easy money is what made ... what enabled, I think, a lot of bad loans. There is a fundamental difference between Spain, Ireland, and the United States, and it is that in Spain and Ireland, the number of actual people who defaulted was relatively limited because all the mortgages there are full recourse.

If you abandon your house, the banks will come after you for the difference between the value of the house and the value of the mortgage. In the United States, some states are fully nonrecourse, some are more ambiguous, but there is a greater tolerance toward other people who walk away from the house and don’t pay the mortgage. And so, in situations like this, it’s a much greater responsibility of the lender to be very careful on the way they lend. Financial institutions not only gave up that carefulness, but also lied about the objective characteristics of the mortgages.

This created not only large defaults, but also an enormous amount of uncertainty. At some point during the crisis, there was even the possibility that all the mortgages would be considered not valid. Why? Because they were not properly transferred according to some legal rules. If fact, some borrowers got away paying nothing, because they could prove that their mortgages were not properly endorsed. Later, Congress fixed the problem with the law, because otherwise the entire mortgage market in the United States would have collapsed.

Kate: One thing we haven’t mentioned, or at least explicitly discussed, is who ends up holding the risk, and why was it that these banks were engaging in so much fraud and pushing these no-documentation or no-income mortgages on people who couldn’t afford them. I think part of the reason is that there was this huge separation between who was ultimately holding onto the risk and who was issuing the mortgages. So, there were mortgage originators, like Countrywide, on the ground knocking on doors, trying to convince people to take out these terrible term mortgages.

Those mortgages were then sold to investment banks like Goldman Sachs, Morgan Stanley, Lehman Brothers, who then put them in the big pools, securitized them, and then sold them off in pieces either to domestic investors, foreign investors, or, for riskier parts of the pool of mortgages, to hedge funds. The people who ultimately bore the risk were pretty separated in this long chain from the people who were on the ground making the loans. If you were making a fraudulent loan, it didn’t really matter, because you were so far removed from the consequences of it that, basically, you were just being incentivized by the fee that you were making on the loan. All you cared about was maximizing volume, the quality didn’t matter to you.

Luigi: Yeah, but, Kate, you’re forgetting an important part. You describe, perfectly, this chain and the fact that this chain somehow did not work properly. However, if I am Countrywide and I make loans and then I sell them to you, let’s say Lehman, so that you repackage and you resell them, I attach to these loans what is called rep and warranty. I make some statements about the way those loans are made and the reliability of the parameters under which those loans were made. If any of this is false, I need to pay for damages. Number one.

Number two, most of the time, those portfolios are audited by the Big Four audit firms. How do they audit? Do they look at every single mortgage? Of course not. But they have some system of random checking that should enable them to catch the problems. And here, both of these things fail. Number one, the audit firms were not able to identify them early, and with a single exception of PricewaterhouseCoopers, PWC, that was held liable in the Colonial Bank trial for not doing that properly, we have not seen the Big Four paying for these mistakes.

And, number two, many firms got away with not paying their responsibility of reps and warrants, because, actually, once the Fed got control of AIG, it waived the ability to sue the banks for having violated these reps and warrants. I think that there was a major failure in compliance, a major failure in audit, a major amount of fraud in the system. One thing that offends me is the fact that, while there were a lot of fines paid by banks in the aftermath of the financial crisis, basically no financial executives went to jail, or was even prosecuted for those frauds. In fact, many of the same financial executives who committed those frauds are back in business like nothing happened.

Kate: The fraud that you’ve been talking about was, for the most part, on the part of the mortgage originators, the people on the ground making loans face to face. But I think the real failure of the investment banks was in the way that they turned these mortgages into actual securities. Banks were basically making securities out of thin air, even though there was no underlying pool of mortgages to back them up. And they did this using bets on the original pool. That way, you could take a pool of mortgages and the securities that stem from them and replicate them as many times over as you possibly wanted. This, I think, led to a lot of the amplification of the crisis that these synthetic instruments really had no underlying securities to back them up.

I think another issue was in the way that tranches of mortgage-backed securities that were not considered super safe were then repackaged together to create what was deemed by the rating agency as super safe, even though it was just kind of a mixture of crap from the lower tranches of other mortgage-backed securities.

I guess the point that I’m trying to make is that there was a lot of risk amplified many times over by the type of engineering that these investment banks were doing, and I think that was maybe not explicitly fraud, but that was where investment banks contributed to a huge amplification of the crisis.

Luigi: By the end of that week ... So, the week that starts with the bankruptcy of Lehman is September the 15th, by that Friday, which is the 19th, the situation is really tense, and it’s pretty clear … Both Goldman and Morgan tell the Fed that they’re not sure they’re going to open on Monday morning. That’s when two things happened. Number one is the Fed intervenes by allowing Morgan and Goldman to transform into bank holding companies, and, two, the first proposal by Paulson to intervene with some government help that will try to stabilize the situation—what eventually became the Troubled Asset Purchase Program, better known as TARP, floated on the 19th of September.

And then, on the 23rd, George W. Bush goes on TV in front of the nation.

George W. Bush: Good evening. This is an extraordinary period for America’s economy. Over the past few weeks, many Americans have felt anxiety about their finances and their future…

Luigi: So, listen to George W. Bush, president at the time, reassure the country that everything is fine, he says.

George W. Bush: …collapse. The government’s top economic experts warn that without immediate action by Congress, America could slip into a financial panic and a distressing scenario would unfold. More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet…

Luigi: And people heard their president saying that we are about to face a new Great Depression. They stop spending, they stop investing. They stop consuming. I think that that is, at least in part, what brought the economy into a tailspin.

George W. Bush: …and, ultimately, our country could experience a long and painful recession.

Kate: Yeah, I can relate to that, because as I was sitting in my dorm room watching Lehman collapse and seeing all my summer money disappear, a couple of weeks later I thought to myself, you’re screwed. There’s no way you’re getting a job. There’s no way you’re going to have anything to do after you graduate, because the economy is just going to be completely tanked. At that point, I decided to quit school. I used the couple of hundred dollars that I had recovered from selling my Lehman stock for pennies on the dollar to buy a one-way ticket to California and just kind of hiked around hoping that I could wait out the crisis and hoping that the economy would recover a year later.

I consider myself one of the lucky ones. At least I had that option. At least I knew that I would be able to return to school the next year, unlike many millions of Americans, who just completely lost their jobs and didn’t have many other options.

Luigi: In the next episodes, we’re going to discuss what we have learned and how we’ve made the system better, or to what extent we’ve made the system better. And, finally, we’re going to discuss, in the third episode, what holes are still there and face the very difficult question of where the next financial crisis will come from.

Economists experience their first major #MeToo moment. Kate and Luigi explore the larger implications of a recent case involving a Columbia University professor who was found liable for retaliation against a female junior faculty member.

Kate: Just a quick disclaimer. Our descriptions of the case and events in this episode are based on media reports and allegations in court documents.

Hi, I’m Kate Waldock from Georgetown University.

Luigi: I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: We are here at the University of Chicago recording together for the first time in a really long time.

Luigi: In a really long time, indeed.

Kate: We’re here for a podcast retreat, which took place yesterday. It was a really lovely time. We did trust falls, we built a log cabin. We did an escape the room. It was a lot of fun.

Luigi: No, we didn’t. We should thank a lot of our listeners who sent us feedback. Very useful.

Kate: Yeah, that’s true. We’ve had a survey up on our website, and you can still go there and let us know what you think about the podcast. On today’s episode, “Sex, Power, and the Ivory Tower,” economists experience their first major Me Too movement. What does it mean for women broadly, and what can we do to prevent situations like this in the future?

This situation revolves around an assistant professor of finance, Enrichetta Ravina. She was formerly at Columbia. Now, she’s visiting Northwestern. Luigi, do you know Enrichetta?

Luigi: Yes, I do.

Kate: How do you know her?

Luigi: I met her several times, because she was an advisee of Paola Sapienza, who is a coauthor of mine. I met her through her, and I met her on the job market. I think she had a very interesting paper on the job market.

Kate: All right, so for some background, Enrichetta is an assistant professor of finance. She does research on how individuals make investment decisions, particularly those that pertain to retirement savings. She started out at NYU for a couple of years. She was poached by their uptown neighbors, Columbia. When she started at Columbia, she was given the opportunity to work with a tenured, senior professor, Geert Bekaert, who offered her access to some proprietary data on four million people and their retirement decisions.

As they began to work together, and as she spent more and more time cleaning this data to make it usable for research, she alleged in court that Geert became increasingly sexually aggressive towards her. His behavior ranged from either talking about his sexual exploits to touching her inappropriately.

At this point, she filed some complaints against him to Columbia’s higher-ups. She alleged that she was allowed to take a paid leave, but that that paid leave was later revoked. Columbia accelerated her tenure process, even though there were letters written by other faculty members at Columbia stating that junior faculty needed to be protected, and that at the rate that her tenure review was going, her work couldn’t be properly evaluated. So, there was a trial in the Southern District of New York, which resulted in a finding that Geert was liable for retaliating against Enrichetta, and ordered to pay $1.25 million in damages. Although, it should be noted that he wasn’t liable for damages related to gender discrimination.

Luigi, you wrote an article on ProMarket.org called, “Why Every Good Economist Should Be a Feminist.” What compelled you to write this article?

Luigi: I’m a man, but I’m not deaf or blind. Over my life, I’ve seen a lot of cases of discrimination. Let me just mention one. When my first wife was studying in Italy, architecture, she experienced a very unpleasant situation, because all the professors were male. It was very hard to get ahold of them, for them to be the mentor of the master’s thesis. It was clearly a situation in which the female candidates were competing for attention from the professors. Competing in, if you want, with sexual innuendos. I thought that situation was wrong, but at the time I didn’t have the legal language to understand what the problem was.

Then, I came to the United States, and I discovered all the movement about sexual harassment. For me, it was very important when I listened to the Anita Hill case in 1991. You probably were not even born when this case took place—

Kate: I was a kid, but I was born.

Luigi: That was a very interesting case, because that was the first time that you had a case of alleged harassment that was debated in front of the entire country. I have to say that, coming from Italy, it was at the beginning a bit hard to even understand what the issue was, because there was no allegation of any physical contact. It was just an unfriendly environment that was created by Clarence Thomas. So, that reminded me a lot about the situation that my wife at the time experienced in Italy. But then, I also study contract economics, and I think that neoclassical economics tends to ignore the issue of power. They try to put power under the rug, assuming that markets are perfectly competitive, that nobody has any control, that everything is determined by technology and taste, and market equilibrium.

But when you start working on incomplete contracts, you realize how important power is in many situations. That also gave me the mental framework to understand why power imbalances can be so detrimental. In that particular case, why is it right that professors should not have relationships with students? Because even if the student is consensual, the power imbalance really shifts the dynamic and creates an environment which is very detrimental for everybody else.

How do you feel if the professor sleeps with a colleague of yours? Regardless, that colleague would be favored in one way or another. That creates an unequal situation for everybody. So, that’s the reason why this case piqued my interest, because it’s not so much about the sexual harassment that was not found in court, but this issue of power imbalance that there is in academia. I think that particularly regarding the control, or the possession, or the influence over important datasets.

Kate: Yeah, so to be fair, I think we should discuss Geert’s perspective on this issue, which was that once he brought Enrichetta onto this paper and into the process of using this data, she signed her own agreement with the company, which was pretty clear. At that point she was working with the data. She was training RAs to work with the data, and so she obviously at that point had her own relationship with the company. So, how could he have really had all the control? How could he have held all the power to be able to hold her up essentially?

Luigi: From a technical point of view, I think that the power of the data rested with a company, not with Geert Bekaert. However, there was a relationship between Geert Bekaert, Enrichetta, and the company. This relationship was not on equal footing, because Geert was a consultant for this company for a long time. There was some relational trust between the two that could be used to shut out, to some extent, Enrichetta from the project. Or, to some extent, delay the entire project. I think that that is what, this is my understanding, why the jury found retaliation.

Kate: Related to this point about power, how does one reach out to companies and get access to proprietary data? This is something that I’m trying to do right now. It’s something that I’m very frustrated about, because there has just been this constant back and forth with these companies. One second they say yes. One second they say no. So, most of the time when people have access to proprietary data from a company, it’s because of personal connections. It’s because someone knew someone from college, or someone had done some consulting research for somebody.

There’s usually some sort of cronyism involved. That tends to be more likely at higher levels. I don’t know that many people who have their own companies. But when you become a senior, well-known, tenured professor, you tend to establish more connections with the industry, and so you get more opportunities to work with proprietary data.

Luigi: I think your description is absolutely right. I find cronyism in everything. I think that here there is an efficiency reason why that is the case, in the sense that I need to, as a company say, trust who has access to my data, and so I tend to trust somebody I work with. So, there is an efficiency consideration.

However, I think the Sloan Foundation is undertaking a major project to try to equalize access to data to everybody, which I think is very important. Actually, the Sloan Foundation, some social scientists, and Facebook have agreed on a common platform to give access to data to everybody under certain conditions. I think that that’s the direction we should go.

Kate: In my own research, I study bankruptcy. A lot of the papers that I’m working on revolve around one dataset of court documents, which, you’re right, it’s publicly available. But the catch is that each page of court documents that you access costs 10 cents, and so, if you really wanted to pull the whole body of publicly available bankruptcy documents, that would cost you millions and millions of dollars.

There is a system, or a way to get around this, which is that you can write to every single judge in the country, begging for access for free to get those court documents, which is what I did. I physically mailed letters to 90 different judges. Eighty-nine of them granted me that access. Then I had to spend a few months scraping a bunch of data. At some point, I got in an argument with a couple of the courts and there was a threat that I had taken too many court documents. Someone called me and threatened to sue me for $750,000 when I was a PhD student. And —

Luigi: And you said, “You’re welcome, because I don’t have any wealth.”

Kate: Yeah. The ironic thing is that I would have immediately had to file for bankruptcy. They would have gotten nothing out of it, except I would’ve gotten the personal experience of bankruptcy, which is what I was studying using those court documents. So, maybe there would’ve been some learning experience, some education for me in the process. But, yeah, there’s such fierce competition over getting access to data in our field that those are the kinds of lengths that you need to go to, to be able to publish well.

Luigi: That’s very entrepreneurial on your part, and very sort of equal access. You didn’t have any particular favor by anybody. You followed the law, and you got this data, so nobody can withdraw the data from you at any point in time. This is the great thing about disclosure mandated by the government. They cannot subject your paper to any review, because you can write whatever you want, freedom of speech.

Kate: Yeah, it’s mine.

Luigi: So, you’re lucky that you’re not in that situation, but I think that it’s a problem when you are in that situation, because you are in a situation of power imbalance.

It just happens that most of the time, the people with power are men. The people that are working with them can be men or women, but, regardless, I think this creates a situation that can lead to abuses of power.

Kate: Yeah, so I know I’m reiterating what you said earlier, but I thought it was great that in your article you pointed out that this sort of relationship, one person having special access to data and another person working on that data, in a way that their career hinges on the success of the publication using that data, it creates a power imbalance between the two. I think in academia there’s a lot of different subtle ways in which there are power imbalances between senior and junior faculty. But, also, often between senior men and junior women.

I think it’s important to point out that we may think of power as your boss versus a subordinate. But in academia, there’s tons of different subtle ways in which there can be power imbalances. I think it’s important that we think very deeply, and very carefully about identifying those ways, and making sure that they’re not exploited.

Luigi: Yeah, you’re right. I remember many years ago that when I hired an administrative assistant who was completely not knowledgeable of the university environment, I realized how difficult it is to understand the power relation in academia, because when you go to a company, you have a title. You have a bigger office. You have a hierarchy that is very visible, and then you know how to relate to that hierarchy.

In academia, we are all on a first-name basis. The offices are more or less all the same. You don’t see this hierarchy, because in a sense as an assistant professor, you’re not assisting anybody. You’re just doing your work the same way I do, so there is not really a formal hierarchy in that sense. But I think that academic reputation and, of course, the power of tenure, the ability to judge, gives senior faculty a disproportionate amount of power, vis-à-vis the junior faculty.

I think this is normal. I’m not saying that this should be changed, but sometimes we need to think about how to minimize the potential damage that this power imbalance creates.

Kate: Yeah. I think academia is not the only area in which this is true, but I think the broader takeaway is that reputations and connections are particularly important for PhD students, who oftentimes don’t have any publication record when they’re up for getting a job. But I will say that one component of the tenure package or the tenure review process is getting letters from other people in the field, in which they’re vouching for you, and they’re making statements about your contribution to the field.

That’s another serious place where there can be a huge power imbalance. Most tenured faculty in finance are men, so if you’re a female PhD student, you rely entirely on what’s often an all-male committee. In my case, everyone on my dissertation committee was a male, in which case you really need to have those people pushing for your reputation.

Luigi: No doubt that reputation is very important in academia, but two warnings. First, a good advisor can probably get you an interview with a good university, but cannot get you hired at a good university. At the end of the day, your paper and your presentation are what make a difference. No matter if you have even the most important academics and Nobel Prize winners that pushed for you, if you don’t have the quality, you don’t get hired.

Two, you’re right that there is this difference between business and academia, but precisely the fact we ask for external reviews makes, to some extent, the power of senior faculty a little bit less important, because you rely on external review. But it makes the power of reputation very important. It’s true that in academia reputation is a major issue, and there were a number of emails that Geert Bekaert sent that were disparaging.

Kate: Yeah, so now that we’re on the topic of hiring, or speaking more directly about the case, in your article that you wrote, what was your prescription for how we can change hiring practices?

Luigi: Full disclosure, they’re not my prescription. I was mentioning two ideas that I thought were interesting. One comes from a colleague at a different university, at Northwestern, Paola Sapienza. She has this idea that when you hire, especially senior faculty, from a different university, you require that senior faculty to sign a statement that he behaved according to the ethics code of the place where he was working before.

Why this is so important is because it’s all too common in academia that if you are accused of sexual harassment, you end up having an internal investigation. Then, if you’re found guilty, you are asked to leave the university with a nondisclosure agreement, so that there’s no scandal, and you move on. That resembles to me a lot like what the Catholic Church used to do with pedophile priests, sort of move them around, but not fix the problem. And —

Kate: Yikes —

Luigi: You don’t think that’s the case?

Kate: No, I’m just cringing because it’s always an unpleasant topic.

Luigi: Yeah, it is an unpleasant topic, but the reason why I make this comparison is, because everybody cringes about what the Catholic Church has done. We should cringe about what universities do. I realized that when we hire staffers, we ask for their criminal record and stuff like that. When we hire faculty, we don’t. That’s pretty crazy, especially because a staffer, you can fire him or her any time of the day. Tenured faculty, it takes a long time to fire him or her. So, I think that we need to introduce some form of screening.

Of course, it’s very difficult to ask for opinions, and there is this nondisclosure agreement, et cetera. So, I think Paola’s idea was clever, because it was putting all the burden on the person. Of course, the person can lie, but then that’s cause for termination as soon as you find out, and so that makes the position much weaker.

Kate: Right, but if there’s nondisclosure agreements, wouldn’t nobody ever find out? You’re technically not allowed to find out.

Luigi: I’m not an expert here, but I think that if there is a case, you can start digging in the past. Then this may be found out. I’m not saying that the solution is perfect. If you have a better one, I’m all ears. But I think that something needs to be done to minimize this risk of moving around, because, let’s be fair, the problem is generally concentrated in a few people who are repeat offenders.

I’m sure you heard the famous case of the faculty, the astrophysicist at Berkeley who was a genius astrophysicist, but he had harassed women for 20 years. There is another case of a political science professor at Harvard that just retired in a hurry, because finally women came out. There are dozens of them over decades that felt harassed by him. So, I think that it’s pretty bad, because a few men ruin the reputation for everybody. I think one way to reduce this problem is to try to filter out for those few.

Kate: When I first read your article, I was a little bit off put by the suggestion. I think that that was because I had discussed this case before with other former PhD students, with other junior faculty members. The way that the case was presented to me had always been, this is a woman from Columbia who didn’t get tenure. She was suing Columbia because she was angry about not getting tenure, on these trumped up sexual-harassment charges.

It wasn’t until after I started reading about the case for this episode that I really realized that that wasn’t at all what was going on. I was annoyed by your suggestion that, “Oh, we should institute this system that relies on formal complaints,” when I didn’t realize that there had been a formal complaint that had been filed by her. So, it’s appalling to me that the facts were so distorted by most people in our profession, in a way that’s just so clearly biased against her.

I am embarrassed that the presumption is that it’s always the woman’s fault for filing any sort of accusation, and that she’s a troublemaker for doing so. I just believed it. I didn’t even bother to look up the facts of the case. And, B, that she had filed these formal complaints. That’s something that’s really difficult to do. It’s something that I certainly would be really scared of doing if I were ever in her position.

She should’ve been elevated and recognized for taking the right steps throughout the process, throughout the harrowing process that she was going through. Yet, rather than being celebrated for doing the right thing and trying to follow the institution’s rules, she was just rejected by the system.

Luigi: Yeah. To be fair, she testified at trial saying that she thinks she doesn’t deserve tenure at Columbia, so I don’t think this was a way to get tenure the legal way, through a process. I think this was her complaint about the way she was treated. I think that that’s the way we should analyze it. Also, to be fair vis-à-vis the colleagues, I think the vast majority of colleagues supported Enrichetta. In fact, they wrote a letter to the dean, I think, that was suggesting a potential solution for this case. This is the stuff I refer to in my article.

They say, “Look, we understand this power imbalance. In order to mitigate it, it must be that whenever there is an intellectual dispute about an article, about a paper you’re writing, about the research project, between a senior faculty and a junior faculty, the intellectual property right, the right to continue the paper should belong to the junior faculty.” Of course, a lot of people say the reaction to this is that senior faculty will stop writing with junior faculty. I don’t think that’s the case, but as every rule has some costs, the question is whether the benefits outweigh the cost. As a junior faculty, what is your view on this?

Kate: It’s kind of like people saying, “Oh, because of the Me Too movement, women are never going to get hired. Men are going to be too afraid to work with them.” I think it’s an unoriginal and distracting argument that has no merit. I don’t even think it’s worth talking about, to be honest.

Luigi: I think that there will be papers not being written. But people are ignoring the other side of the picture, that a lot of smart junior faculty don’t want to work with senior faculty, because they are afraid of being taken advantage of. I think that if we’re thinking about what we’ll gain and what we’re losing, I think that we’re gaining so many more people willing to work with senior faculty. We’re going to get a little bit less senior faculty wanting to work with junior faculty. But probably the ones that shouldn’t be working with them to begin with. So, I think in the overall scheme of things, it is a good rule and should be implemented.

Kate: I definitely agree with the points that you made in your article. I think that they were valid points that should be taken seriously and should be implemented. But there’s also a part of me that gets a little frustrated when the bigger picture isn’t addressed. I mean, there has been this culture of women and women’s research not being respected and elevated the same way that men’s research is. I think that is the deeper point that I would like to see addressed and discussed.

I pulled up a few quotes from my favorite website, “Econ Job Market Rumors,” which is the place to go if you’re trying to figure out what schools are hiring whom. But it’s also a place to go if you’re an angry “incel” who wants to rage about how much he hates women. I think I searched for women and math, and I’d like to just read a couple of things that came up.

“There are no impressive women in my cohort. Several of the men are the smartest I’ve ever met. This pattern is broadly true across all years.” Another person writes about a few different big companies— Uber, Google, Facebook, etc.—“Why are all the great companies still started by only men? Because there is no BS tolerable at the startup phase. Sorry, women, you are done here.” Another person wrote, “Men are empirically better at linear, analytical, scientifically driven thinking. Although some women can achieve competency, there will never, ever, ever be as many female math geniuses, ever.”

This is just the type of language that I think is totally regular. It’s so normalized, that it’s appropriate for men to say this to women’s faces when they’re PhD students. I experienced that sort of treatment.

Luigi: Really? People told you to your face that you cannot do math?

Kate: Yeah. I mean, I’m sorry to toot my own horn, but I was asked to take a special math class, just to prove my abilities when I was a grad student, when I was, I think, a third year or a second year. This was a stochastic calculus class that I took at Courant, which is NYU’s math department. It was amongst other grad students, and I did the best in the class. I was the number one performer. I don’t know why the other guys in my cohort weren’t also instructed to take that class, but that’s an aside.

This type of math is what’s useful in options pricing, but I wasn’t interested in options pricing research. I kind of knew from the very beginning that I wasn’t interested in it, so I never really applied those skills. Very quickly I pivoted back to working with data. Despite this, a fellow student of mine came up to my desk and said, “Come on, Kate, be honest. You know you’re working with data because you can’t do math.” It’s like, “How much more does one need to prove?”

It’s not about ability, it’s about preferences. People do the sort of research that they do because they’re interested in it. One should never be made to feel bad about that, particularly not bad because of the fact that you’re a woman. Anyway, I think that I’m getting sort of emotional as I talk about it, but it also feels good to get stuff like that off my chest. I mean, it’s not something I feel like I talk about every day. I’d like to know other people’s experiences, too. I’d also like to be able to create a forum where people can get stuff off their chests, anyone who has experienced sexual harassment. But not just that, anyone who has been made to feel like a second-class citizen in their own profession. Or, if anyone has good solutions for what we can do about this to change our culture. I want to hear about all of that.

Luigi: So, if you want to share your experience, or give us some proposals, go to our Facebook page, Capitalisn’t Podcast.

Our third and final episode on antitrust law looks at the E.U.'s recent $5 billion fine against Google. Kate and Luigi hear about double-sided markets from Nobel-winning economist Jean Tirole and explore the E.U. vs. U.S. approach to antitrust enforcement.

Speaker 1: Today, the commission has decided to fine Google €4.34 billion for breaching EU antitrust rules.

Luigi: This is Luigi Zingales at the University of Chicago.

Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Speaker 2: Breaking news this morning. It is official. Google has been fined a record $5 billion by the European Union.

Speaker 3: The company is accused of abusing its Android market dominance by bundling its search engine and Chrome apps into the operating system.

Speaker 4: But what the European Union is telling Google is that, “Because you’re breaking our antitrust rules, you not only have to pay this $5 billion fine, which is a record, but you also have to change your behavior.”

Kate: Luigi, have you heard of ... do you know who Chris Crocker is?

Luigi: No.

Kate: Do you know who Britney Spears is?

Luigi: Yes.

Kate: So, 10 years ago, Britney Spears was in the news, and everyone was being mean to her somehow, and there was this viral YouTube video that exploded of this guy, Chris Crocker, sobbing hysterically and being like, “Leave Britney alone! Why won’t people just leave her alone?” And that’s kind of how I feel about Google. Why can’t the EU just leave Google alone? They’re being so unfair.

Luigi: I have to admit that you really threw me for a loop. I’m not up on your stardom world, and so I can’t really empathize with your comment, but I think that the issue of Google is a very important one, because we all love Google, because we all use Google for many things in our life, from searching information to going places, and you who are more hipster ...

Kate: Not a hipster.

Luigi: Look at the YouTube video. But, anyway, I think that we all use Google massively, and so when Google gets fined, the question is, why? What has it done wrong? And is it right to fine Google or not? And why has the EU Commission done it, and American antitrust started a similar investigation and dropped it in 2013?

Kate: Yeah, I can’t help but think that this feels a little bit like the EU is ganging up on US companies.

Luigi: You’re becoming too Trumpian in your words, which ...

Kate: I know. I know.

Luigi: This is actually the negative effect of starting to think that way that becomes me versus you, and you think that everything is motivated by trying to get ahead in some trade war. I actually think that this is not true, that there is evidence looking at antitrust enforcement in Europe that the nationality doesn’t matter, that the European Union seems to be as tough with local companies as with foreign companies.

I think that, while reasonable, this guess, in my view, is wrong, but there is a fundamental question of how do you deal with digital platforms like Google that represent a completely different business model?

Kate: I think we should get back to that paper that you just mentioned later on, because there’s actually a ton of literature trying to figure out whether the EU is tougher on US companies or foreign companies or European companies, and if you look at all the literature, the jury is kind of out. I think there’s arguments on both sides. But before we get into that, we should probably recap the past couple of episodes, and talk about what’s going to be discussed today.

If you haven’t heard those last two episodes, you may want to go back and give them a quick listen. But, really quickly, the consumer welfarists think that the best approach to antitrust is to figure out whether a company is actually hurting consumers by trying to look at their impact on prices and output.

Luigi: While the Brandeisian approach is concerned not only about consumers, but also about the political implication that too much concentration of economic power has on the political system overall.

Kate: And I’d also add that I think the New Brandeisians focus particularly on the tech sector and the outsized influence that big tech has had on the economy, as well as politics today.

Luigi: Because what is interesting is that the tech sector—in particular, business models like Facebook and Google—are generally different business models than have been analyzed in the past. The technical term for this is two-sided or multisided platforms, and this is a concept that did not exist in the literature until 2000, and then was introduced in 2000 by a paper by Rochet and Tirole, and we have the fortune of hearing a description of the concept by one of the two authors of this paper, in fact, the Nobel Prize-winning Jean Tirole.

Jean Tirole: OK. A two-sided market is a situation where you have one platform or multiple platforms which try to attract two sides or more sides of the market who want to interact with each other. For example, Google is going to try to attract eyeballs, you and me, and the way it does that is basically by offering free services, and then it’s going to attract advertisers.

And advertisers, of course, want to target their hearts to you, and basically you have to attract both sides of the market for it to work. Same thing with credit cards, which is, if you are American Express or Visa or MasterCard, or maybe PayPal or Apple Pay or whatever, you need to attract cardholders, people who are going to pay with your card, and also merchants who are going to accept the card.

What you have to do is to balance your pricing structure and other dimensions so that you attract both sides, while still making money. And those markets, actually, have specificities. Those other antitrust policies actually don’t work that well in those markets. For one thing, you cannot consider one side of the market in isolation.

For another thing, you often notice that one side of the market is treated very well, and the other side of the market is treated less well. So, we enjoy all those great benefits of using Google, but the advertisers are actually paying a lot. We get a free payment card, the credit card, or debit card, actually it’s even negative price because we often get frequent-flyer miles, cash back, what is it ...

Kate: But maybe pay interest.

Jean Tirole: We may be paying interest if we’re ... That’s another scenario. It’s a behavioral thing, it’s ... That’s right, but if you pay attention, you can get your card for free and even get paid for using your card, whereas the merchants are going to pay a fair amount of money when they accept the card and there’s a transaction.

You cannot just look at one side of the market, you might think there is actually predation on the one side because its price is zero on one side, and you might think there is monopoly, excessive money paid on the other side, because the prices are very high. But you know, you have to look ... The point is that it’s not only dominant firms which have this kind of business model, it’s also smaller entrants. You may get a free newspaper, for example, and this newspaper may not have a dominant position, but of course, it’s getting the money from the advertisers.

So, this business model is actually very important. What we economists can contribute is trying to think about principles for the businesspeople to use, because often it is done by trial and error. You try a business model, it fails, and then you try to convert to another one. But also, we can advise the policymakers, you know, competition-policy authorities, so as to deal with those markets, and what we should be doing with those.

Kate: Jean Tirole just described for us what a two-sided market is. And the reason that this is particularly relevant to today’s antitrust debate is because it’s often the case in two-sided markets that one side doesn’t charge any money for a product at all. And this is relevant for the recent EU fine of Google, because the background of that case is that the EU was fining Google for forcing cellphone manufacturers that were using the Android operating system to also install certain apps that were Google apps.

Neither the Android operating system nor the apps charge any money, and so there is this open question as to whether these even count as markets, because there’s no transaction going on. There’s no actual money being exchanged. So, depending on your view of the applicability of antitrust to two-sided markets, this could either say the European Commission had the right to say that Google is a monopoly in this area, even though it’s not charging any money for its products, or, no, the European Commission had no right to intervene in this area because Google is providing these services for free, and so there’s no way that we can consider it a monopoly.

Luigi: Let me make an old technology analogy. In the old days, I hear now the world is changing, but in the old days, when you wanted to buy a house, you had to go to a real-estate agent, and that real-estate agent was, at least partly, free for you because he was paid out of the proceeds of the sale of the house. Technically, who was paying for the real-estate agent was the seller, and the buyer could get a real-estate agent for free. And this is a two-sided market because in transacting on a house, you need a buyer and a seller, and the market was designed in such a way that the buyer wasn’t paying anything for the broker, while the seller was paying for both brokers.

If you are a buyer, you have the perception that this transaction is free. In fact, in equilibrium, you pay for that cost. Why? Because the price of the house is bigger. And in Google, the story is the same. When you use Google, you have the perception that Google is free, and even without considering the transfer of data that we’re going to come back to later, even when you don’t consider that, it is not true that it’s for free because you pay ... Actually, the advertisers pay for Google, and that price is reflected in the price you pay for the goods that are advertised. Exactly like in the case of the house, you pay indirectly for that service.

Kate: Now, for our younger listeners, who care more about the actual operation of Google, there are some technical details here. Google makes Android, which is an operating system for phones, and if we consider all operating systems for phones, Android, globally, has an 80 percent market share.

The way that it works is that Android is open source. So, all of the code that you need to install Android on a phone is available online for free. Anyone can just download it. If you’re technically savvy enough, you can download that open-source software and put it on an actual phone, and then you can have yourself an Android phone.

And Google also has this relationship with its phone manufacturers. Google isn’t really in the business of going out and making actual hardware phones. I mean, it is, kind of. Now it has some of its own products, but the majority of Android phones, the actual phone, is made by some other manufacturer that’s not Google, like HTC or Samsung or any number of manufacturers.

Google gives its Android software to these phone manufacturers for free, like it does with everybody else, but the catch is that certain Google apps are not open source. For example, Gmail, and Google Search, and the Google Chrome browser, all that stuff is considered proprietary by Google. Not only that, but certain key apps for the phone are also proprietary, like if you want fancy swiping on your keyboard or if you want a fancy phone app, that stuff is not open source. So, if any of the phone manufacturers wanted to put those Google apps on their phone, then they had to comply with a bunch of rules and regulations coming from Google.

So, in some sense, Google’s Android is open source, and in some sense, it’s not. This is what the European Commission took issue with, is that even though Android itself, there’s a version of it that’s free and open source, in actuality, Google was forcing its manufacturers, its Android manufacturers, to comply with their terms by putting a bunch of Google apps on the phones that they were manufacturing.

Luigi: To get a sense of how valuable it is to have Google Search or Google Play preinstalled on a phone, there are some numbers that float around of how much Google is paying Apple to have Google Search preinstalled on the iPhone. And the numbers are between $1 billion and $3 billion a year.

This is an enormous value that Google captures by giving Android for free, and in a sense, recapturing that share through the fact that with Android, you cannot choose any search engine other than Google.

Kate: Yeah, and so to get back to your point about the two-sided market, where is Google making money? Well, now almost all the phones in the world have Google Search and Google Chrome installed in them, as well as a bunch of other Google apps. Google collects all of this information, they know exactly what we’re doing and what we’re looking at, and they in turn sell ads to advertisers who can target us pretty well. And that’s valuable for Google, that’s how they make their money.

Luigi: So, the tension between the two sides of the discussion in the European case is one side, the European antitrust authority, claims that by giving away this product for free, but tying it to Google Search, you are de facto maintaining your monopoly, or your market dominance, in Google Search, and it’s a way to use dominance in the market, like the one in Android, to leverage and get dominance in another market, which is generally considered a violation of antitrust.

The Google side, or the American side in this particular case, is saying, “Wait a minute. Here there is a competition between two business models. There is a competition between the iPhone business model, everything is integrated, and then in that particular case, Google has to pay Apple to have the search preinstalled, or there is free software, à la Android, but then because there is nothing free in the world, the way in which this is paid is by restricting the ability to introduce other search engines.”

Kate: I think an interesting point in this debate is that if you’re Samsung, you can make an Android phone and not install any of the Google apps, but why do they think it’s so important to install the Google apps, which therefore make them compliant to Google’s terms and regulations, is because people want those apps, right? They can’t really sell cellphones that don’t have a bunch of these apps preinstalled, because people want Google Search, people want YouTube preinstalled on their phones. Otherwise, it wouldn’t really matter. Samsung could just take the open-source software and install whatever apps they wanted to.

Luigi: They certainly prefer to have something preinstalled, but if I was given the choice, I would probably preinstall DuckDuckGo rather than Google Search.

Kate: What?

Luigi: You don’t know DuckDuckGo?

Kate: No. Is this some sort of weird Italian search engine?

Luigi: No. It’s not a weird Italian thing. This is the only search that does not follow you and get all the information from you. It’s much more discreet. It’s 0.3 percent of the world market share, so it’s not exactly a popular thing, but I think it’s a very good search engine.

Kate: Are you one of those people who does all your search through some VPN or through Tor, so no one can track you?

Luigi: If I were more computer-savvy, I would do it. But I’m not computer-savvy enough to do that.

Kate: OK. Did the European Commission do the right thing here?

Luigi: Actually, I was much more sympathetic to last year’s fine of $2.7 billion against Google for distorting the ranking of shopping options. And the story was that Google favored in the ranking its own shopping choice against competitors. And this is, I think, a fundamental problem, because if you are the access to the market for most people, and Google is, and you tilt this access to the market in favor of some or against others, then you are really distorting these other markets, in this particular case, the shopping options. I think in that case it was absolutely right.

In this case, I can see the argument of both sides. However, I’m sympathetic to the view that sometimes the trial is the remedy. The level of scrutiny, the level of transparency that this trial requires, put Google on the alert and makes it less likely to push its weight around and try to get market share in other markets using its quasi-monopoly in the search market.

Kate: It’s probably worth going a little bit through the actual enforcement mechanisms in the US versus the EU. We’ve talked about the United States and its antitrust law. In some sense, the EU is pretty similar, with the major distinction that antitrust is enforced at the EU level, right, the European Union level, rather than at the country level.

Actually, each European country does have its own set of antitrust laws, but the decision that we’re talking about came down from the European Commission, which is a broad regulatory body made up of the member states in the EU.

The laws that govern the European Commission’s antitrust, there are what are called Articles 101 and 102 of the Treaty on the Functioning of the European Union, and they’re basically very similar to the United States’ Sherman and Clayton Act. Article 101 is like the Sherman Act in the sense that it just broadly rules out actions that are in restraint of trade or competitive market policies, and Article 102 is similar to the Clayton Act in that it rules out specific types of actions that are considered abuses of power, such as tying and bundling of services, which is relevant in this Google case.

Luigi: It’s interesting because while both the EU and the United States have local antitrust and federal antitrust, I think the role of the so-called federal antitrust at the European level is quite different because Europe is not a country yet, so you don’t have the commissioners appointed by a president of Europe. There is a president of the European Commission, but this guy is nominated by the various governments of Europe, not by a vote of the population.

In a sense, what is interesting is that on one hand, the commissioners tend to be a little bit more shielded from political pressure. On the other hand, they tend to be more often than not politicians with a political career, rather than in the United States, you’ll observe lawyers that are antitrust lawyers that one day work as antitrust lawyers fighting antitrust, and the next day become FTC chairman or chairwoman, and then after they are FTC chairman or chairwoman, they return to fight the FTC on the other side.

Kate: I’m not necessarily sure that I agree with that characterization. I mean, one of the lawyers who was very key in the US case against Microsoft was Richard Blumenthal, who at the time was the attorney general for the state of Connecticut, and now is senator for the state of Connecticut. So, I do think that, in some cases, these antitrust lawyers do have a political agenda.

Luigi: You’re right, and I think the way I see it is actually more common for state antitrust than for federal antitrust, because I look at the chairperson of the Federal Trade Commission in the last 18 years, and with one exception of somebody becoming a professor afterward, all the others went back to business practice in antitrust law firms.

Kate: Yeah, I do agree that the Federal Trade Commission or the FTC, while it’s one of the branches that can enforce antitrust law, state attorneys general can also do so, and I think that that is an area in which they do that with an eye towards politics in the future.

Luigi: Because one of the explanations for this different level of enforcement is the different degree of capture of the two systems. In the United States, companies like Google or Facebook have a tremendous amount of power on the executive. And it’s not only because of the campaign financing, it’s not only because of the lobbying, it’s not only because of the revolving-door policy, it’s also because they help tremendously the various candidates being elected.

So, in the last campaign, there were people from both sides, from the Trump side and from the Clinton side, who were embedded in Facebook and Twitter to learn how to use this instrument in the most effective way. They were equally supported on both sides, so no matter who wins, it feels that they have a legacy of gratitude vis-à-vis one of these companies. And it’s not a coincidence that the FTC case against Google was dropped at the beginning of 2013 after Google, and in particular, its then-CEO, helped Obama tremendously to be re-elected. And immediately after the re-election, the Obama White House and his appointee at the FTC decided to drop the case against Google.

Kate: Yeah. I can’t argue with you there. I completely agree with you that more campaign spending, more political spending on the part of US corporations, helps US corporations influence US antitrust policy.

Now, these companies do spend money in Europe as well. And I guess what I’m struggling to understand is why they don’t have as much influence on European antitrust.

Luigi: I think that’s an excellent question. I’m not sure I have the definite answer, but I think that at least in the case of Margrethe Vestager, who is the head of the EU Commission on Competition, she has a very strong prospect of going up the political ladder, and I think that taking these actions makes her more popular. And linking this to our two previous episodes, one of the characteristics of US antitrust is that we made it so technical that the people in charge of it tend to be technical people, and technical people who work in that industry tend to be more easily captured without any offsetting effect.

And I think that Europe has not gone as far yet, and maybe with time it will, but I think that, in my view, the fact that they are thinking about the other side is crucial. Several years ago, the European Commission on Competition, first of all, it’s not called antitrust, it’s called the Commission for Competition. So, they are much more willing to take proactive measures to favor competition and favor, also, consumers.

One example is the position they took against roaming charges across European states. For an American listener, this sounds primitive, but the older ones among you remember that there was a roaming charge, there was a charge to call out of state. In Europe, every time you moved from one country to another, and some of the countries are teeny-tiny, so it’s easy to move outside, you used to be charged an arm and a leg to call. And the European Commission imposed the elimination of these roaming charges with great benefits for consumers, and of course, telecom companies were not happy about it, but I think at the end of the day it was the right thing to do.

Kate: Yeah, I think it’s good that you brought that up, because that’s certainly an area where Americans can relate. Maybe not necessarily in the roaming charges, but how insanely expensive it is to pay for your local cable and internet bundle, when there’s no other options for you. And how you have to pay all these annoying transactions and institutional fees that are always changing, and you never really know where they come from.

I think it would be incredibly popular if US antitrust regulators took more action against big telecom companies, and it’s a bit of a puzzle as to why we don’t see that more.

Luigi: But you’re also right that it’s more difficult to take antitrust actions against somebody that gives its product for free. Google and Facebook are extremely popular because they give the product for free, and taking antitrust action in that direction could actually potentially backfire.

Kate: There’s some people who think that the European Commission is pretty impartial in the way that it metes out judgments. If you look at the entire record back to the ’90s of antitrust decisions levied by the European Commission, it does look that way. There might even be evidence that they’re a little bit more hesitant to go after non-European companies, but I don’t think that you can compare all cases against one another.

A popular study done by a number of authors, one of whom is Rob Jackson, who is a commissioner now of the SEC, they compare cases of transaction value of $10 million. They treat them equally as they would this most recent case, even though this recent case isn’t in their dataset. And I think it’s relevant to look at only the big fines, and if we’re only looking at the big fines, then I do think there is a little bit of an anti-US slant coming from the European Commission. I mean, in terms of collective fines of over a billion dollars, most of them were against US tech companies. There was one fine against Daimler, of about a billion dollars, but other than that, the major billion or multibillion fines have been against Intel, Microsoft, Qualcomm, Google. And if you count tax fines coming from antitrust authorities as well, then that includes Apple. Those are all US companies, with the exception of Daimler. And I think it’s a little bit ridiculous to argue that, “OK. So, they went after a bunch of small European companies, so they’re impartial.” When, actually, their major actions have been against US companies.

Luigi: Now, it could also be their history. I think that Europe is much more concerned with privacy than the United States is, but for very good reason, because the memory of brutal dictatorship that abused that power is very fresh and not that distant in the past.

So, Kate, at the end of the day, Europeans do it better?

Kate: Do what better, Luigi? Look. I think I agree most with a point that you raised on our episode with Lina Khan, which is that we have reason to be worried about big companies, big tech in particular, and the role that those companies are playing in shaping our democracy and shaping our political systems.

Whether or not they actually ... this is what’s motivating European antitrust regulators, I do think that’s in the back of their minds. And I do think that they’re using antitrust to go after companies for reasons aside from purely antitrust, I don’t know, violations.

Your point earlier was that there is reason to be concerned, but we should use a separate set of laws, or we should be more clear that this is why we’re concerned about the companies, from a democratic angle, not necessarily from an antitrust angle. And we should separate the two motivations.

Even though I think that the outcome on the European side is the right outcome, I’m not necessarily sure I agree that Google and these other big tech companies were violating antitrust law.

Luigi: So, you are saying that Europeans are Brandeisian without knowing it or without recognizing it?

Kate: Yeah.

Luigi: I think it’s an interesting idea. I think that, in my view, this wave is coming here as well. My prediction is that the next presidential campaign will be very focused on these issues, both on the left and on the right.

Kate: Yeah. I’m looking forward to the debate.

The second in a special 3-part series on antitrust law. Kate and Luigi talk with Lina Khan, author of the article “Amazon’s Antitrust Paradox,” and a member of the the New Brandeis Movement, which believes that antitrust enforcement should be more broadly applied and not just rely on consumer welfare.

Kate: Hey guys, this is Kate. Luigi and I want to know how to improve the podcast, so we’ve made a survey, and it’s available on our website for you to fill out. We’d like to know stuff like what your favorite episode was and what your least favorite episode was, and what you enjoy hearing about and what you want to hear more about. So, if you could go to capitalisnt.com, the survey should be right there on the home page. Help us help you. I hate it when people say that.

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: And I’m Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On today’s show, we’re going to pick up from our last episode, in which we were talking about the antitrust debate and how the debate has been changing in the past few years. On this episode, you’ll be hearing from Lina Khan, the director of legal policy at the Open Markets Institute, also a fellow at the FTC.

Now, on last week’s episode, we talked about the consumer-welfare approach to antitrust, and we heard from Carl Shapiro. The consumer-welfare approach broadly views antitrust as a mechanism to make consumers or people better off. The concern about monopolies only becomes something that the government should intervene in if those monopolies are actually hurting people, by either charging higher prices or limiting the quantity of a good that’s produced. Now, a different approach to antitrust that has arisen in the past few years, particularly in response to big tech companies like Amazon, is what’s now termed the New Brandeis Movement.

Luigi: This approach is called the New Brandeisian approach in memory of Louis Brandeis, who was an advisor to President Wilson and then was appointed to the Supreme Court. He was a very famous judge with a new perspective, not only in antitrust, but also on transparency, on regulation, and so on and so forth.

Kate: Brandeis is famous for having said, “We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can’t have both.”

Luigi: Joshua Wright, an antitrust expert who is a law professor at George Mason, defined the New Brandeisian Movement, and in particular, Lina Khan, as part of a “hipster” antitrust. I was included in that category. Honestly, I don’t even know what it means. I’m so not hip that I don’t even know what hipster means. Can you explain to me and the listener what that means?

Kate: What a hipster is?

Luigi: Yeah.

Kate: Well, it’s funny because the term “hipster” has always been something that’s hard to define. Historically, it was defined by the look that hipsters have. They wear, like, skinny jeans and they live in Brooklyn and they wear gratuitously large glasses and they drink really expensive coffee. Now, I think hipsters are more associated with young people who are socialists and overly ideological, even though that may be misguided.

Luigi: OK. I’m not a socialist and, unfortunately, I’m not young. I do drink a lot of coffee. Maybe that’s the only thing I have in common.

Kate: I think your glasses are a little ... Yeah, you have huge glasses.

I mean, what bothers me about that description of the New Brandeis Movement is that it’s pejorative. It makes it sound like people who are New Brandeisian are young and responding in sort of a knee-jerk, passionate way to antitrust issues, as opposed to the well-established, sound reasoning of the consumer-welfare approach, and that’s what bothers me the most. I think that there’s plenty of reasons to think that the establishment approach to antitrust hasn’t evolved properly with the times.

Luigi: Kate, I think you’re absolutely right that that is the undertone of this debate. That’s clearly the way, now that you explained to me what hipster means, that’s exactly the way in which Joshua Wright tried to say, “We are the serious economists, and everybody else is a bozo and does not have any argument for it.” So, that’s exactly what we don’t want to do.

Kate: All right, so now that we’ve presented two very biased approaches to defining the New Brandeisian Movement, why don’t we leave it up to Lina Khan to do a better job of it for us?

Luigi: So, Lina, first of all, thanks for joining us. You have become famous thanks to an article about the Amazon antitrust paradox. Can you explain to us why you’re so worried about Amazon?

Lina Khan:So, I wrote the article about Amazon because I think Amazon is a particularly elegant illustration of what’s wrong with our current antitrust regime, because it shows how a company can come to monopolize certain markets, or at least grow very dominant, but in ways that don’t trigger our antitrust laws, and so I use the story of Amazon as a way to tell the larger story about our antitrust laws.

You know Amazon, most of us engage with it as a retailer, but Amazon is involved in all sorts of businesses. It’s a dominant online platform, but it also has a massive logistics network, it’s a book publisher, it’s a TV and movie producer. It has its own private brand, so it’s engaged in the direct production of goods, and that places it in direct competition with the companies that are relying on its platform. These are some of the dynamics that I explore in the article, and I describe how Amazon has grown to become Amazon in part through relying on practices that 40, 50 years ago, would have been illegal under the antitrust laws.

Luigi: But we’re not lawyers, we’re economists, and we want to know, what’s wrong from an economic point of view? We may debate what is the right antitrust law, but we’re more interested in saying, let’s try to think about whether this is good or bad for American consumers, American producers. So, what do you see wrong in Amazon?

Lina Khan:I think the underlying question is, what is our goal, what is our aim? And I think under the antitrust laws, our goal is to promote competition. It’s to promote marketplaces that are open, healthy, that promote entrepreneurship. I think the current system, where Amazon is a dominant platform, makes it into like a railroad, where all these independent producers have to ride Amazon’s rails to get to market, and Amazon’s able to abuse that power. The fact that Amazon is vertically integrated, that it’s now involved in the direct production of goods, also places it in direct competition with the companies relying on its platform, and that creates a conflict of interest, so it’s now swooping in, kind of stealing the business insights of other companies. So, I think from an economic perspective, what we’re seeing is the disjunction between risk and reward, because you see these independent entrepreneurs, businesses, undertaking the original risk of bringing a product to market, and then Amazon is able to swoop in, steal their insight, and reap the reward. So, I think these are dynamics that are not really conducive to an open, healthy marketplace.

Luigi: But before Whole Foods was actually bought by Amazon, it was a normal supermarket, and a supermarket is the old-fashioned platform, in the sense it provides access to consumers to a lot of suppliers, and Amazon was competing with its suppliers. There was a brand called 365 that was cheaper than most. I am a cheapskate, so I always bought that, and so—

Kate: Such a cheapskate, buying 365 at Whole Foods.

Luigi: A restrictive cheapskate. But, so what is the difference between Amazon competing with its suppliers and Whole Foods competing with its suppliers?

Lina Khan:The difference is that Amazon is a network monopoly. In the grocery sector, you actually have competition, so suppliers that are selling through Whole Foods have options. They can sell through Safeway, they can sell through Kroger, they can sell through local farmers markets. The companies that are relying on Amazon don’t have that level of options, and so I think that’s a basic difference that makes Amazon’s conduct more problematic in this space.

Luigi: What fraction of online sales are done through Amazon?

Lina Khan:Over 44 percent of online sales are done through Amazon, and that share is growing faster than the share as a whole. Over 50 percent of online shopping searches now begin on its platform, and I think these numbers are expected to continue to grow astronomically. Amazon just revealed that it has 100 million individuals enrolled in its prime program, and Prime is really a key engine of growth, because studies show that once you become a Prime member, less than 1 percent of Prime members are likely to even price compare. So, there’s a huge incentive to just keep using Amazon because you’ve already dished up your money for free shipping, and so, why would you look other places? And I think Amazon has done a particularly great job creating the impression of always having the lowest prices, which I think historically has been true in certain sectors, but there have also been studies in the last couple of years showing that, actually, Amazon is not always the place where you can find the lowest price.

So, I think these dynamics will continue to evolve, especially with the risk of Amazon introducing price discrimination. Price discrimination is when every person is paying a different price for the same good or service. Amazon and other online companies now have a level of information about each individual where they can start tailoring prices to a very precise degree. Uber has already admitted that it engages in first-degree price discrimination. My sense is that if Amazon starts doing it ... Well, A, we don’t know if Amazon’s doing it. It’s perfectly legal for Amazon to do it, and I think it would be in its interest. I think the question is how does Amazon and how do these other companies roll out price discrimination in a way that’s not discernible to consumers, because Amazon tried this 15 years ago and there was a huge consumer backlash.

So, I think we’re going to start seeing Amazon and other companies start relying on tailored coupons and discounts. So, if you were looking at some shoes, put them in your shopping cart but you’re like, “Mm, still not sure about those, a little expensive,” two days later, you might get a coupon in your inbox that’s just for those shoes, gives you a 30 percent discount. So, that’s another way to start implementing price discrimination but in a way that’s not as discernible.

Luigi: But people do have alternatives. You mentioned Uber. This morning, I drove here ... actually, I was planning to drive here with Uber. I looked at the price and it was higher than expected, so I switched to Lyft. So, Uber lost a customer this morning because it was trying to increase the price. We know the platforms have a big interest in bringing people on the platform. They are trying to avoid taking advantage of the consumers because, otherwise, consumers walk away. So, as long as there is an alternative, then why should we be so worried?

Lina Khan:I think the ride-sharing space is a little different in that you do still have Uber and Lyft. I think Amazon is distinct from that because it controls the railroad, because it controls the infrastructure of online commerce. Most obviously—

Luigi: Wait a second. The railroad was only one, OK? The infrastructure ... You have alternatives. You can buy books from online Barnes and Noble. You can buy stuff from other people. So, it’s not as unique as the railroad was.

Lina Khan:I think from a consumer perspective, that’s right, but I think from a producer perspective, Amazon is a railroad to them, because if you don’t sell on Amazon, you lose 60, 70, 80 percent of your sales, and so, in order to be viably in business, you have to rely on Amazon. Then, the question becomes, OK, so do we really care about producers, or do we only care about consumers? And I think that’s the debate that’s happening within the antitrust community right now. Antitrust laws are supposed to address monopsony harms. Right? They’re supposed to look at buyer power issues.

Kate: Are they, though? I thought historically there hadn’t been very strong monopsony provisions in antitrust law.

Lina Khan:So, I mean, there aren’t strong provisions for anything in the antitrust laws. They’re written very broadly, very vaguely, but antitrust, the Sherman Act, the Clayton Act, FTC Act, they were all passed in response to producer and supplier discontent. So, it was the farmers, it was the suppliers that were being discriminated against by the railroads, they were being kicked off, and so there were monopsony harms that were animating the laws. There have been some monopsony cases that the agencies have brought, and last year, Senator Cory Booker actually wrote a letter to both DOJ and FTC, asking them this question. He said, “My sense is the antitrust laws are supposed to address monopsony issues, but you guys never seem to do anything around monopsony. What’s up with that?” I think they’re still waiting to make the letters public, but the response they got really suggested that the agencies do recognize they’re supposed to address monopsony harm. But there hasn’t been as much case law and so, when they’re bringing a case, they’re going to usually try to rely on consumer harm. But the antitrust laws are supposed to and do, in fact, cover monopsony harms.

Kate: How do you think we should change antitrust law to address a company like Amazon?

Lina Khan:It’s a great question. I think, when thinking about changes to antitrust law, we have to be really careful, because the laws are vague and broadly written, and so, a lot hinges on the enforcement philosophy that the agencies are using. So, I think there are ways in which even the current law could be used to address some of Amazon’s conduct through provisions like Section 5 of the FTC Act, which gives agencies broader mandate than, say, the Sherman Act or the Clayton Act. But, that said, there are other areas of the law, like predatory pricing doctrine, that have made it virtually impossible to succeed in bringing a case. So, I think on predatory pricing, we would need a new assertion from Congress that, in fact, predatory pricing is anticompetitive. So, I think there are certain areas where even under existing authorities, the agencies could do more, but another instance is where we would probably need new statutes, new legislation, to ensure that practices that are supposed to be anticompetitive are still enforceably anticompetitive.

Kate: Can you quickly define predatory pricing and how Amazon engaged in predatory pricing?

Lina Khan:Sure. Predatory pricing is when a company is pricing a good below a certain measure of cost. There have been debates about what that is, but, broadly speaking … and usually the concern is that if a company is in the short term able to price below cost, it’s able to use that tactic as a way to kind of drive out certain competitors of business, and then, once it has the playing field to itself, it’s able to raise the price later. This is the kind of dynamic that animated the first set of predatory pricing suits. It was mostly against the big chain stores like the Great A&P.

In the case of Amazon, there have been certain instances where it has engaged in aggressive pricing wars, one example being against Diapers.com. This was a startup in around 2009 that was doing really well. Amazon actually expressed interest in acquiring it, but the founders declined. They wanted to stay independent, and so Amazon waged a pricing war. It lost hundreds of millions of dollars pricing its diapers below cost. It had actually tweaked its algorithm to track how Diapers.com was doing its pricing in order to make sure it was always just below it. You know, Diapers.com was a startup. It was still trying to prove to investors that it was viable, and the investors started feeling really shaky after seeing that Amazon was price cutting so aggressively, and then Amazon made another bid and Diapers.com ended up selling out to Amazon. What Amazon went on to do was to scale back all of the discounts it had been offering on diapers. It closed, temporarily closed the kind of moms’ membership program that was making diapers so cheap, and so, it effectively went on to raise the price once it had limited competition in this way.

So, I think that’s one example, but I think if you look through Amazon’s business history, there are other examples in which it has made huge inroads into a market through pricing a good below cost, including, for example, in the e-book market, where it both priced its Kindle device below cost and also priced e-books below cost. And I think that’s something that we’re going to see with platform players, because these are winner-take-all markets in many ways, and so, there’s a huge incentive to prioritize growth over short-term profits. And I think that’s one way in which the law is no longer really registering the reality of these markets, because predatory pricing law assumes that companies are short-term profit maximizers, but in the case of the platforms, when you’re trying to capture the market by just growing as quickly as possible, it’s actually entirely rational to engage in predatory pricing, especially when you have Wall Street backing. Amazon has enjoyed a unique privilege from Wall Street to not have to report dividends. Historically, it would routinely report losses and its stock price would rise. So, I think there’s something interesting going on here, where investors are pricing Amazon stock at multiples that actually reflect market power, and so, Wall Street’s recognizing a reality that Washington hasn’t really been able to get its head around.

Luigi: So, you are considered one of the leaders in this new movement called the New Brandeisian Movement in antitrust from the famous justice, Louis Brandeis. But how do you differ from, for example, Carl Shapiro, in the view of antitrust?

Lina Khan:My sense is that Carl Shapiro views the role of antitrust as being one of maximizing consumer surplus, promoting consumer welfare, and thinks that there’s a very narrow role for it to play. I agree in the sense that I think antitrust is a law-enforcement regime, and so it is naturally responsive. So, you can’t really use antitrust as a policy lever. But I do think that thinking that antitrust law is only supposed to address consumer welfare is misguided. There’s a lot of scholarship that shows that in terms of legislative history, that was just a fiction that Bork imported into the law, and I think we’re also at a stage where we’re seeing all these merger retrospective studies that are showing, actually, mergers that were approved in fact have led to higher prices and lower output, suggesting that the consumer-welfare approach has actually failed, even on its own terms.

So, even if all you care about is consumer prices as the main metric of competition, actually, all around us we’ve seen instances where mergers have been approved and then have led to higher prices. So, I think the Carl Shapiro approach really hews very closely to a consumer-welfare approach to antitrust and a somewhat narrow definition of it, whereas I think the New Brandeisians think of antitrust law being able to target other forms of market power, such as, say, monopsony or innovation or quality harms.

Luigi: So, what do you want to maximize?

Lina Khan:Competition.

Luigi: OK, so there are two points of contention between, let’s say, for lack of a better word, Carl Shapiro and Lina Khan. One is, what is the objective of antitrust itself? The Chicago approach to antitrust pioneered by Bork, et cetera, was very clear that the role of antitrust is not to preserve competitors. Because sometimes you say you want to preserve competition. Now, “preserve competition” is a bit of a source of confusion, because are you preserving competition for what goal? Is competition a goal by itself? Do you want to keep alive inefficient producers just to have more than one producer? So, that’s the first tension.

Then, there is a second tension, which is, should we be concerned about democracy, for example, in antitrust? Not to give away the punch line, but, ironically, I am much more concerned about the second than the first. I’m with Lina more on the second than the first. So, in the first, I don’t think, and maybe because I’m too much of an economist, but I don’t think that we need to preserve inefficient competitors just to preserve competitors. On the other hand, I am worried that excessive concentration might have negative repercussions on the political dimension. And so, the Brandeisian name and label really refers to this second point.

Now, Kate, what is your position here?

Kate: I like your distinction between antitrust for the sake of preserving competition versus antitrust for the sake of preserving democracy. I agree that it’s ridiculous to say, “Oh, we need to preserve competition just for competition’s sake,” if you have an industry in which it’s very natural for there to be at most one or two companies, and anything more than that would be super inefficient. In those sorts of industries, I think the right thing to do is allow those one or two companies to dominate and just make sure that the government keeps a close eye on that industry, so that they don’t take advantage of their monopoly or duopoly power.

So, in that sense, I agree with you, but I think to your point about democracy, what’s really complicated is that there’s no good economic way of analyzing the effective monopoly power or just concentrated large companies on democracy. We don’t have a good model for that, because it’s sort of outside the realm of economics. I agree with the New Brandeis Movement in that we can’t just rely on this vague concept of consumer welfare and expect that to solve all problems.

Luigi: I agree, but the question is, from a legal point of view, should we consider problems to democracy in the implementation of antitrust? The lawyers and the judges are not necessarily asking if you should do it in the narrow economic framework. They are concerned about the problem, and my fear is that we economists, unless it fits in our model, it doesn’t exist. And that’s a problem. I think that I’m 100 percent with you that these connections are vague and should be studied more, but we cannot deny that they exist.

There is a long tradition, at least from the historical perspective, linking the two. Most listeners probably don’t know that the reason why in Japan, the zaibatsu, which are conglomerates that existed before the war, were destroyed and fragmented, and the reason why the big industrial complex in Germany was destroyed after World War II is because the American troops, when they arrived, brought with themselves the Brandeisian concept that there is a strict association between dictatorship, especially fascist dictatorship, and concentration. So they, once they had the chance to be in power, destroyed ... They also tried to destroy them in order to set these countries on a more democratic way. So, it’s not that there’s not a historical record, there’s not any connection, it’s just that we cannot model it properly in our economic models.

Kate: Yeah, I think we’re on the same page, and I think we’re on the same page with regards to the possibility for overreach of the New Brandeisian approach. I totally agree with you that just preserving competition for competition’s sake could be misguided and could, in certain situations, lead to inefficiencies. On one of our last podcasts, when we talked about whether Facebook is a monopoly, I thought that we needed to amend our antitrust laws to be more specific, and now I’m sort of leaning in the direction of, “Oh, we need to have an antitrust approach that’s flexible, that can take into account ideas outside of just an economic model.” So, I’m conflicted on this. It’s a hard question.

Luigi: No, but I think it’s useful to say, “From an economic point of view, this is what we can say, this is what we cannot say,” and then say, “We are concerned about these other channels, and, to be honest, we’re not the most competent to analyze those channels, but that doesn’t mean those channels shouldn’t be analyzed or shouldn’t be discussed in antitrust, but it’s also useful to keep them separate.” Because in my reading of Lina’s work and other people’s, especially Open Market, they put all these things together, and sometimes it’s a bit hard to disentangle, and they might be connected.

So, take the view of protecting small shopkeepers, for example. I think that from a political point of view, some people might argue we need to protect small shopkeepers. Why? Because they are really instrumental to democracy. There is a long tradition of protecting small farmers because small farmers give stability to the democratic system. So, I can see somebody making that argument. I’m not sure that I want to buy that argument, but I can see somebody making that argument. That argument, to me, is different from an economic argument that the low prices of Walmart or the low prices of Amazon hurt potential suppliers, and this is something we should be concerned about from a purely economic point of view.

Kate: Again, I agree with you. I do think that the New Brandeis approach is a little bit lacking in focus. I mean, one interpretation of it is, “Oh, once companies get too big, that’s bad.” And I don’t think that that’s at all what Lina was saying. I think she was actually very precise about her economic interpretation of the New Brandeis Movement, and I would say, from Lina’s perspective, at least based on our interview with her, she thinks that the consumer-welfare approach just historically hasn’t done a good job of developing with the times and with technology. It’s a little bit too narrow in what they define as harms to consumers. They haven’t done a great job of going after monopsonies. They haven’t done a great job of going after predatory pricing. And so, in some sense, I would describe Lina ... I mean, I think I’m sure neither she nor Carl would like this description, but I think she could be considered a consumer welfarist that’s just more modern in her approach to how big companies can actually hurt consumers.

Luigi: I think you underestimate the difference there. I think that Lina said clearly, “I want to protect competition,” and she didn’t say, “I want to protect competitors,” but I think that at the end of the day, they want to protect competitors. They want to protect small producers because they think these are useful to democracy. And I think that step has not been fully proven to me.

Kate: I think you’re putting words in Lina’s mouth. Ultimately, I agree with the people on the New Brandeis side who think that the United States’ historical approach to antitrust hasn’t kept up with the times. I disagree with the people who think that we should just preserve small producers.

Luigi: So, Kate, are you going to wear your tight jeans and go to the expensive coffee shop to read more of Lina Khan’s papers?

Kate: No. I’m going to be wearing my tight jeans, going to my expensive coffee shop to read more Karl Marx.

So, we’ve talked about the consumer-welfare camp and we’ve talked about the New Brandeis camp, but on our next episode, we’re going to be talking about the recent $5 billion fine coming from the EU imposed on Google, and whether there’s actually anything the US can learn from the EU in terms of antitrust enforcement.

The first in a special 3-part series on antitrust law. In the wake of the approved merger between giants AT&T and Time Warner, Kate and Luigi talk with a leading expert, Carl Shapiro, about the evolving concept of consumer welfare and whether antitrust law needs to change with the times.

Speaker 1: All right, let’s talk a little business. Two tech giants have decided to go ahead and merge after a contentious, years-long battle. A federal judge has now approved the $85 billion merger of AT&T and Time Warner.

Speaker 2: It gives AT&T access to Time Warner’s assets like CNN and HBO, and its content. Critics say the merger could lead to higher prices.

Speaker 3: I mean, this was a scathing and total rejection of the government’s theory that this merger would violate antitrust law.

Kate: Hi. This is Kate Waldock from Georgetown University.

Luigi: And this is Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t. And speaking about what isn’t working, one of the key elements of capitalism is competition.

If there’s not enough competition, we should have some antitrust enforcement. The United States was the first country that understood that in order to create competition or maintain competition, sometimes you have to add some form of government intervention.

Kate: You probably heard about the recent AT&T/Time Warner merger that the government tried to block on antitrust grounds, but fell a little short of.

What you maybe haven’t heard of is that there’s actually a debate raging in Washington. It’s not about Trump or Stormy Daniels or Russia or collusion. It’s actually about antitrust.

Luigi: This debate is about what is the soul of antitrust, what is the antitrust that policy should aim at, and how should it be conducted? And this debate is a debate that started more than 100 years ago and has been resurrected in recent years.

Kate: One side we’re going to call the consumer welfarists, and we’re going to focus on that side in today’s episode. One of the things we’re going to do is go back to an interview between Luigi and I and Carl Shapiro, who’s a prominent academic in antitrust, and who also supports the consumer welfare camp.

On our next episode, we’re going to interview Lina Khan, a prominent legal scholar who is on the other side, the New Brandeisian side, and get her perspective on the antitrust debate.

Luigi: Let’s start the episode with a little bit of history that gives context to the problem. First of all, there’s a long-lasting tradition in The United States of fighting against monopoly. In fact, this tradition goes back to nothing less than the American Revolution.

Most people remember the Boston Tea Party as a revolt against taxes. In fact, it was a revolt against the East India Company that was dumping tea and damaging the local importers of tea. You can think about the American Revolution as a revolution against one of the worst monopolies in history that was the East India Company.

But more recently—and what generates some of the legislation that is still in place today—at the end of the 19th century, people were concerned about the excessive concentration of economic power in a few hands. In particular, these were the railway companies and the telegraph. You probably have heard, if you remember your history, of the robber barons. This is exactly the period of the robber barons, and this is when Senator Sherman introduces in the Senate, and then makes law, the so-called Sherman Act. The Sherman Act is the first piece of legislation that tries to fight monopolies.

Now, what is important to keep in mind is that the 1890s is also the time when the Principles of Economicsby Alfred Marshall is published for the first time in England. There’s no doubt that Sherman did not know about what was going on at the time. So, all the economic apparatus that we now use in antitrust, and got started to some extent by Alfred Marshall, was completely not present at the time.

The spirit behind the Sherman Act is a spirit that was also behind the American Revolution, to limit concentration of economic power, because power corrupts, and absolute power corrupts absolutely.

Kate: Luigi’s favorite phrase. The Sherman Act is the basic foundation of antitrust law in the United States. What it does a little more specifically is that it outlaws monopolies, and it also outlaws “every contract, combination, or conspiracy in restraint of trade.” The text of the Sherman Act is pretty vague, but that’s partially what has allowed it to be flexible and adapt to the changing nature of commerce over time.

There’s two other major pillars of antitrust law in the United States that came about a little bit later, about 25 years later. One is the Clayton Act, which was passed in 1914, and that prohibits other types of monopolistic behavior. In particular, price discrimination, anti-competitive mergers and acquisitions, and certain forms of sales that are considered anti-competitive, like tying agreements that force people to buy one product if they also buy another product. If that gives rise to a monopoly, that is outlawed under the Clayton Act.

There was also, in 1914, the Federal Trade Commission Act, which banned “unfair methods of competition,” as well as “unfair or deceptive acts or practices.” That gave the FTC a slightly broader mandate than just antitrust.

In the context of today’s antitrust enforcement, if you’re wondering who can bring about an antitrust suit against one of the big businesses, well, there’s the Department of Justice enforcing the Sherman Act or the Clayton Act. There’s also the Federal Trade Commission. Any of the state attorneys general can also bring an antitrust suit based on either state or federal antitrust law. And private citizens can also bring antitrust actions against businesses.

Luigi: Much of this law was introduced toward the end of the 19th century or beginning of the 20th century, and most people remember from their high school history that Theodore Roosevelt was a big antitrust guy. In fact, during his period, major antitrust cases were brought.

However, antitrust for a while got prominently less important until, actually, Thurman Arnold was appointed as attorney general in 1938. He was the first one that really went after many, many businesses and associations. He sued even the American Medical Association for closing practices, exploding the realm of antitrust.

In the ’50s and ’60s, the antitrust enforcement was extremely aggressive. In 1963, for example, there was a case that went up to the Supreme Court of the National Bank of Philadelphia that was trying to merge and gain a 20 percent market share locally. And the Supreme Court said that 20 percent was too much. Now, the 1963 Supreme Court decision was written by a young clerk for the then-justice named Richard Posner.

Richard Posner later moved to Chicago and became one of the main proponents of the Chicago school of antitrust that actually revolutionized the view of antitrust in the world in a way that is still there today.

The premises were actually quite interesting, because most people think that Chicago was always against antitrust as a tradition. This is not true at all. In the ’30s, Henry Simons, who was the most prominent intellectual at Chicago, was a big proponent of antitrust, and his students, including Milton Friedman and Joe Stigler, were in their early days very much in favor of antitrust.

Why did these people change their minds later? I think that a key historical figure in this change was a faculty member at the time called Harold Demsetz. He had this idea that I thought was quite clever, that if you punish bigness per se, you are punishing success. The companies get big because they are very successful at doing what they do.

That was one line. The second line was brought by Robert Bork, who was a student at Chicago and then became a professor at Yale. He used to say, look, what is the purpose of antitrust? Because think, for example, in modern terms, Google is the best search engine. If you break up Google, the search engine will be of inferior quality. Robert Bork raised the question of, “What is the goal of antitrust itself?” The reason why we do antitrust is to maximize consumer welfare.

Kate: OK. That brings us to one side of the argument. Today, the consumer-welfare approach to antitrust. One way that economists think about consumer welfare is in terms of what they call consumer surplus.

Everyone, for every good or service out there, is willing to pay a certain amount. Some people are willing to pay more than others. If I’m willing to pay for an iPhone, let’s say, $800, and it actually costs only $600 to me as a consumer, then there was $200 of consumer surplus that I would’ve been willing to pay for that phone, but I didn’t actually have to pay it.

Luigi: Kate is absolutely right in that she defined what is consumer surplus. Now, ironically, it is a bit vague what Robert Bork meant by consumer welfare, because consumer surplus is a well-defined economic term. Consumer welfare as the welfare of all the individuals, and that is just welfare, not consumer. Or, it’s just consumer surplus, and then you’re saying that you ignore the other side, which is the producer surplus.

If you go in the direction of saying, “We maximize the welfare of all the individuals,” then you should treat consumers and producers the same way. If you think, “No, the purpose of antitrust is to defend consumers, because, for whatever reasons, they are the weaker side,” then, you go into consumer surplus. Not into consumer ... Sorry. You go into consumer surplus, not into consumer welfare.

I think that in going to the conversation with Carl Shapiro, it is important to keep this in mind, because this is one of the controversial points that is arising even today.

Kate: All right. Now, we’re going to play an interview between Luigi, me, and Carl Shapiro, who is a professor at the Haas School of Business at UC Berkeley. He’s also incredibly influential in the antitrust sphere. He was the deputy assistant attorney general for economics in the antitrust division of the U.S. DOJ. He’s also the major expert witness that’s brought into a lot of antitrust cases, including the recent AT&T/Time Warner case.

Carl Shapiro: Fundamentally, in antitrust we want to ask whether, let’s say, a merger, harms consumers, typically through higher prices or reduced innovation, lower-quality products. And that’s an inquiry that we, as economists, can conduct. At least, try to predict the effects.

A merger may harm the competitors, if the merging firms become more efficient. That would harm the competitors, and that’s not the test. The test that we care about is, if we’re harming consumers, it’s a problem. If it harms the competitors, that may reflect that it’s actually a pro-competitive merger, because it puts the competitors under more pressure.

Luigi: But suppose a merger gains, at least in some areas, so much market power vis-à-vis the labor market, so it’s not necessarily consumer, but it’s a supplier in the form of labor. Should we take that into consideration as well or not?

Carl Shapiro: Absolutely. This is where the consumer-welfare label can be a little misleading and narrow. But the normal case we look at would be this, what I’ve described with how we look at the consumers. But if a merger creates power over workers, or a case that ... does come up at the Justice Department with some regularity is agricultural markets.

Say, two companies that process chickens, they’re the only ones that the chicken farmers can sell to, so the company may have monopsony power, buyer power. That’s absolutely a concern. It doesn’t sound like that would get picked up by the consumer-welfare standard, but the more complete description of the standard would be, if the merger gives significant additional market power to the merging firms, either as sellers or as buyers, that the counterparty, the other side of the market, would be injured by the reduction in competition, that becomes an antitrust problem.

Kate: But that’s not traditionally how antitrust has been enforced, correct?

Carl Shapiro: I think it is, actually. I mentioned agricultural markets would be one. Another example, there was a merger, British Petroleum and ARCO merged and they merged their—attempted to merge, actually, it was blocked to some degree by the Federal Trade Commission—to merge the operations in Alaska, in the North Slope oil fields.

The concern was that if the government would be selling the rights to explore additional oil fields to oil companies, and instead of the two of them bidding against each other to pay more for those exploration rights, they would pay less after merging. So the government, as a supplier of land and oil exploration, was harmed.

So, it is the way antitrust has been enforced historically. It’s just there are fewer cases that involve buyer power than seller power. There’s also a section in the Horizontal Merger Guidelines, which were most recently updated in 2010, that talks about mergers that create buyer power.

Luigi: I think historically, certainly, there were fewer cases, but now people are raising the issue that maybe Amazon is getting so much market power—not with consumers, or at least that doesn’t seem to show up with consumers because the prices are quite low—but with suppliers.

Are you concerned about the larger market share that Amazon has in certain sectors, and is that potentially a source of antitrust investigation, if not enforcement?

Carl Shapiro: Potentially, yes. I don’t know enough of the facts to make a call on that, but, yes, if it got to the point where there were many suppliers who feel they could only get to the market through Amazon, and Amazon could depress unreasonably low the prices they receive, that could definitely be a problem.

The other area that you mentioned earlier, labor markets, has not generally been an area that’s seen much antitrust attention. We had a case involving the tech companies, the so-called no-poach case, which was not a merger, but more of a collusion case, actually, when I was at DOJ. But I think there’s additional research going on now.

There are people, scholars, who are suggesting there’s significant market power, buyer power, among large companies in labor markets, and I think that the antitrust agencies should be looking into that. This might be state attorneys general, as well as the DOJ, for example, because this could be more local markets, and see whether that’s true, and if it is, it may be a whole new front for antitrust that’s been underdeveloped.

Kate: Do you think that there’s room for the text of antitrust law to be changed, or do you think that most of the changes should come about through enforcement?

Carl Shapiro: Well, there’s legislation currently proposed by Senator Klobuchar to beef up some antitrust enforcement. I think moderate changes could be made, for example, to codify the structural presumption against mergers that significantly increase concentration, and I think a number of ... I’m open to that, for example.

More fundamentally changing the Sherman Act, or a more fundamental change about what antitrust law is trying to do, I am very skeptical of, and I view as hazardous, actually, to the extent that it might move antitrust in a direction away from focusing on promoting competition and trying to do other things that might not work well in the law-enforcement setting.

Kate: A New Brandeisian might also argue that an issue with the consumer-welfare approach to antitrust is that it’s excessively focused on M&A analysis and not enough on large, dominant firms, particularly in tech. The type of exclusionary actions that they could undertake and, say, predatory pricing, and it doesn’t really have a good response for the platform economy. What would your response be to that?

Carl Shapiro: Yeah, I think that’s kind of a misdirection in the sense that I view it as not really fundamentally a challenge about the consumer-welfare approach or ... Which, let me summarize again, meaning we look for mergers or conduct that disrupts the competitive process and hurts consumers. That’s what we’re looking for under that approach.

I think that set of challenges as more to be about the actual operation of antitrust law. What does it take to bring a monopolization case against, maybe, Amazon as one of the companies that is criticized by this way of thinking? Is predatory-pricing analysis, is it too high a hurdle for the plaintiff to bring a case against Amazon, accepting the consumer-welfare standard? I don’t think there’s a problem right now on that front, and I think Amazon brings a lot of benefits, but that’s a perfectly legitimate debate to me. I would say it’s a debate ... one we had vigorous debates about that in ’70s and ’80s, particularly in the 1980s, which was Brooke Group, the key Supreme Court precedent that was reached, with a lot of literature on different standards for predatory pricing.

And the world’s changed, technology changed, but there’s learning there, and I’m not sure the people who are revisiting this have fully appreciated the debate that took place 30 years ago.

Luigi: Let’s hit the pause button for a second and discuss this first part that is quite important, which is, how convinced are you, Kate, about the consumer-welfare approach as Carl presented it?

Kate: What I think is convincing is his argument that, yeah, in all of these cases the consumer-welfare approach could be applied, right? In the case of monopsonies or antitrust in the labor market, in any manner of cases, you could adopt the consumer-welfare approach, which is to do a cost-benefit analysis of how much consumers would be hurt by potential monopoly and how much they could also benefit on the other side. I mean, that seems sort of very general and very foundational. It’s hard to argue with that approach.

But when I step back and think about it, what bothers me is that the practical reality of the consumer-welfare approach to antitrust is very different in the sense that we haven’t actually been going after that many cases.

The recent AT&T/Time Warner case was dismissed and before that, the last major successful antitrust enforcement was with Microsoft in 1999, which was like two decades ago. When I listen to what he says, it makes sense to me. But when I look at the actual practice of antitrust enforcement, I think it’s much harder to say that it’s impartial and it’s purely economic. I think it’s too influenced by political forces, which can distort the way that antitrust actually works.

Luigi: I think you raise an excellent point, but I would like to distinguish enforcement from principles. The principle could be right and the enforcement could be lax, and if we need to fix enforcement, it’s a different story than if we need to change a principle.

I have to say that I think he did an excellent job, but I’m a little bit perplexed by this position of the consumer-welfare approach, because they claim to be very scientific and behave like economists, but at the end of the day, they’re not. I’m very glad that Carl believes that you should also go after monopsony, but why do you call it consumer welfare? It’s not consumer welfare because in a monopsony, consumers might be better off.

What is it that they’re maximizing? The question that Robert Bork asked: What are we trying to achieve with antitrust? And we should have a clear principle. I don’t think that has been fully answered, yet.

Kate: At the top of this episode, we talked about the other side of the argument, the New Brandeisians. Let’s bring this up with Carl and see what his response is to the presence of this New Brandeisian movement and whether he agrees with them at all.

Luigi: But you have taken a position against these New Brandeisians’ approach to antitrust that is not exactly new. It’s trying to go back to the original foundation of antitrust that was written in sufficiently generic terms that it could include also being concerned about the excessive political power that firms had. Why are you so dead set against that?

Carl Shapiro: I should say, as a citizen, I’m very deeply concerned about the excessive political power of large corporations and too much money in politics. I’m very concerned about that. Corruption, writ large, if you will. I want to say that first.

In terms of antitrust, I just think that asking the Justice Department to review mergers based on political power sounds like a really bad idea. A really dangerous thing to do, or even to ask the judiciary to do that. I’m not sure what they would do and it seems hazardous.

Now, you mentioned the original Sherman Act, and it’s certainly true that if you go back and look at the congressional record there, what the historians tell us is there was a generalized concern about corporate power at that time, in the late 19th century, as the industrial companies grew large and became more national.

But if you look at the text of the law, it talks about monopolization and economic effects, and you look at how the law was immediately interpreted by the Supreme Court. It quickly went to applying the statute, it was about economic power. And we now have more than a century of well-developed case law in this area. I don’t think people who’ve proposed some alternative have really given us a practical way to go, and as I said, it could be quite dangerous.

Luigi: I agree it’s dangerous, and I agree there are not set guidelines, but why can’t we ... And I’m not saying that we’re there yet, but why can’t we do more work in this area and have some guidelines saying that, look, excessive concentration leads naturally to more capture and is negative for the political economy of a country?

Carl Shapiro: Look, I think there’s a lot of intuitive appeal to what you say, OK? It sounds like now that would be economy-wide, though, right? That could be many different sectors you could be concerned about this.

Luigi: Absolutely, yeah.

Carl Shapiro: OK.

Luigi: Could be chickens.

Carl Shapiro: Right, right. I think, let’s just say, I don’t have a good answer on this one. Now you’re telling me, “We’re so concerned about political power and we don’t seem to have other tools to deal with the political power of large corporations such as campaign-finance reform or transparency—”

Luigi: After Citizens United, I think that we are limited in that ability. You’re absolutely right, if the Constitution were not limiting that, then we could go in a different direction, but—

Carl Shapiro: OK. I’m saying, if we think those tools are unavailable, for whatever reason, Constitution or political will, or whatever, then I think it is not unreasonable to point in the direction of some broad-based, concentration-limiting rules.

I am nervous about how those would work in practice. As an antitrust expert, I bristle at calling that antitrust. It’s a different regime. It’s not competition in the market, the way that antitrust folks tend to think about it. And I guess I would say, would you please flesh out how this would work and specify? And then we could have a debate about whether it might cause a lot of trouble or whether it would be important to protecting democracy.

Kate: Luigi, I think he was hitting the ball back over to your court.

Luigi: Yes, he was, but most importantly, to Lina Khan’s court. She’s one of the leading proponents of the Brandeisian approach, and we’re going to interview her next week.

Kate: It’s like a doubles match. You’re letting her handle the shot.

Luigi: Absolutely.

Do central bankers have too much power? Paul Tucker, a former official at the Bank of England during the 2008 financial crisis and author of the new book 'Unelected Power,' explains to Kate and Luigi how technocratic hubris can imperil democracy.

Kate: So, Paul, why are you trying to impose constraints on yourself?

Paul Tucker: I believe in democracy. It’s a precious—

Luigi: This makes him even more unique, a central banker who believes in democracy.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Kate: Should I introduce Paul?

Paul Tucker: Only use the Sir once, but only once. Okay?

Luigi: Sir Paul.

Paul Tucker: Yes. Luigi carries this off with the appropriate derision that a European knows how to deliver.

Kate: Okay, I had a plan for the Sir. Ahem, today we’re joined by Sir Paul Tucker, an economist who is the former deputy governor of the Bank of England from 2009 to 2013. He’s now a fellow at Harvard’s Kennedy School and Harvard’s Center for European Studies. He’s also the first knight I have ever spoken to, which has me swooning. He has a new book, Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State. So, welcome to the show, Paul.

Paul Tucker: Well, thank you very much for having me here.

Luigi: Paul is unique in many dimensions, but I think one I want to share with my listeners: generally retired, important figures like Paul write memoir books that are pretty boring. They sell very well. They make them rich, but they’re pretty boring, and they tell the gossip of what was going on when they were in power. Paul has written a book which is exactly the opposite of this; it is a scholarly book where he reflects about the role of central banks today. He’s the only central banker who would like to limit the power of central banks.

Kate: So, Sir Paul, what prompted you to write this book in the first place?

Paul Tucker: Two things, and they came together. The first was, I was intimately involved, and that’s understatement probably, in designing the powers that were granted to the Bank of England after the financial crisis. It became a much more powerful institution. But actually, we leant against, I leant against some powers that some people wanted to give us. We argued for careful constraints around the new powers that we were given: supervisory powers, regulatory powers, all sorts of things.

In the back of our mind was a desire not to be too powerful, to be legitimate. I wanted an opportunity to write down what lay behind that, which was things like the values of democracy, and the rule of law, and constitutionalism. Not the kind of things that feature in discussions about central banking, but I absolutely promise were in my mind, and I think in Mervyn King’s mind, the then governor, as we navigated all of that.

The second thing was the kind of ... This came to me really while I was writing the book, I started writing the book in 2014, is the debate about technocracy versus populism. I just ended up believing that technocracy needed to retreat a bit, both for its own sake, and, actually, because there was a risk of people saying, “Well, too much, too much is in these unelected hands.”

The book in some senses is about central banking, because central bankers are so powerful today. I was lucky enough, privileged enough to have some of those powers. But it is also, I don’t think of it as a book that’s about economic policy. I think of it as a book that is about democracy, and power, and populism. But not one of the books that attacks populism, or attacks technocracy. But it’s about technocracy from the inside, and where would one technocrat take technocracy? Well, shrink it a bit.

Luigi: In your book, Unelected Power, you make some very interesting remarks and comparisons with the judiciary and the military. One of my favorite lines issued by Clemenceau, who was prime minister in France during World War I, is that, “War is too serious a matter to let generals run it.” Can you say the same thing about central banks?

Paul Tucker: Not quite, but I think that’s exactly the right way of thinking about it. I should’ve used that quote in the book. The reason you can’t ... it’s not just that you can’t leave war to generals, the generals can turn on you. Finding a place for the military in our societies was a huge thing for centuries, because they are capable of taking over. They have in some countries. One of the great achievements of our societies is avoiding that.

Where this matters for central bankers is when you get absolutely to the edge of their powers, but they could still save the world. They could still make things better. But you haven’t provided for it in law. Or if it is provided for in law, no one ever remotely contemplated it. Let me give you an example. The European Central Bank saved the euro area in 2012, and it acted within its legal powers. The constitutional court later determined that. But it certainly acted in a way that no one ever had thought it could.

I think they did consult the German government. I think they should’ve gone to the Council of Ministers, which is essentially the governing body of the EU—in intergovernmental mode, there’s an important constitutional nuance there—and said, “Do you want us to rescue your project, your country, your jurisdiction,” rather than just assume it? That may sound like a formal thing, but it amounts to ... it’s consistent with our values that the unelected people should not take over. I certainly ... you can’t have central banks going beyond their legal boundaries. If they reach their legal boundaries, then it’s over to the legislature. It’s over to the fiscal people.

That might sometimes ... when I say this in this country, sometimes people will say to me, “But then the people would’ve been worse off. Of course, the Fed should always come to the rescue, and they’re going to get criticized.” I understand that sentiment. But there’s a trade-off between welfare today, and whether people accept the system of government. This is a judgment. The judgment about what to do when you’re at the boundaries, those judgments must be made by elected people, not by unelected people.

Luigi: The mood today is exactly in the opposite direction. You certainly belong to the group of people called experts. There is an increasing tendency of experts to say, “You should let us do our job, because you people don’t understand what you’re doing.” Certainly, a lot of people don’t understand what central banks and bankers do. “You people don’t understand what we’re doing, so we need to operate without the constraint of you politicians who don’t understand what we’re doing.”

Paul Tucker: I mean, what you say is true, but it’s not the whole truth. There are other people that say, “Well, we’ve had enough of being ruled over by people that we didn’t vote for, and can’t vote out.” We live, around the western world, in complex times. I absolutely don’t just mean since the presidential election here, or the referendum in the UK, and the various elections in continental Europe.

Part of the reason people are ... Let me put it this way. The more and more we put into the hands of so-called technocratic experts, the more we take a risk that there will be a backlash. So, I deliberately put it just through the voice of the technocracy itself. Part of my message would be, the technocracy needs to retreat a bit, if only out of self-interest.

Now, I actually think there’s a deeper principled reason for retreating as well, but if only out of self-interest, technocracy ought to back off a bit, and not claim that it has the answer to every set of questions, because it doesn’t.

Kate: All right, so I’m pretty sure ... I’m 100 percent positive that I am the lowest common denominator amongst the three of us when it comes to knowledge of what central banks do. So, I’m going to start out with my impression of what the Fed does. Okay? It’s as follows. It sets monetary policy. By that I mean it adjusts interest rates so that if, say, employment is low, and prices are low, or inflation is low, then the Fed will cut interest rates, so that it’s less attractive to save, people will go out and spend more, and that will boost the economy, therefore raising employment.

The opposite may also be true. If there’s high inflation and also high employment, the Fed may raise interest rates, and people will therefore cut back on their spending, and hopefully bring inflation down. Is that a fair characterization of monetary policy?

Paul Tucker: Yes, but it’s quite a few steps down the road of what a central bank is. A central bank is an institution of the state of government that issues money. It’s a special kind of money. It’s the money that we pay our taxes with, ultimately. It is the money that people are obliged to accept in settlement of payment for the goods and services that we buy, consume, et cetera.

This is an extraordinary thing. The state creates this money, and it says, “We will give this money a special legal underpinning.” If you and I ... if I bought something from you, you and I would settle, not in that money probably, certainly if it was a large amount. We would settle. There’d be a transfer from a deposit, my deposit account with a commercial bank, to a deposit account with your commercial bank. But those banks would settle amongst themselves in the money of the Federal Reserve. Once you’ve created this money, you have to decide how much of it to have out there in the economy, or what price to put on it. That’s where what you say comes in.

Luigi: But Paul, you said correctly that most of us do not transact with that money. We transact with deposits. Why in the 21st century, and there are, of course, a lot of reasons in the 18th and 19th century, but why in the 21st century do we actually let banks be in control of the creation of most of the money? Today when I deposit my money in the bank, I get zero percent. When my bank deposits at the Fed, it gets an interest. Why do they have access to an interest and I don’t?

Paul Tucker: I think this is a great question. I think there is a good answer. Imagine that we all, all the population, had accounts with the Federal Reserve in this country, with the Bank of England in the UK, with the European Central Bank in continental Europe. We would hold balances with it. I want to suggest that if that was the case, that as well as being depositors with the central bank, when times got hard we would expect to be able to borrow from the central bank as well. We would want an overdraft account from the central bank.

It seems to me the most important thing in political sense that commercial banking does, is it gets the state out of determining the allocation of credit, who gets loans, and who doesn’t. Now it may well be with the new technology that there will be a way of solving for us all being able to hold money issued by the Federal Reserve, without having accounts at the Federal Reserve, which could be used to borrow from the Federal Reserve. But I would be very nervous about what started off as a monetary initiative ending up as a credit initiative. There’s a long history in this country, by the way, of people wanting to change the monetary system, and then when politicians get a hold of it, actually turning it into a policy about credit and lending.

Luigi: Why not use prices to allocate a given quantity? I think that if the deposits are safely at the Fed, and … you can then decide on where to invest them based on prices.

Paul Tucker: This is a model which is trying to separate the monetary system from the capital markets essentially.

Luigi: Yeah—

Paul Tucker: No, no. That might work eventually. But so long as you find small businesses, or people who can’t access the capital markets, which is how things have been through the 20th and first part of the 21st century, then you will have some kind of banking-type institution, public or private, I prefer private, that makes loans to them. I think if we all have accounts with the Federal Reserve, the next stage, it

wouldn’t happen in the first week ... over the years, as decades passed, people would say, “Well, actually, the Federal Reserve should get into lending to parts of the economy as well.” Be careful what you wish for.

Kate: All right, so in addition to what we’ve been talking about, the Fed also has other roles, though. Right? I mean, we’ve mentioned private banking. The Fed monitors, and, to some extent, does have control over private banks.

Paul Tucker: What I think central banks should be doing is ensuring the resilience of the biggest banks. Resilience comes in two forms, actually. For small or medium-sized banks, if they fail, the deposit insurer pays out to the insured depositors, regular people. That’s fine. I don’t think anyone should be in the business of trying to ensure that small or medium-sized banks are so safe that they never fail.

Now, actually, everybody made the mistake of hoping that the biggest banks would never fail. That, of course, wasn’t true. They did fail, so we can’t rely, even for the biggest banks, on supervision, the Federal Reserve, people in Europe, doing this so well, and the banks being so well managed that they will never fail. That failure will happen again. We need to ensure that that can happen in a more or less orderly way, so that the politicians aren’t faced with a stark choice between fiscal bailout of the banks, and the bankers, and the bondholders, and the equity holders in the banks on the one hand, or, on the other hand, complete chaos.

Kate: But now I’m a little confused, because who is the lender of last resort? Is it the Fed, or the FDIC?

Paul Tucker: Yeah, sorry. The debate about these issues in the United States isn’t terribly good. That’s because somehow the perception has grown over the years that the central bank, the Federal Reserve, is a lender of last resort, is a bailout facility. It’s not. You should only use the lender of last resort, creating money and providing liquidity, to a bank that has got liquidity problems, but not to a bank that has got deep, deep solvency problems.

Now, of course, in a world where you can’t resolve a failed bank, a fundamentally bust bank in an orderly way, the lender of last resort and their political counterparts in the administration and Congress get tempted to reinvent themselves as a bailout mechanism. Actually, the Dodd-Frank Act, and the work the FDIC has done with others around the world kind of protects the Federal Reserve from that temptation in the future. So, the Fed is the lender of last resort, but the FDIC enables the Federal Reserve to stick to its mission, and not get into the fiscal business of bailing out banks.

Luigi: We are approaching the 10-year anniversary of the famous Lehman weekend. Even today, we’re discussing whether Lehman was solvent or insolvent. Had you been chairman of the Fed, would you have lent to Lehman, and what would your policy suggest in that case?

Paul Tucker: With today’s powers, you’d put Lehman into resolution. It would go through ... For listeners that are familiar with the jargon of the Dodd-Frank Act, Lehman would today, I hope, go through what is called Title II resolution. What would happen is that the equity holders would be wiped out, consistent with capitalism and market economy. The bondholders would take a big hit, with part of their investment converted into equity. The authorities now have the powers to do that, and—

Kate: I’m so excited to be talking about bankruptcy on the podcast for once.

Paul Tucker: Bankruptcy, good mechanisms for handling bankruptcy, are completely integral to a successful market economy, capitalism.

Kate: I couldn’t agree more.

Paul Tucker: If someone said to me, and I think I’m on the record when I was in office saying this, if someone said to me, “If you could lift one thing from the United States’ economic policies and institutions, and take it into Europe,” it would be the Chapter 11 bankruptcy procedures that you’ve had in this country, and have served you very well, because it allows failure. We’re talking now about nonfinancial companies. It allows failure to happen without the earth quaking, and that’s a kind of ... capitalism is about success and failure, and somehow getting to good places in slow motion.

Kate: Paul, I said that because I do research on Chapter 11, so I’m always trying to give it a plug.

Paul Tucker: I didn’t know that.

Kate: In any case, how would you have resolved Lehman if Dodd-Frank hadn’t existed?

Paul Tucker: Hadn’t existed—

Kate: Since it didn’t—

Paul Tucker: I’m not going to answer that question, because I wasn’t there. I mean, you have to be ... I’m not going to rerun history when I wasn’t in the room, and I didn’t have the information. I mean, it’s well known that the UK regulator, speaking loosely, didn’t permit one of the UK banks to buy Lehman. The reason for that, broadly speaking, was because the UK authorities weren’t convinced that Lehman wouldn’t bring down the combined entity, and transferring a problem from the United States to the United Kingdom.

I think that the central banks need to articulate and publish how they would go about assessing fundamental solvency in a crisis, rapidly. When I first said this to my old tribe, my old community, the response from many, not all, the response from many was, “This is going to be almost impossible. All these things happen very quickly. It has to be improvised.”

Well, I can remember when monetary policy used to be improvised. Now, your listeners might be slightly surprised, the monetary policy process that the Federal Reserve, or the ECB, or the Bank of England, it’s like a General Motors, Ford, factory production process, with the hands doing the work, typically got PhDs or master’s degrees in economics. But they are part of a very structured process that is repeated again and again, because it happens every six weeks. It’s a lot of resources as well. I see absolutely no reason why the same kind of structure couldn’t be put in place.

Luigi: Why has so little attention been put into this so-important topic?

Paul Tucker: I don’t have a complete explanation for that. I think partly because during the 1990s and into the 2000s, people started to identify central banking just with monetary policy, and with a certain type of academic macroeconomics. Also, because there hadn’t been a need in the advanced world for the lender of last resort to act as the lender of last resort for a long time. Except that even what I just said isn’t completely true. I deliberately misspoke, because it had been used in Japan.

One of the things that I think is inexplicable, and doesn’t shine a happy light on North America or Europe, including Britain, is central banks had been acting as lender of last resort in emerging-market countries, and even in Japan, but somehow that was because of something special about those countries. It couldn’t possibly happen to us. Then it did. Of course, one of the great lessons is that anything that can happen eventually will, and you should prepare for the big things.

Kate: One of the functions of the Fed is to oversee financial stability. You’ve mostly been characterizing that as, at least how I interpret it, their lender of last resort functions. But actually, it seems to me, overseeing financial stability is a much broader mandate. In some sense, what we should be worried about is the power of the Fed beyond just their lender of last resort responsibilities. Do you think that those are areas we should be worried about?

Paul Tucker: You’re right. I mean, the lender of last resort function, and the parallel FDIC resolution function, is for when things have gone wrong. But you also need policies to reduce the probability of them going wrong. That’s the regulatory and supervisory function of the Federal Reserve. There’s something big going on here, particularly with regulation. In that, what does a regulator do? A regulator issues rules that certain people or businesses are obliged to obey, and can be punished if they don’t.

Although everyone talks about the biggest thing the Federal Reserve does is monetary policy, and it is a very big thing to do, it’s a very big thing for anybody who isn’t elected to issue legally binding rules, which can be enforced with the coercive power of the state. Where that takes me, and what I argue in the book, is that for an institution that’s insulated from day-to-day swirl of politics, in my view, the function of the Fed or the Bank of England, ECB in this area, should be just to ensure that the banking system is resilient: there will be boom and bust, but when the bust comes, the financial system doesn’t collapse, and that it can continue to carry on providing the core services of payments, so we can go shopping, and credit, so that we can invest, and insurance, and risk transfer.

Then you say, “Well, how resilient should the financial system be?” You say, “Well, actually, that’s a job where you need to involve Congress, because the more resilient you make the system, maybe there is a trade-off with long-term growth.” The truth is that no one knows.

My own view is that the US financial system is quite a lot more resilient than it was a decade ago, but should be more resilient still. But I actually think that ultimately that judgment should be made by people who are elected. Then the Fed and others should get on with the job of implementing it.

Luigi: I don’t know in Britain, but in the United States, the perception is that Congressmen are not that sophisticated to make many of these decisions. How do you answer that kind of criticism?

Paul Tucker: I’ve heard this for years, but whenever I have conversations with people in government here about that, the time horizon tends to be, “We couldn’t persuade them now,” or, “We couldn’t persuade them this year.” Well, of course, that’s true. But what about over five years, or 10 years, or 20 years? These are big issues. A curiosity, by the way, of the United States, is the way the Fed is referred to as the Greenspan Fed, the Volcker Fed, the Bernanke Fed, the Yellen Fed. I mean, in a sense, those are just words that don’t matter, but I’ve worried slightly that the institution doesn’t have a long enough horizon about the deep institutional ... I mean, it’s a terrific organization at dealing with policies used today. But somehow persuading Congress of certain things, you need to have a timeline of 10 years or 20 years, so you won’t finish the work yourself. You need to hand it on to your successors. That’s what it is to be an institution, the orders passing through.

Luigi: To what extent, the resentment that is widespread, particularly in the United States, is a reflection of a sense, as you indicate in your book, that you can’t get rid of some of those people? That many of the decisions that matter for our lives are not taken by elected officials, and we cannot get rid of them?

Paul Tucker: Part of it is historical here, because there wasn’t a Federal Reserve. There were great debates about the First Bank of the United States, and the Second Bank of the United States. But I think there are two other sources of broad concern that come and go. One is this business of, does it bail out Wall Street? We’ve talked about that, but it’s really, really important that when banks and dealers are fundamentally bust, that the equity holders lose money, that the bondholders lose money, that they should not be bailed out.

The third thing is, is it clear enough what they’re expected to do? We don’t live in 1950. In today’s world, it’s really important for holders of unelected power to encourage politicians to set them clear objectives. Then, if they don’t, if politicians don’t set them clear objectives, to articulate what they will be trying to do with the powers that they’ve been given. This is trying to bind yourself in, and it’s trying to make yourself comprehensible to the public. I think that the Federal Reserve chair went on television during the crisis. I mean, that was obviously an important initiative.

In Britain, the central bank governor and others we’ve had have been going on television for some years. I hope, think, carefully, not in a way that competed with the politicians.

But if you’re invisible, if you hold so much power and you’re invisible, people can be alienated by that. So, on the whole, I think, get out there and explain. Explain in as simple language as you possibly can, so—

Luigi: This is the opposite of what Greenspan was saying. Greenspan was famous to say to a journalist, “If you have understood me, I misspoke.”

Paul Tucker: Well, I can’t remember the exact context of the question, so maybe this was a question which he just didn’t want to answer at all. But if one takes it out of context, would that be a good recommendation for central bank communication? No.

Kate: Paul Tucker, author of the new book Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State. Thanks so much for being on.

Paul Tucker: It’s been a real pleasure to be here.

Should a kidney be sold to the highest bidder? Luigi and Kate debate Nobel-winning economist Al Roth whose algorithm for kidney transplants has saved more than 6000 lives. Roth says matching markets could be used for everything from online dating to the global refugee crisis.

Luigi: How many lives did you save?

Al Roth: Well, so first of all, that’s hard to know, but so far there’ve been about 6,000 transplants arising through kidney exchange in the United States.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Kate: On today’s episode, we’re going to interview a Nobel laureate who saved 6,000 lives.

Luigi: Kate, I thought we were running a economics podcast. We’re interviewing a doctor?

Kate: No, we’re interviewing Al Roth, a Nobel laureate in economics who saved at least 6,000 lives through his mechanism to allocate kidneys.

Luigi: Most people outside of economics think that economists only study the behavior of markets, but economists study many things including the way markets should be designed. And not only a traditional market like the stock markets or the oil market, but also markets where there’s not a price.

Kate: When you think of the term markets, you usually think about money exchanging hands, but even in advanced economies, there are markets without money either because people just don’t want to use money or because it’s not allowed. Think about the dating market, for example. Right? People are trying to match up. You’re trying to, in some sense, engage in a transaction that works out for you, but most of the time there’s no money involved even though, I guess, there are dating sites where you can pay, or you can pay a matchmaker, or whatever. But anyway, this isn’t what I’m getting at. On today’s episode, we’re talking about markets where money is explicitly banned. In some cases, these can be what society considers repugnant transactions. Often when it comes to medical practice, such as the exchange of organs, money is explicitly outlawed. Obviously, this makes sense for an organ which you can’t live without—for example, your heart—but actually people have two kidneys, and you can live without a kidney. Yet we’re still not allowed to put a price on a kidney.

Luigi: Now, people might question and say, “Wait a minute. If there’s no price, there is no market. What kind of market are we talking about that hopefully leads to a better allocation?” The challenge in this particular market is there are people who are willing to donate organs. Generally, they try to donate organs to people they care about, but these people are not necessarily compatible, and so you have to find another pair in order to do the exchange. Sometimes you want to do it even more complicated with three pairs of organ/recipient donors.

In a normal market where prices are allowed, if I am a very difficult guy to match, I can start to offer the highest price. This naturally will bring the people to me to try to transact, and this guarantees that the maximum number of possible transactions will take place.

In a market without prices, we tend to be indifferent between two transactions because no consideration is paid. If I swap my kidney with Kate’s boyfriend or if I swap my kidney with my cousin, that is completely indifferent to me. However, because of difference in compatibility, if I swap the kidneys directly with Kate’s boyfriend, I might prevent my cousin to match with somebody else. The complication of the algorithm is to find a way to match pairs that maximizes the number of transplants that can take place. Today Al Roth is going to explain to us how his mechanism saved 6,000 lives.

Kate: Before the innovation that you introduced to the kidney market, can you talk about some of the reasons why it was hard to find a kidney?

Al Roth: Well, the main reason it’s hard to find a kidney is there’s a shortage of transplantable kidneys. This morning, and every morning lately, there are 100,000 people waiting for deceased-donor transplants in the United States, but we only do about 13,000 a year. The main reason it’s hard to get a transplant is there aren’t enough organs. We also can use living donor kidneys because healthy people have two kidneys and can remain healthy with one. There also, there aren’t enough donors, but the additional problem is that even if someone loves you enough to give you a kidney, you might not be able to take their kidney because kidneys have to fit well with your own physiology. That’s where kidney exchange came from. Sometimes you are healthy enough to give someone a kidney, but you can’t give it to the person you love who needs a kidney. I might be in the same situation. I love someone enough to give them a kidney, but can’t give them my kidney, but maybe your patient could use my kidney, and my patient could use your kidney. That’s where kidney exchange comes from.

Luigi: Before we go into the algorithm you devised, in most markets when there’s not enough supply, prices go up, and you have more supply.

Al Roth: Yes.

Luigi: At least that’s what we think in economics. Why this is not a case in this market?

Al Roth: Well, in the United States, and everywhere in the world except in the Islamic Republic of Iran, it’s illegal to pay for a kidney for transplant.

Luigi: That’s interesting, so Iran is more a market economy than the United States?

Al Roth: Yes. Yes, and it’s the only one. You would be less surprised if I said to you, “All of the countries we know of work in a usual way, but the Islamic Republic works differently.” But that’s not the case. One of the things I’ve been led to study through my work in kidney transplantation is what I call repugnant transactions. Transactions that some people would like to engage in, but other people think that they shouldn’t be allowed to. Of course, these are most interesting, most worth studying, if there aren’t obvious negative externalities; we’re all, as economists, we’re already good at understanding markets that some people would like to engage in and other people think they shouldn’t if they have big externalities that harm other people.

With kidneys, that’s not the case or not obviously the case. I think it mostly has to do with worrying about somehow exploiting vulnerable people, the idea that rich people would buy kidneys from poor people and maybe the additional idea that only rich people would be able to get transplants because the price would be driven up. Of course, those are market design issues, but it remains the case that the supply of transplantable organs is much less than the demand and the law requires that the price be zero, that kidneys have to be a gift.

Luigi: So everybody’s making money in the transaction except the donors.

Al Roth: Yes. In fact, the donors may lose money. If you loved me enough to give me a kidney, you would have to incur some expenses. You’d have to come to California probably before the surgeries for some tests. You would have to get a hotel room. You’d have to fly to California, you’d have to get a hotel room a couple of days before your nephrectomy and maybe a couple of days after. You might miss some work. The law actually allows the expenses a donor incurs to be repaid, but it’s very hard in the United States and elsewhere, it’s very hard to repay them.

Luigi: Do you know anything about how in Iran it works? Does it work better in Iran with the price?

Al Roth: It’s a little complicated in Iran. There are some studies of the market. It’s a legal market in Iran, but it’s not one that people are proud to participate in, so there’s some stigma associated with selling a kidney in Iran, which suggests to me that the market isn’t working as well as it should.

An example that the late Gary Becker used to like to give about this was he said how about the transition in the United States from a conscription army to a volunteer army, which of course happened around the end of the Vietnam War. What Gary used to say was that, well, Gary used to say, this is a natural analog for paying kidney donors. What I recall from that time when that debate was going on was there was some concern that American soldiers would come to be regarded as mercenaries because they were going to be paid a wage like a regular job for being soldiers. That hasn’t happened. People are proud to be soldiers. When someone runs for the Senate in the United States, it’s their campaign that emphasizes their military service. When we board airplanes, we’re invited to board after serving soldiers. People are proud to be American soldiers, even though soldiers are paid.

Of course, making something legal isn’t the same as making it unrepugnant. Prostitution is legal in Germany, for example, but I don’t think anyone runs for political office in Germany saying, “You should vote for me because when I was young, I was a sex worker.” It’s still a repugnant market. My sense is that’s going on in Iran with kidney selling. I don’t know a whole lot about that. There are going to be papers quite soon by Mohammad Akbarpour and his colleagues on this subject, but there’s something that although it’s legal hasn’t made it honorable.

Kate: Yeah, I think maybe a closer analogy for the US would be that of plasma donation. Right? A lot of people who need money have to donate their plasma, but you don’t hear people talking about it all the time because it’s not exactly a badge of honor.

Al Roth: Right, and paying for plasma is illegal in lots of places. Canada is debating its laws as we speak. Some of the argument in Canada is that it would be immoral to pay people for plasma and besides, you don’t have to because you can buy all the plasma products you need from the United States. We turn out to be the Saudi Arabia of plasma, and there are-

Kate: Good for us.

Al Roth: ... important medical products like interferon and albumin that are derived from plasma, and we’re giant exporters of those medical products.

Kate: In addition to the requirement that prices have to be zero, are there other constraints legally in the United States to exchanging kidneys?

Al Roth: Well, the main legal issue for living donation is that you can’t pay, so the donation has to be free. Incidentally, of course, kidney transplantation is expensive, as you say. Everyone else in the supply chain is paid. It’s a special program in Medicare. So there are only three entryways into Medicare: you could be over 65, you can be disabled, or you can have kidney failure. Medicare covers the costs of kidney failure for everyone. It’s 7 percent of the Medicare budget. It’s the biggest single program in Medicare. If you have private insurance and you have kidney failure, your insurer will be responsible for you for the first 33 months, after which you become Medicare-eligible. If you don’t have insurance, you’re already Medicare-eligible for kidney failure. It’s a giant American program. Dialysis is the big part of it. Dialysis is much more expensive than transplantation and also not a cure at all. It’s a really good thing for people who have kidney failure and for the American medical system in general, even just financially, it’s a very good thing for someone to get a transplant.

Luigi: Can you explain to our listeners, what is your contribution as an economist in setting up this matching market?

Al Roth: Well, exchange is something that economists study, so the economists, my colleagues and I, so Tayfun Sönmez, and Utku Unver, and Itai Ashlagi, and other of my close analytical colleagues, we certainly didn’t invent kidney exchange. A few were done around the world starting in the 1990s. The first one’s actually in South Korea. There was one in Europe in early 1999 that was met with great repugnance, incidentally. The first kidney exchange in the United States was conducted in 2000, and I had been in a, just a rhetorical way, talking to my class about kidney exchange for some time because I would present a paper by Shapley and Scarf that was published in Volume 1, Number 1 of The Journal of Mathematical Economicsin 1974. They had a model of trading houses with no money, trading a discrete, indivisible good without using money, and my students would say to me, “We use money when we trade houses, you knew that, didn’t you?” I would have to admit that I did know that. I was at the University of Pittsburgh at the time, where a lot of transplants were done, so I started, just as a rhetorical device, saying supposing these were kidneys. You can’t trade kidneys.

When I heard that kidney exchange was starting to be done in the United States, I understood that economists knew some things that would help organize the market. Before we started helping organize the market, there were only four kidney exchanges among the 14 transplant centers in New England. At least one of them had been organized by the patient-donor pairs themselves. Two spouses who were waiting for their spouses in dialysis struck up a conversation, what are you doing here, and one of them said, “My husband, but he has blood type B, and I have blood type A, so otherwise I would give him my kidney.” The other one said, “Oh, you know that’s funny, my wife, she has blood type A, and I have blood type B.” They figured out themselves that they could do a transplant and, and they were able to make it happen in New England. Of course, this is no way to organize a market, so what economists brought to the table was the idea of creating a marketplace that we could have a database of patient-donor pairs and use sensible algorithms to try to propose matches that might go through.

Luigi: Can you give us an idea of a sensible algorithm?

Al Roth: You start with a database of patient-donor pairs, and you need a compatibility matrix. You have to have some idea of which patients can take which kidneys, so which donors and patients are compatible. Mostly, the people enrolled in kidney exchange in the United States are incompatible with their intended donor. You have these patients and donors. The donors are healthy enough to give kidneys, but they can’t give it to their intended recipient. You can start guessing, based on the data about proteins that the donor has, the human leukocyte antigens and the antibodies that the patient has, you can start guessing which donations might go through. That allows you to start looking for exchanges, and you can then run the various algorithms. The first one we proposed was top trading cycles. You can look for cycles of exchange that might go through. Now, we wrote a paper on that and we sent it to all the kidney surgeons we could think of. Only one answered, and that was Frank Delmonico in New England. We helped him form the New England Program for Kidney Exchange.

One of the first things they said to us, is they said, “Look, you have this top trading cycle algorithm. It can propose cycles that are big, but because we do surgeries simultaneously, we can’t do big cycles. To just exchange between two pairs, to do everything simultaneously, you needed to do two nephrectomies and two transplants. You need four operating rooms. You need four surgical teams all available at the same time. That’s it. If you want to help us do kidney exchange, you have to help us organize the market on just exchanges between two pairs,” and that’s how we started. When you do that, you go back to old, elegant results and graph theory about matching and undirected graphs, but of course, you lose a lot of potential transplants. When Jevons wrote about barter, what he wrote about, the difficulty of barter, the reason we don’t see much barter exchange is the difficulty in finding the double coincidence of wants.

When you do exchange between two pairs, they each have to have a kidney that the other one wants. Because some patients are highly sensitized, which means they have trouble finding a kidney that they want, it’s hard to find just that double coincidence, but if you could enlarge it to larger cycles, three pairs, say, where pair one gives a kidney to pair two, who gives a kidney to pair three, who gives to pair one, now you enlarge the possibilities and so forth. Eventually, we managed to convince our surgical colleagues that solving the logistics would be worthwhile, and we could do larger cycles. That helped, and then we were already using integer programming algorithms to find, for instance, the maximum number of transplants you could get from a given population of patient-donor pairs. We don’t actually simply maximize the number of transplants because there’s some concern about the quality of the transplants, but you can think about it as maximizing a weighted sum of the number of transplants.

More recently, we get a lot of benefit from chains that don’t have to be done simultaneously, that are started by a non-directed donor. A non-directed donor is someone who is moved to give his kidney and doesn’t have a particular recipient in mind. You can organize a chain started by such a donor by having the donor give to some patient-donor pair, and then the non-directed donor gives to a patient whose donor continues the chain by giving to another patient-donor pair, and so forth. If you do it so that each pair receives a kidney before they have to give one, if a link breaks there isn’t a tragedy where some pair has had a surgery that didn’t help them and no longer has a kidney with which to participate in kidney exchange.

Some chains have been very long. For a time at least, I don’t have the latest data, the average chain in the United States had five transplants in it, so 10 people in the picture, five donors and five recipients. We get really a lot of use out of chains. More than half of the kidney exchanges that go on in the United States now come through chains. Kidney exchange in the United States accounts for 10 percent to 15 percent of the living donor transplants in the United States. On the one hand, that’s a great success. On the other hand, these victories I’m telling you about are victories in a war that we’re losing because there’s a diabetes epidemic. There’s other things going on, so the number of people in need of kidney transplants is growing.

Luigi: What are the major obstacles to setting up bigger and bigger exchanges everywhere?

Al Roth: Well, there are lots of obstacles. I don’t understand them all. Some of them surely have to do with incentives. Dialysis is a very big business, and many of the people who could profit from transplantation are in dialysis. The law requires dialysis centers to inform patients about the possibility of transplantation, but it seems possible that they do so in a way that isn’t effective in encouraging patients to seek out transplantation. I think one of the big obstacles is reaching people who have kidney failure early in the course of their disease and letting them know that transplantation is a possibility.

Another one is letting them know that kidney exchange is a possibility because I think what can often happen is you need a transplant, maybe you don’t know about living-donor transplants, or maybe you do but the people in your family are incompatible, or have kidneys that are compromised themselves. A lot of kidney disease has a genetic component so that someone who has kidney failure, a lot of their relatives might have kidney failure too. I think that if people, early on in their diagnosis, were aware that transplantation, and in particular kidney exchange, were possible, then we’d see more living-donor transplants. Again, Gary Becker used to say, “There’s no shortage of kidneys, there’s a surplus because you have two.”

Kate: Based on your research, what real-world problem do you think needs solving the most?

Al Roth: Well, there are lots of matching markets, markets where you can’t just choose what you want, but also have to be chosen, that aren’t working very well. Of course, the ones that are working worst are not necessarily the most ripe for redesign. Sometimes the reason a market is working badly persists in keeping it working badly, but one matching market that’s working very poorly right now is refugee resettlement that we’re seeing lots of big migrations of people and we’re not good at resettling them, but neither are we good at keeping them where we would like to keep them. It’s a matching market.

You can’t tell refugees to stay at home. Neither can they choose where to go. When you see people putting their children in small boats in the Mediterranean, it’s clear that there’s something wrong with the way that market is working. But of course, it faces all these very serious issues. Lots of people, well lately, there’s been lots of anti-immigrant feeling around the world, not just in Europe, but also in the United States. If we think that there’s going to be large-scale human migration in the future, which there might be in the coming century, for example if the sea levels rise, then we’d better learn from our current failures how to do it better. I would think that that’s something that we should be very actively thinking about.

Kate: Who do you envision on the other side of that match? Is it a host family that’s interested in taking in a refugee family? Is it a municipality that’s interested in piloting a program, or is it a state?

Al Roth: I think that that’s a great question. There’s matching that happens at each moment. The easiest part to tackle, and the part that market-design economists have started to tackle, is how do you place, and house, and take care of refugees who have already been granted asylum in your country. Once refugees are granted asylum, you have to settle them. There was a lot of sentiment among refugee resettlement authorities that refugees should be spread thinly around the country with the hope that that would make them assimilate easier. Of course, when we observe refugee communities, that’s not how they like to be settled. The example I like to give is that there’s a big Somali-American community in Maine. It’s not because of the cross-country skiing that attracted them. It’s that there started to be a Somali community there, and it turns out if you’re a new Somali migrant to the United States, that’s a nice place to go where there are people who can help you out, get started. We have to start thinking of not randomly allocating refugees but thinking what is needed to help them integrate into the host economy.

Then there’s the harder question of who should be granted asylum in which countries. Again, when you see people in little boats, it suggests that we’re not doing a good job, either of the deterring them from coming or of placing them effectively. I say little boats, I’m thinking of Europe and the Mediterranean. In the US, we see unaccompanied children showing up at the border. The system is working very badly. We are not in control of it. That’s something that I would like to see us do a better job of.

Luigi: We have talked about organs. We have talked about immigrants. Can we talk about a lighter application of this, because also the dating market is a matching problem, right?

Al Roth: Absolutely.

Luigi: And generally we don’t use prices for that.

Kate: I have written down, “What do you think about dating apps?”

Al Roth: Right. Well, dating apps are great to talk about because, of course, they’re matching markets and they run into the same sort of generic problems that all marketplaces run into. First, to be a successful dating app, to be a successful marketplace, first you have to make the market thick. You have to get lots of men and women or people who want to date each other on the site. Then you run into congestion problems if you ... Some of the early dating sites, there are so many men and so many women that the internet traffic in which they tried to meet each other starts to be spammy. People with attractive profiles get more emails than they can answer so people who find their emails aren’t being answered send more and more superficial emails to more people, and that gets you a bad equilibrium. A new generation of dating sites came up that tried to curate the email to say that only women could initiate a conversation, for example, or to get rid of conversations entirely and just have people swiping left and right. Those are efforts to deal with congestion.

There’s the whole question of safety and reliability, of should you curate the people on the site so that you aren’t afraid of meeting them. Nevertheless, Americans seem to meet each other, in increasing numbers, through internet dating sites that result in marriages. I think that that has to do with the fact that other matching markets have become less thick. Right? There was a time when few Americans went to college and it made a lot of sense to marry your high school sweetheart because that was the moment in your life when you knew a lot of people of marriageable age, of your age, who were single, and that would be a good time to get married because afterward it might be hard.

Increasing enrollment in colleges meant that wasn’t the last thick market you were going to see. Increasing female participation in the labor force meant that all of a sudden we had people graduating from college and going into work environments where the marriage market might not be so thick. It’s not always so easy to marry the person in the next cubicle. I think part of the growth in internet dating sites is related to the rising age of first marriage and is an effort to keep the market thick, to give people opportunities when they don’t have them day-to-day. I imagine that that’s going to remain a important part of courtship.

Kate: Thank you so much, Al, for joining us.

Al Roth: Well, thanks for having me.

Luigi: Al is a great guy. His contribution is extremely important for economics but more importantly, is also very important for humankind. However, listening to his discussion and listening to how complicated it is to do these matches even with his algorithm and how many people are left out, the question arises: Why don’t we pay for people to donate an organ? Of course, not your heart because it means that you are killing yourself, but what about a kidney? People can very happily live without a kidney. If they’re willing to donate a kidney for money, why is it so wrong?

Kate: Luigi, how much money would you have to be paid to sell your kidney?

Luigi: Wow, that’s a good question because I would give a kidney to my wife and my kids, but I don’t think I would sell it for money.

Kate: All right. Fair enough. I’m not sure there’s a price that I would accept either.

Why was Steve Bannon in Rome last week? Luigi and Kate look at the recent formation of Italy's populist government and analyze Bannon's attempt to forge a similar left-right coalition in the U.S. uniting supporters of Bernie Sanders and Donald Trump.

Fareed Zakaria: So why did I come all the way to Rome to interview Steve Bannon? Well, Italy’s politics were in absolute chaos this week, and Bannon has a lot to say about the subject.

Steve Bannon: We’re coming up on the 10th-year anniversary of the financial crisis. The fuse that was lit then, that eventually brought the Trump revolution, is the same thing that’s happened here in Italy.

Kate: Hi, this is Kate Waldock from Georgetown University.

Luigi: And this is Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in Capitalism today.

Luigi: And most importantly, what isn’t.

Fareed Zakaria: What a week to be in Italy. I was invited here to Rome by Steve Bannon, who has been an avid supporter of the populist movement here—a movement that has created even more political chaos than Italy usually has.

Kate: Luigi, you were just in Italy this past weekend, right? So are things absolutely wild over there?

Luigi: Yeah. I think things are pretty crazy, but there are a lot of people who are upset. A lot of people that are interested in what’s happening. And I think that what’s happening should be watched also from the United States, because it can be game-changing.

Kate: And I think they were being watched in the United States, right? As of the end of last week, the stock market had tanked, it was down, what, a couple percent? Mostly on news from Italy. There was a lot of volatility due to news from Italy, so I think people are actually paying attention over here.

Luigi: Yeah, but—it’s surprising, said from a financial economist—but I think that the biggest reason to watch Italy is not from a financial point of view, and there are plenty of reasons to watch it from a financial point of view, but from a political point of view.

Believe it or not, Italy is 20 years ahead of the United States. Unfortunately, 20 years ahead down the tube, but it’s 20 years ahead. And I think that you want to watch what’s happening there to understand what might happen here.

Kate: OK, so just to recap really quickly, we did an episode on Italy just about two months ago called “Worse than Brexit,” and on that episode, Luigi shared with us a little bit of insight into what’s going on in Italian politics today.

Luigi: Eventually, a coalition between these two parties, who are anti-establishment, the League and the Five Star, took place after a lot of problems, shenanigans, that I will skip, say for brevity, but I think that the important point is two parties that are kind of like Bernie Sanders and Steve Bannon getting together and form a government.

Kate: That’s insane.

Luigi: And this seems so crazy, in fact, you laugh, Kate, but I think it is not that crazy after all. And that’s what we would like to understand is why they got together, on what basis, and what does this imply for the rest of the world? Because, as we heard in the clip in the beginning of the podcast, Steve Bannon is in Rome, claiming that this is a victory of nationalists against the globalist elite. And is it, and is this the sign that things are changing? I think that’s what we want to discuss today.

Kate: I know you said for the sake of brevity, you don’t want to get too much into the details, but why were markets so spooked as of the end of last week?

Luigi: At some point in the negotiation for forming this coalition, the two parties converged on the name of an economic minister, who has positions that are quite anti-Euro. The president said that he did not want to appoint him as economic minister, because of the impact this will have on the market. This is at the borderline of the constitutional powers of the president. In our constitution, the president is a bit like the queen in England; the president appoints the prime minister and, under the suggestion of the prime minister, appoints the minister. He does have some power in saying no, but generally it is not for ideological reasons. If you appoint a crook as justice minister, I think the president has all the right to say no. If you appoint somebody who’s perfectly qualified to be, but has a different ideology, in principle, you’re not supposed to say no.

But I think the reality is, there was a lot of uncertainty whether one of the two parties in the coalition, particularly the League, wanted to be part of this coalition. My understanding is this tension with the president was used as an excuse to get out and then when they got out, the market was spooked even more. So, they realized that they’d better do something, otherwise the country can fall apart and they are blamed for this lack of government. I think, eventually, sanity prevailed and they did form a government.

Kate: Can you tell us more about how the League is like Trump’s party, and how the Five Star Movement is like Bernie Sanders’ party?

Luigi: I think, for American listeners, the League is relatively easy to explain because, in spite of its historical origin, today it’s very much like a Trump party. In fact, the leader of the League, Salvini, was one of the Western leaders to endorse Trump. They are anti-immigrant. They are very much pro-business, especially pro-small business. They are in favor of cutting taxes; they even proposed a flat personal income tax, which really is not that flat, but at least they claim it is that way. They are really kind of a Trump party, I would say even a Bannon party, because Trump is the combination, in my view, of a populist root and a plutocratic side. I don’t think there is any plutocratic element in the League; it is only the populist side.

Kate: What about the Five Star Movement? How are they like Bernie supporters?

Luigi: The Five Start Movement is, in my view, the most interesting because, first of all, they didn’t exist 10 years ago. And in 10 years, they went from being nobody to express the prime minister. They did that without being supported by any big business, by any big donors, by anybody, and having all the establishment, all the media against them. In a sense, it’s a bit of a miracle. Imagine that you have Jon Stewart hooking up with a Silicon Valley genius—

Kate: Elon Musk.

Luigi: —yeah, maybe Elon Musk, and forming a party together and really going grassroots. Because they start so grassroots and so in a non-ideological way, they are, first of all, not a strong ideological party and trying to express what ordinary people care about. One thing, they are very pro-environment. Which is quite unique in the Italian environment. They are pro-universal basic income. And they are very strongly anti-corruption and anti-establishment. So in that sense, they might resemble a lot to Bernie Sanders’ party. On the other hand, they are, I wouldn’t say anti-immigration in general, but they are worried about the consequences of the way immigration took place in Italy. That is one of the points of connection with the League. They’re not exactly a Bernie Sanders party, but I would say they are pretty close to a Bernie Sanders party also in the way they finance themselves, which is very diffused. Not having strong donors supporting it.

Kate: So now that the League and the Five Star Movement have come together to form this coalition government, what are some of the policies they’re proposing?

Luigi: In a move that is unprecedented in Italian politics, they actually spent almost a month creating a contract between the two parties to discipline what they’re going to do in government. It’s a bit like what Angela Merkel did with the Social Democrats in Germany, and this is fairly usual in other countries. In Italy, it’s unique. However, this document contains mostly how they’re going to spend the money, not how they’re going to raise the money. Which, of course, creates some problems, given that Italy does not have the flexibility of running such large deficits, given the amount of debt it already has. The characterizing element of this is some form of a flat tax, even if the word flat, as I said a second ago, is not precisely right. But some form of fiscal reform that will lower the burden of taxation on individuals and on small corporations.

Second, some form of welfare. Again, it’s not exactly universal basic income because they’re going to make it conditional on searching for a job. But it’s going in a direction of increasing welfare in Italy, which is quite underdeveloped. And then they have a number of initiatives that are much more on the justice side. For example, in Italy, there is this absurdity of having a very short statute of limitations. If you commit a crime, and your lawyer is good enough to drag trial with all the excuses, you end up being acquitted because of the statute of limitations. This law was introduced by Berlusconi many years ago in order to get out of a number of trials. But of course, it not only got Berlusconi off the hook, it got a lot of other people off the hook. In fact, it’s a fairly common idea today in Italy that you can get away committing crimes, especially when it comes to financial crimes, without paying for them.

Last but not least, they want to renegotiate many things in Europe. The most important one is the way immigrants are handled. There is an agreement called the Dublin Agreement that basically gives all the responsibility of accepting and nurturing and supporting the immigrants in the countries that first received them. And then, it makes it difficult for them to relocate those within the European Union. Because most of the immigrants now are coming from Libya, Italy is the country with this enormous amount of immigration, and we don’t have the resources to handle them properly, and the other countries don’t want to accept them. So we are not the country of destination of most of the immigrants, but we are the country that is burdened the most.

Kate: So there seems to be a lot going on in Italy, but I would say that this is hardly new, right? We had Brexit. We had Marine Le Pen in France. We had the populist elections of Orban in Hungary. And then we recently had populist elections in Slovenia. So it seems like Italy is just part of a bigger movement across all of Europe.

Luigi: There is definitely a common element in all these movements. However, what I think makes Italy somewhat unique is it has two populist movements. A more right-wing one and a more left-wing one. What makes it extraordinary is that these two movements decided to form an alliance and, at the moment, they’re running the county. While Trump won an election, first of all, the coalition that led Trump to election is not just a populist coalition, there is a populist part and there is a traditional Republican part. And there is definitely no element of left-wing populism in the Trump administration. This is the first contrast between populists and, if you want, globalists. Even in England, where you had Brexit, the Theresa May government is struggling, but you cannot say that it’s completely an anti-globalist government, while I think that the government that is forming today in Italy is of that type.

Kate: So why is this happening in Italy first?

Luigi: I think this is the result of two factors. One, the very poor economic conditions of Italy. Per capita income is lower than 20 years ago. We had two crises, one after the other, very costly. And we have a very high level of unemployment, especially in the south of Italy. The second is, Italy has 20 years of Berlusconi, more or less, on its back. And 20 years in which the televisions and the main media were somewhat influenced by one description of the world. What happened in the last government, while in principle this government was of the Democratic Party, it had the explicit or implicit support of Berlusconi. So there was kind of an alliance between the elites of left and right that naturally led to a counter-alliance of the people who felt left behind, whether they were ideologically more on the left, or ideologically more on the right.

Kate: Do you see a parallel between Berlusconi in Italy 20 years ago, versus Trump in the United States now?

Luigi: I think I see a parallel between what’s happening and the feeling that people have in the United States today, and the feelings of Italy because it is true that there is a lot of left and right ideology based on civil rights and abortion and religious beliefs, but very little difference in terms of economic discourse. Both the Bush administration and the Clinton administration are very much in the pocket of business. I think that this is exactly what Italians feel about the political environment, that whether it’s left or right, it doesn’t really make a difference because at the end of the day, they play the same strategy, the same policies with a little bit more politically correctness on top, but that’s not what changes the life of somebody who’s unemployed. Whether you are more politically correct doesn’t change his future.

Kate: But I don’t think it’s fair to say, “Oh, there are some cultural differences between the US and Italy, but at the end of the day there’s this unifying theme in economic circumstances.” Because those cultural differences, I think, are huge, whereas the unifying economic circumstances between discontent in the US and discontent in Italy are actually quite big. We didn’t realize two recessions. Our unemployment rate right now is back down to 4 percent. Growth since the financial crisis has been higher than growth in Italy. So we haven’t had it as bad as you had it in Italy.

Luigi: I think you are absolutely right, and that’s the reason why you don’t have such a strong coalition, yet. But imagine things get worse, I think that’s a distinct possibility. Second, I think there is much more variety within the United States than within Italy. There’s a lot of geographical variety in Italy, but I think in terms of growth, it’s true that on average the United States grew. It’s also true that if you look at the median income in the United States, it did not grow for 40 years. So while it’s true that the average income is growing, I’m not so sure that the median American feels that.

Kate: So then you think that this is an epidemic for all of Western societies. That there has been a slowdown in median incomes and, what? You think that this will inevitably lead to the convergence of these populist movements between the right and the left in all Western countries?

Luigi: I think it’s a distinct possibility we need to be worried about because I think that this convergence arises from the convergence of interests on the other side. The fact that, at the end of the day, leaving abortion and gay rights aside, there is not that much of a difference between Bush and Hillary Clinton. So, if they are all too similar, I think that on the other side, people are saying, “Why are we left behind?” The answer is, because of the influence that corporations tend to have, investors in general tend to have on US policies. But also, in the world policies. I think that what is stunning to me, you take the biggest leaders of left-wing movements across the world and they all end up becoming rich catering to large corporations. From Tony Blair, who goes around giving speeches for millions, to Bill Clinton himself, to Schröder, who was the leader of the SPD in Germany, to Matteo Renzi, who is still in parliament, is the former prime minister, goes around giving paid speeches all over the world.

If these are the leaders of the left, I think there is room for a new left. And I understand, this takes a realignment. This does not happen overnight. But let me tell you this funny story: In 2007, I think, Beppe Grillo, who is the founder of the Five Star Movement, wanted to run in the Democratic primary. The guy in the Democratic primary said, “We don’t let you run, go found your own party.” And he did, and now he won the election. That’s a pretty good story, but that is what it takes to realign. I think that if the Democratic Party pushes out everybody with different ideas, maybe there will be another party coming. Another party with some of the characteristics of the left, but not others. What is amazing is, in the world of social media, this is more possible than it was in the past. As the Trump election shows, having all the established media against you is almost like a badge of honor. In the past, it was a kiss of death. Today, it might be worn as a badge of honor and might bring you to the White House.

Kate: I think another key difference between the US and Italy is we don’t have Brussels. We don’t have the EU and the ECB taking the other side against us. There’s no overarching governing body that we feel like is disenfranchising us, whereas I feel like anti-eurozone or anti-Euro sentiment in Italy is what’s bringing a lot of these parties together.

Luigi: Wait a second, you have Washington. The ultimate swamp, right? All the reaction that there is in Europe against Brussels is the typical reaction that people have here against centralized government and against a government in Washington that is competently dominated by vested interests, and not responsive to the needs of the people. I don’t think that there is any difference in that dimension.

Kate: No, but that’s not a fair comparison because Washington would be like ... anger against Washington would be like anger in the Five Star Movement against the establishment within Italy. I see that comparison. But there is also this anger against a broader party of other countries in which Italy feels disenfranchised.

Luigi: I think you are right in the issue that you can play on some ethnic differences in Europe you cannot play in the United States. People in Colorado might feel that Washington is a swamp and that Washington is taking away powers and money from them, but they don’t feel that people in Washington are necessarily different from who they are. And people in Washington don’t make fun of people in Colorado.

What we have seen, especially in recent weeks, we’ve seen the German magazines and newspapers making fun of Italy using the worst stereotypes on the face of earth. Something that probably, in the United States, will disqualify you to speak in Parliament. These were not fringe magazines or newspapers, these were the mainstream media. Even some mainstream politicians. There was one politician that said, “Financial markets will eventually teach Italians how they should vote.” Which is clearly a very anti-democratic thing to say. They don’t even resign when they say these things. Sometimes they apologize, sometimes not. I think that that is really the difference. There is more ethnic fractionalization within Europe than there is within the United States.

Kate: Speaking of fractionalization, this brings me to my last point which I think distinguishes the US from Italy, which is that we have a different history. We have a unique and sad relationship with slavery that still persists and is very dominant in our culture today. We have things like Black Lives Matter and we also have a lot of movements around police brutality towards young black men. I don’t think that that is as strong of an element of the debate in Italy as it is here in the US. I also think that there are other social issues that are much more absent in Europe. For example, gun control. That’s a huge issue in the US. That’s very fundamental to the divide between the left and the right and it’s not at all present in Italy. Even though you might say that gun control is a relatively minor issue compared to economic growth, I think in the minds of most Americans, it’s something that no one is willing to compromise on, and it’s something that will always keep the parties apart.

Luigi: I think you’re right. Of course, every country is different, and the importance of the legacy of slavery in the United States is a tremendous legacy that other countries in Europe don’t have. Even if, now, they do have racial issues because the number of immigrants has increased quite a bit. The issue of gun control is a big dividing issue, so it is possible that the coalition will never form. However, I think that there is an element of truth in the tension between a group of people, let’s call them globalists, that are benefiting tremendously from globalization—and let’s be fair, we are part of that—and a group of people who are left out.

What we need to think is how to fix the problem before this coalition is forming, because I think it would be very divisive.

Kate: I think the solution to how we can prevent a left-right populist coalition in the United States has to stem from a deep and true understanding of what the cause of all this resentment is. There’s some people who claim that these populist movements are coming about as a result of the financial crisis and the inability of Western democracies to heal from the financial crisis. And then there are others who think the roots are much deeper and that they stem from the rise of globalization and technology that started taking place in the ’70s and ’80s. I’m more in the camp of people who think that populism is the result of globalization and technology, and I think that the only solution to these challenges, the challenges that they pose to Western democracies, is to increase the quality of our education so that we’re more competitive.

At the end of the day, though, maybe none of this matters. Maybe Trump is going to implode in a violent Tweetstorm and maybe the coalition between the League and the Five Star Movement in Italy is going to fall apart because ideologically, they’re actually pretty different. So who’s to say that the remedy isn’t going to be that these current governing parties in the US and Italy just fail one day?

Luigi: It’s entirely possible, but I think we should watch this experiment with interest because, if it succeeds, it might change the way we look at politics, also in the United States.

Tristan Harris, a former design ethicist at Google and “the closest thing Silicon Valley has to a conscience,” warns Kate & Luigi about targeted digital advertising that creates individual, orchestrated experiences dictated by nothing more than an algorithm.

Tristan Harris: We live right now in two billion Truman Shows. Two billion individual, personalized, orchestrated experiences where an algorithm is deciding exactly what we personally will see.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales from the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Tristan Harris: If I talk about persuasion right now, in this room, we’re probably all thinking, “Well, we’re the smart ones here at University of Chicago. If we talk about persuasion, we’re only talking about those people over there, those manipulatable people. But they’re so gullible.” But actually, persuasion works on everyone. A chimpanzee doesn’t get to choose whether a banana is seductive to its instincts, that’s just how we work.

Kate: All right, so what we’re actually going to talk about on today’s episode is how tech manipulates our brains. We had the opportunity to talk to Tristan Harris, who is known for being the closest thing Silicon Valley has to a conscience. Now he actually started by founding a company called Apture, which was acquired by Google, and he worked as a digital designer for Google for a number of years. Then, he went off to start his own nonprofit called Time Well Spent. He spends a lot of time thinking about, as well as researching, this idea that tech companies have the ability to manipulate our perception.

Luigi: Tristan told us that it was very important for him to start as a magician, at least as a kid he was a magician.

Tristan Harris: It’s super important. Yeah. When I was a kid, seeing the world through the eyes of a magician flips your whole worldview around, because instead of looking at choice as an authoritative thing that human beings are doing, basically you’re looking at reverse engineering and breaking down the entire foundation of this thing that we tend to think of as being in a secure enclave, called a mind. A mind does this secure thing called choice making. Being a magician and having that worldview is all about flipping that completely inside out, using all evolutionary instincts, physiology, attention, psychology, against the spectator or subject, and seeing if you can control, shape choices. Make them believe or see things they don’t see, control attention. It teaches you that those things are highly influenceable.

Luigi: Yeah, but how is that related to your concern about the power of digital platforms today?

Tristan Harris: Well, because essentially what we’ve done is we’ve created a channel by which essentially you have direct access to the human skin of two billion people, meaning you can buzz something in their pocket. You can then use colors, social cues. Basically everything you see on a screen is designed by engineers who people never meet, who basically know a set of persuasive techniques to engage or hook you. That’s the addiction layer.

This problem has two layers. The first is, can we hook two billion people so that they check their phones 150 times a day, from the moment they set their alarm when they go to bed at night, to the moment when they unset their alarm when they wake up in the morning? The answer is yes. That first layer is like, “Can we establish a matrix by which two billion people are jacked in to an environment controlled by two or three companies?” The second problem is that you then create these advertising models where basically anyone has access if they pay the guy at the front door of the control room, aka Facebook or Google, to directly target thoughts and influence to any vulnerable population that they want. I think both these things set up huge externalities and a society that we don’t want to live in, and that’s why we have to change it.

Luigi: You use the term we. What part did you have in that?

Tristan Harris: Well, so I was a tech entrepreneur. I should say that too, in the sense that I know the system from the inside out. I used to have a start-up called Apture. We got acquired by Google. I was friends with a lot of people who made this stuff, so we is ... I went to Stanford. I had a computer science degree. The we is the people in the industry. People don’t often understand how this stuff really works. These are not just products and services we’re trying to build to help serve people. That is a motivation, but the main thing is can you get it to work? Can you get it to grow? Can you get users? Can you get usage out of those users? Can you get them to come back tomorrow? Those incentives mean that we, the people, the engineers, the designers, are really shaping culture. We’re shaping politics. We’re shaping public health, and mental health, and loneliness. These are all externalities of a system like this.

Kate: Was there anything about your time at Google that made you uncomfortable in your work? Did that lead to you leaving and starting Time Well Spent?

Tristan Harris: Yeah. It wasn’t something that Google specifically was doing, just to be really clear. That’s not just to be diplomatic. I mean, I was within Google. They acquired our company. I was a product manager on Gmail. It’s not like Gmail’s goal was to hook people to slot machine-like rewards where you pull to refresh, to see if you got new email, and it was an intentional, deliberate, like, “Let’s turn this thing into Vegas.” But I was uncomfortable that of all rooms in the world where there would be people who cared about email’s impact on the stress, mental health, well-being, anxiety, and distraction of the people that it was influencing, I didn’t get a strong enough sense from that team that we had that responsibility. That email was where information knowledge workers spent a third of their day.

I got concerned about this, and I made a presentation at Google. It was a slide deck. I sent it to 10 people, basically asking for feedback. The slide deck basically said, “Never before in history have 50 engineers in Silicon Valley shaped what two billion people will think and do with their time every day. We have a moral responsibility as Google to get this right, from the perspective of someone who understands how people’s minds work, and cognitive biases.”

This presentation spread throughout Google virally. I got a meeting with Larry Page. It was really more about the industry overall. But I thought Google ... The reason I stayed is Google is one of the few companies that can do something differently. YouTube can’t. It’s stuck in this maximizing watch time model. But Android and Chrome are kind of the gateways between a human being’s brain, and then all these things competing for their attention. So the opportunity was, can we make Android and Chrome better defenders of human agency? I couldn’t unfortunately get much to happen while I was inside of Google.

Kate: I think it’s worth taking a step back and talking a little bit about how companies like Google and Facebook make money. We’re used to the product end of the platform. We’re used to using Gmail or Facebook to post pictures. Or Instagram to post pictures, or to tell our friends about our status. But those aren’t in and of themselves ways that the companies make money. They make money by collecting a ton of information about what we do: from the way that our faces look, to the type of words that we use when we describe our days, to the type of words that we use in our emails.

They aggregate that information, and they try to use it in the best way that they can, to target advertising towards us. The way that they’re actually making money is by charging people who are willing to advertise on their platforms, to be able to target ads to us specifically. If I have, let’s say, if I own a store and the store sells clothing to women, it sells Radiohead band t-shirts, and I want to target my ads to women between the ages of 30 and 45 who live in Pennsylvania, who like to listen to Radiohead, I can go to Google and Facebook and say, “Target my ads specifically to these people.” They have the power to do that.

Not only do they have the power to do that, but they can target it even more specifically to people who have been interested in those types of ads before. Or who when, say, scrolling down their news feeds, have stopped and paused, and looked at ads that are similar to mine before. They have this ability partially just through data, but also partially through machine learning and AI, to target things very specifically.

Luigi: Kate, you’re absolutely right. But I think it would be useful to remind our listeners what is unique about digital platforms, because we keep using this term. But besides the digital, what is important is the platform component. Google and Facebook are what economists call two-sided markets. Two-sided markets, I will explain in a second what they are, are very unique in many characteristics. Let’s start with an example from the 20th century, so even older listeners can appreciate it. Think about the market for classified ads that used to be there in traditional newspapers. You want to buy a house, you want to buy a refrigerator, and you want to go to the place where most people are advertising, or posting their refrigerators or their homes. Vice versa, if you are trying to sell the refrigerator or sell your home, you want to be in the place where most potential buyers are.

You have both the buyers and the sellers trying to go to the same place. The platform is the place where they meet. In the old days it was a newspaper. Today it is Facebook, or to some extent it’s Google. What is unique about digital platforms is you have kind of two clients at the same time. You have the buyers and you have the sellers. You want to have the highest number of buyers so you can attract the sellers, and vice versa. So you’re often trying to subsidize one side in order to attract the others.

In the particular case of Facebook or Google, they subsidize us as consumers, because we get the product for free. But they charge, and sometimes they charge very high prices, to the advertisers. So when we think that we get the product for free, we don’t really get the product for free, for two reasons. One is that we pay a higher cost of goods, because the advertisers are paying a higher price for advertising. Second, we pay with our data. When you quickly sign on to, or agree to the terms of use of Facebook or Google, you are giving away a lot of confidential data that Google and Facebook use to target those ads.

Kate: Yeah, you’re totally right. There are plenty of qualms that you can have with the fact that Facebook and Google do target advertising so specifically. But just in the context of whether or not they actually sell data, I think it’s important to make three distinctions. One is that they definitely target advertising based on the information that they have. Second, I wouldn’t necessarily call that selling data, but you can decide on your own whether or not you think that’s problematic.

The second way that they use data is that some companies or apps interact with the data if you want them to. For example, if I have the Tinder app on my phone, the easiest way for me to connect to Tinder is to let Tinder use all of my information on Facebook. It’s just easier to set up. That way Tinder can quickly import all my friends, and they can know who my network consists of. So it’s easier for me to get people or matches that I think I would like. So I’m OK with that too. I mean, of course there’s a question of whether or not that’s OK. But there is some agency in that, in the sense that I’m allowing my Tinder app to use my Facebook data.

Then finally, there’s this question of companies like Cambridge Analytica, to whom Facebook just handed over some data. The way that it was set up was an opt-out process that no one really knew about. So by signing up for Facebook, you were signing over your rights for Facebook to be able to turn over to Cambridge Analytica whatever they wanted. If you really wanted to prevent that from happening, you would have to figure out how to opt-out, which was pretty complicated.

Luigi: Tell us more about the Persuasion Lab at Stanford. What does it do, and what does it teach?

Tristan Harris: Well, so back to the magician’s metaphor, we tend to think that people cannot be persuaded. If you put on a VR headset, you don’t get to choose whether or not all your millions of years of evolution tell you, “Do not take that step forward, because you’re about to walk off a ledge.” I can know with my mind that there is no ledge in front of me. But if I put on a VR headset and that ledge looks like it’s right there, I’ve got too much evolutionary instincts driving me to say, “I cannot take that step off.”

Persuasion is understanding what are these immutable, deep-rooted features of the human mind and our motivational system. It really was teaching engineers to think about the world in that way. It wasn’t this sort of diabolical manipulators’ lab that was trying to teach you to ruin people, to addict people, or manipulate anyone. In fact, the whole point was, could you use it for good. Could you help people go to the gym if they wanted to go to the gym, or floss, or establish social norms that they wanted? But there was always a danger. In fact, the final class was actually about the ethics, and the future of ethics of persuasive technology.

One group came up with the idea that what if in the future, you had a perfect profile of what would persuade every single mind uniquely. With your mind, are you more motivated by hearing that the New York Times says it’s true, so an authority figure says it’s true? Or are there certain people, out of all the people that you trust that I could tell you that if they think it’s true, then you’re much more likely to believe that it’s true? What if in the future we had this perfect map, that for every single mind, you knew exactly which kinds of things persuaded it? That’s exactly what Cambridge Analytica is 10 years later. Cambridge Analytica is a metaphor for an entire system that basically is also what Facebook intrinsically is. It’s not really about Cambridge Analytica. It’s about systems whose business model is coupled with how best can I service the advertiser, the manipulator, to successfully influence your thoughts.

There’s a huge contradiction built into Facebook. One of two things is true. Either it’s true that it’s a neutral platform, it’s just a tool, users are responsible for their own choices, and they get what they want—in which case, advertising is not effective, and they’re deceiving their advertisers—or it’s true that advertising is really effective, and they’re selling advertisers on that, and it is the best tool in the world to influence and manipulate every audience, which is what their entire business is based on, and I think is also more likely true to the point. But so far these platforms have tried to claim that they’re just these neutral objects. They’re just sitting there waiting to be used. You choose who your friends are. You choose who you like. You choose what comments you make.

That’s kind of like a magician. If I say, “Well at the end of a trick, did you choose whether it was a face card or a number card? Yes you did. Did you choose whether it was a red card or a black card? Yes you did. So you made the choice independently, did you not? I didn’t influence your choice in any way.” You think, you nod your head like, “Yeah, I did make that choice.” But of course, I the magician stacked the deck in my favor many steps ago, and you just didn’t see how that happened.

Luigi: I understand that the power of technology now is much stronger. But the fact that advertisers manipulate customers, or try to persuade them in one way, is not new. I read many years ago in an interesting book that Nestle, for example, introduced in Japan some cookies that had the flavor of coffee, because in Japan coffee is not a taste that they ever experienced. In order to sell coffee in Japan, you need to develop this acquired taste, and so they did it. They put a lot of sugar, because we know that sugar ... and McDonald’s puts sugar in our hamburger because we like sugar more, and so on and so forth.

Tristan Harris: Correct.

Luigi: In what way is this different?

Tristan Harris: This is so important, because this comes up all the time. The number one rebuttal to this whole thing that we’re talking about is, “We’ve always had manipulation. We’ve always had marketing. … I don’t see why we should think about anything new.” There’s a few distinct characteristics. One is the level of intimacy that this persuasion can happen. Just think about access, first of all. We check these devices 24/7, 150 times a day if you’re a millennial. That was never true of any other medium. You drove past a billboard. You happened to see an ad on TV, but not ... I’ve got something up against your skin, causing you to reach for something in your pocket, thinking that it buzzed when it didn’t. I have intimate access to your moment-to-moment thoughts. Even when you’re not looking at a phone, and you go off and do something, you’re still thinking things that were driven by what was in the phone.

Luigi: Actually I read somewhere that 20 percent of the people check their messages even when they are making love, so that’s-

Tristan Harris: Yeah, exactly. We’re addicted to these things, and everybody is. That’s the amazing thing.

Kate: That can’t possibly be true. Oh my God, that’s so sad.

Tristan Harris: It is pretty sad. It is kind of where we are right now. But one thing is this intimacy. The second thing beyond intimacy is social intermediation. Before, I didn’t have direct access to manipulate the way in which you relate to, or all channels by which you communicate with other people. In other words, any time Person A communicates with Person B, we’ve introduced Person C, who can manipulate the terms of that relationship. I don’t mean in certain advertisements, I mean like Snapchat.

I gave this example today, all the time, Snapchat actually uses this technique to manipulate kids called streaks. It shows between two children, the number of days in a row that they’ve sent a message back and forth. They introduce that, so right there in your contacts list you see, here’s my most recent messages. Next to each person’s name is the number of days in a row you’ve sent a message with that kid. Now if that kid is your best friend, you’ve got this going for about 150 days. So what they’re doing is they’re socially manipulating the terms of your relationship. The currency of your friendship is, can I keep this streak going. That is a totally new form of manipulation.

Also, for the advertising. The fact that Facebook knows or would make available to advertisers, the keywords that you are ... they don’t sell this data by the way, but they’ll let you target to it. When you talk to other friends on Facebook, and you talk about anything, that’s open and available now to manipulators. That’s a totally new thing, and the scale is unprecedented. The last thing, the third thing, so first was intimacy, the second was social manipulation ...

Luigi: Can I, just for me to understand, it’s the difference between I’m able to show you a picture, or paint you a room, versus The Truman Show, in which I manipulate your entire life.

Tristan Harris: That’s right, and we actually use that metaphor. We live right now in two billion Truman Shows, two billion individual, personalized, orchestrated experiences, where an algorithm is deciding exactly what we personally will see. We think, if you and I had the same friends, the exact same 200 friends ... So we both have Facebook accounts, and let’s say we have the same 200 friends. You would think that if I open up the news feed on both phones, we would see the exact same set of material, because we have the same set of friends. But that’s not how it works. It specifically ranks whatever it wants to show you. There’s thousands of things it could show you. It selects from that, and orders them based on what you specifically have ... has worked on you in the past, what has engaged you and hooked you. That’s also part of it is a new, unprecedented form of this manipulation is it’s personalized.

The fourth one is that it’s powered by AI, and it’s self-improving. If you think of this as a ... how AI works, the fact that this is actually getting better and better over time to do this through automation, is a huge and new feature of the system.

Luigi: In terms of ... Thank you for this explanation. This is very helpful. In terms of the moral responsibility, I think that other businesses have moral responsibility, too. Going back to food companies, they certainly don’t care too much about our waist, or they don’t care about our health. What you are trying to suggest is that digital companies should have a higher moral ground than the rest.

Tristan Harris: Yeah. I mean, we have a name for this relationship. It’s called a fiduciary relationship, where one party ... if you walk into a lawyer’s office, they know way more about the law than you do, so they can just exploit the hell out of you. And because they have so much asymmetric power over you, and they can exploit you, we don’t just say that they if you do get exploited, “Well that was your fault for going with that lawyer.” It’s like, “No, no, no. This is a party that has asymmetric information, in the same way that a surgeon has asymmetric power over a client, or a psychotherapist does.” But now think about if you stack those up: doctor-patient, attorney-client. How much asymmetric power do they have in those situations? Now let’s put right next to it, side by side, Facebook.

Facebook is like a psychotherapist who knows more about every single secret of your life. They know who you’re clicking on, your old romantic partners that you click on at two in the morning when you feel lonely. They know your every single word choice you use around political topics. You use immigration, you always use the same adjective next to it. They know which button colors light up your brain. They know things about your mind that you don’t know about your mind. Now they have this asymmetric access to information.

The very first step, we should say, “Whoa, that’s a whole new species of asymmetry. We’ve never seen that one before. That’s huge.” Now, you ask: the business model. Who pays that person? In the psychotherapist territory, who has asymmetric power over you, you’re revealing all your secrets to them, you’re paying them, so at least they’re in some relationship with you. So when you add to this huge asymmetry, now the business model for Facebook is actually selling that personal, intimate information about how your mind works, and everything about you. They sell that to a third party. They don’t sell the data, I mean they sell access to manipulate you on that intimate ground, to a third party. That is an unprecedented level, and dangerous level of influence.

We were advising Congress when the November 1st hearings happened on Russia, and that is a huge part of this too. We’re not talking about this just because it’s a fun philosophical debate. It’s very serious geopolitical consequences that are emerging from this asymmetry.

Luigi: What Tristan is saying is that Google and Facebook are maximizing our addiction to those gadgets, and it’s almost like the evil empire is conspiring against us. They’re doing it just to maximize profits, but I’m not so sure that this is something that is right, given that they’re really exploiting our weaknesses, our psychological and biological weaknesses.

Kate: I’m sort of playing the devil’s advocate here, because I see your points, and I agree with your and Tristan’s point to some extent. But I do think that it’s important to point out the difference between something that’s addictive and harmful, versus something that’s just purely addictive. If Facebook knows that I like the color pink, and so they show me a bunch of ads that feature pink more prominently, I mean yeah, they’re trying to get me to click on those ads. But how is that necessarily harming me, just because I like the color pink? Maybe I want to see those ads more. It’s not gonna give me lung cancer.

Luigi: That’s true, but in a sense, this is where the idea that Tristan has of fiduciary responsibility is important, because they do know much more about yourself than you know. So if showing pink is not a problem, if I am somebody that is addicted to alcohol, and they keep showing me advertising of booze, I think that that’s a problem.

Kate: You’ve spoken a lot about Facebook, but ironically one of the people who has really bought into your ideas of ethical persuasion has been Mark Zuckerberg. He’s used a lot of your language to influence the public image of Facebook, as well as the morale of people working at Facebook. How do you feel about that?

Tristan Harris: You’re totally right. Did someone brief you on that beforehand? You must have some asymmetric access to information-

Kate: Perhaps-

Tristan Harris: ... on me that I don’t know about. How do you know this?

Luigi: You don’t know who she’s clicking at night.

Tristan Harris: I know. I know, exactly. Yeah, this Time Well Spent thing isn’t just a phrase. It was a concept that we introduced at this TED Talk in 2014. Basically we were saying back in 2014 that there’s this huge problem with a time-spent-maximizing system. We introduced Time Well Spent. Zuckerberg recently co-opted that phrase, and made it the new design goal for the whole company. It was a surprise to me when I heard that call on November 1st, his earnings call, the same day they were testifying before Congress, saying the new design goal was to make time spent on Facebook time well spent.

It has exactly been used to sort of re-moralize or re-engage the employees, that we have a new goal. We’re fixing the problem. But it really isn’t authentic, because they’re only interested in making sure that your time on Facebook is time well spent, when the whole premise of the work was how to go beyond the advertising-maximizing time-spent model overall. Meaning Facebook can’t be in the business of just enabling you to make choices off the screen: go on hiking trips with your friends, be in nature, take the cooking classes you want, whatever it is that your goals are. They can’t just be in that business, and they could be. Yeah, they have co-opted that phrase, and they have co-opted our concept. They haven’t really given much credit over to us in the process either.

Luigi: They don’t pay a copyright?

Tristan Harris: No. I think honestly this business model is going to come tumbling down. I think that in the future we’ll look back and say, “Why would we have ever given someone who had this amount of power and access, why would we have ever allowed them to have a business model which directly incentivizes them to do things that are not in the interest of the people that they’re serving?” Now the question is, what is a new accountability model that does guarantee that they are ... even with psychotherapists, they can still not be in your interest, even though you’re paying them. So how do we guarantee that trust? In nature and biology, the reason that we can trust a parent who controls the food supply of the child is through genetics. The fact that the child has the genes of the parent means that a parent is intrinsically motivated. Everything in their biology makes them want to be aligned with the party that it’s serving. But we don’t have that in technology.

How could you replicate that? How could you create a system by which something that impacts two billion people treats the agents, not really the agents, the people that it’s serving, with the same level of care and true, genuine, sort of it-can’t-be-any-other-way compassion as we have in biology?

Luigi: Fantastic.

Kate: Tristan, it’s been really great having you.

Tristan Harris: Thank you for having me.

As ad revenue continues to decline more and more news organizations are turning to paid and sponsored content. Luigi and Kate revisit the decades-old music payola scandal and debate how to ensure proper disclosure in the digital age.

Speakers: The sharing of biased and false news has become all too common on social media.

Kate: Hi, this is Kate Waldock at Georgetown University.

Luigi: And this is Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Kate: A media organization called Sinclair has been in the news recently because it was making its anchors read the same statement, and everyone across a bunch of stations was sounding like zombies just reading the same thing over and over again, which was something like:

Speakers: Unfortunately, some members of the media are using their platforms to push their own personal bias and agenda to control exactly what people think, and this is extremely dangerous to our democracy.

Speaker 4: This is extremely dangerous to our democracy.

Speaker 5: This is extremely dangerous to our democracy.

Kate: To back up for a sec, Sinclair is both a TV and a radio broadcasting company. They own something like 193 just television stations, but there’s also talk about them acquiring even more from Tribune Media soon. What’s ironic is Sinclair was actually fined by the FCC a few months ago in what was basically the largest fine in history because they were found guilty of accepting money in exchange for endorsements.

Speaker 6: More and more patients at Huntsman Cancer Institute are recording their life stories.

Speaker 7: My grandfather’s family all died, usually in their late 20s, early 30s, because they were not diagnosed back then.

Speaker 8: It’s taking too many lives, and my husband at 54, he had a lot to offer the world.

Kate: But they were reporting news tied to cancer organizations as if it were news without disclosing that they had accepted payments for what they were claiming was news.

Luigi: So we’re going to try to unpack today these practices, starting from payola to go to advertising to sponsored content, but we want to start with actually the music industry.

Kate: Yeah, can I talk really quickly about the word payola?

Luigi: Please.

Kate: I just, I hate the word payola. It makes me think of 1950s naming conventions, like Crayola and Victrola. They just added ola. Terms that you may be more familiar with now are pay for play, #sponcon, which stands for sponsored content. But anyway, it’s all the same idea.

Luigi: And this is a practice that has been going on in the music industry since probably the beginning of the music industry. What really shook the industry is that in 1955, four traditional companies were controlling 78 percent of record sales. By 1958, the same four companies dropped to 34 percent, and the reason was the explosion of rock ’n’ roll that was done by other record companies. Many senators got concerned about the spreading of this evil music, and of course, the evil music could only spread because of corrupt practices. As a result, there was an investigation in Congress about the use of payola to promote the new music, which was rock ’n’ roll.

Kate: So anyway, Ronald Coase, who’s a Nobel Prize winner, he wrote this paper describing everything that happened, and his opinion, payola in the music industry was really not that bad of a thing.

Luigi: Yeah, and his argument, I think, is quite clear. Number one, he says it’s not a bribe, because in legal terms, a commercial bribe is when you pay somebody to use his discretionary power in a way in which his boss does not want him to. In this particular case, the radio stations were perfectly happy to have the DJ take that money, and they knew this money was taken, so it’s a little bit like a waiter in a restaurant. You give him or her a big tip to get the corner table. This is not a bribe by any measure of the word.

Kate: Yeah, and another argument that he makes is that from the DJ’s perspective, it doesn’t really make sense to accept money to play bad music, because you still want people listening to your station, and so you’ve got this sort of joint optimization problem, where on one hand, you want to make money by being paid some amounts by these record labels, but you also want to make money through your salary from the music station, which means that you want to have a lot of listeners. So it’s not necessarily the case that bad music was being pushed on a lot of people. Maybe once in a while there was the occasional record that people wouldn’t have normally wanted to listen to that they had to listen to, but for the most part, people were still listening to music that they enjoyed because that was consistent with the incentives of the DJ.

Luigi: Actually, I don’t like that argument too much, because as we will discuss hopefully later, this leads to being too sort of accepting of other practices I have more quarrels with. I’m more intrigued by two points that he makes that are quite clever. The first one, it says, look, it’s not like the rating or the combination of music that you receive on the radio is not distorted without the payola. In a world without the payola, the way that radio supports itself is through commercial ads, and as we know, if you want to maximize audience, you’re trying to play the music that is more enjoyed by people who buy more products, and so you make yourself more valuable to the commercial ads.

So to some extent, the payola was useful in getting the music that actually listeners wanted, independently of the kind of commercial power they had. That’s the reason why they started to play the rock ’n’ roll, because the rock ’n’ roll was appealing to teenagers, but it was not appealing to old farts with a lot of money in their pockets.

Kate: Yeah, so I think Coase’s most compelling argument is that the groups who were really anti-payola were the big band music stations or the music labels of the 1930s, and they were pitted against these new, up-and-coming rock ’n’ roll artists, who they considered obscene. If you think about it, big band was already being played on the radio, and so the marginal dollar spent on payola by someone who was already super popular was not really that valuable, whereas if you were a new rock ’n’ roll artist, then maybe you would want to spend a little bit of money, you want to give a little bit of money to DJs asking them to play your stuff so it would be introduced into the mainstream. So it was really the old incumbents who were trying to fight against the new upcomers and prevent them from breaking onto the scene.

Luigi: And many of the actions to ban payola were actually conceived as a way to restrict this payment and maximize the revenues of the music industry, and that’s the reason why the attacks to payola are very cyclical, because the payola starts as a very common practice, then becomes so widespread that it actually takes the form almost of blackmail, that now the radio controls the access to listeners and they ask for a payment, an extortion, in order to reach the listeners. When this arrives to this point, in a normal situation, you should have an antitrust enforcement. In the payola industry, you have a surge in the protests, and often either the parliament gets involved or people like Eliot Spitzer, who want to run for a political position and think to make themselves popular by going after the payola industry.

Kate: Yeah, so let’s talk about payola or sponcon in the context of today. It shows up all over the place, and I think it’s important that we make the distinction that it can show up in cultural contexts. For example, if you listen to Spotify or Pandora, there’s a lot of concerns that the curators of playlists are being paid off by the artists themselves. That’s very different than if we’re talking about Twitter, which is actually a medium that people use for learning about the news and learning about information.

I think an important component of what makes this so widespread today is the internet. There’s just so many people offering up their opinions and offering up ratings and anonymously posting on Yelp or anonymously blogging, and it’s impossible to tell who’s accepting money and who’s not, and that’s why I think it’s important to make this distinction between news and culture or product reviews.

I think when it comes to culture and product reviews, I have a pretty good sense of when people have been paid for. In news, it’s more difficult to tell, and so I think we should talk about where payola shows up today, but also distinguish between news outlets versus culture and product sales.

Luigi: I think we should distinguish, but honestly, I think it’s problematic even in cultural issues, in the sense that I love wine and I really value the opinion of one wine critic, Robert Parker, who has a publication without ads. I trust him because over time, I really enjoy the kind of wine that he selects, but also, I am reassured by the fact he doesn’t take any ads. In fact, there is an economic paper looking at the comparison of ratings between Wine Advocate and Wine Spectator, and it finds that the difference in ratings are correlated with the amount of advertising that Wine Spectator gets. So there is this at least prima facie evidence that even traditional advertising might distort content in a major way.

Kate: OK, well maybe you like wine, but I like makeup, and I follow an Instagram makeup artist named Militza Yovanka, and she obviously accepts money from makeup producers. I think that she’s probably getting a lot of money from L’Oreal, I don’t know, different places. She posts these videos where she’s doing her own makeup using all these different products, and I know that she’s being sponsored by these products, but it doesn’t really bother me because A, she’s really good at doing her makeup, and B, I feel like I can tell the difference between when she’s doing something promotional and when she’s not, even if it’s not disclosed.

Luigi: I would like to test you on that declaration. You’re definitely right that you like wine more than I like makeup, so I think that you have clearly a lot of absolute and comparative advantages there. But I don’t claim I can tell the difference. And I have no problem if you announce that you’re just showing stuff that you have been paid to show. That’s part of what advertising’s about. I’m more concerned when you cannot tell the difference, and honestly, if it comes to wine or makeup, it’s not the end of the world. When it comes to news or important information that makes you decide, for example, on your lifetime savings, that’s quite important.

Kate: So when it comes to payola in culture, where do you fall?

Luigi: To me, the crucial aspect is deception, or the risk of deception, and in the case of payola, actually Coase has a great argument, and in my view, I’d say, “Look, music is an acquired taste, but you need to listen to it to know what it is, and while it’s true that the DJ is forcing me to listen the first time, actually I don’t buy the music unless I’ve listened to it. So it’s not like I’m deceived because I don’t know what I’m buying. I know exactly what I’m buying, and the only thing that the DJ is doing is exposing me to that music.” I don’t particularly like, for the wine, even if for most wine, the worst that can happen, you buy a bottle and unless this is a Château Lafite 1955, it’s not a fortune, and then if you don’t like the bottle, you can make up your mind and discard it.

I think that the argument is quite different if we move from the music industry to other systems of exposure, where the good is not that easy to identify. Suppose I am a travel editor of a major magazine, and I receive payment to promote particular locations. As a buyer, you don’t know if the reason why I rate this trip in Myanmar as the most valuable trip of my life is because it’s really great or because I got paid, and you’re only going to find out after you travel to Myanmar. So it’s very different from music.

In many other situations, it’s very difficult to not be deceived. If you trust somebody to give you an opinion, you would like this opinion to be unbiased. The more the good is an experience good, the more the good is a good that costs a lot of money, the more the risk of deception, the more I am against this practice.

Kate: Well, exactly. If it’s a really expensive product that you’re about to buy, then I think I would be willing to pay for a unbiased report, but if it’s just various shades of lipstick, I think that it’s not worth it for me to pay for an unbiased report. Instead, there’s so much competition in the blogging and Instagram space for these sort of relatively cheap products that if I get fooled by somebody, then I’m going to stop watching their Instagram channel and I’ll just go to somebody else, and so I think that there are incentives for people to report somewhat accurately.

Luigi: OK, so let’s agree that for lipstick and music, we don’t care, but then when it comes to portfolio investment or pension retirement plans or stuff like that, this is even more important than your restaurant or your car. If you are a reputable journal or magazine and you can rely on a very diversified set of advertisers, then you are not dependent on any one of them. Once the set of advertisers shrinks, because if you are a money magazine, there are only so many advertisers you can deal with, and annoying one of them can be very expensive. And actually, the most extreme form of this, a colleague of mine experienced a tragedy: her son was killed, 20 years ago, by a defective crib in the kindergarten where he was.

Kate: That’s terrible.

Luigi: Yeah, it’s terrible, and this person is a very lovely person who tried to transform this tragedy into a good for humankind, so she made a battle to try to expose defective products all over the place. The first place where she went to place the news of this tragedy and a warning for the defective crib were parenting magazines, and to her surprise, the New York Times and the major newspapers were willing to publish the news, but the place where she found the strongest resistance were parenting magazines, and why? Because if you are a parenting magazine, you rely very heavily on a few advertisers, and one of those was actually the producer of the defective crib. And if you have only a few advertisers, you cannot afford to piss off any of them because you end up losing, let’s say, 20, 30 percent of your ad revenue, and that is something that a magazine cannot afford to do.

The reason why this story, besides the tragic aspect, but the reason why this story is so important is because I fear that even the mainstream media is going that direction. There used to be a time in which advertising was plenty, and so magazines and newspapers were very independent because they could annoy any one of them and still have a queue of people who wanted to advertise in the magazine. I think that time has gone with the internet and the diffusion of Facebook and Google and different types of digital ads; mainstream media cannot be this picky anymore, and they are heavily dependent on a few large advertising budgets, and that ends up distorting the news they report.

Kate: I think that’s a really interesting point that you raise about the concentration of your advertisers, I think that it ... I agree it probably has something to do with the way that advertising has changed and the pressure coming from competition from Facebook and Google, but if anything, those are reasons that we need to be supporting our independent media organizations, and so I’m just sort of, I’m at a loss for what to think about that, because on one hand, this heightened competition is leading to adverse outcomes and reduced reliability of the news that we consume, but on the other hand, I want to be supporting our news.

Luigi: Yeah, but the way to support the news is not by hiding a problem that’s been going on for decades, now it’s become worse, but has been going on for decades. Because while it’s true that it was easier to annoy one single advertiser, it’s also true that when there was an entire industry and this industry was important, then even the traditional media in a traditional time did not do that great. There is a study showing that magazines that did not receive any advertising from cigarette companies, at the time where advertising was possible, were 40 percent more likely to report news about the health consequences of smoking than a magazine that did take advertising, and similar stuff has been true about research on passive smoking. I think that the acceptance of tobacco advertising has been correlated to less articles and articles more critical of the research on the damage of passive smoking. So I think that this problem has been going on for a long time.

Now, you might argue that this is simple correlation. It doesn’t prove that they pulled out the articles because they were writing negatively about the industry. It might be that if I am a cigarette manufacturer, I want to advertise naturally in a magazine that has as customers people who like smoking or are more open to smoking, and that’s a natural coincidence. However, even if this is pure correlation, it does have a very strong implication. If I want to maximize my ad revenues, I better not talk negatively about smoking when smoking could advertise, and the same is true for a lot of other products today.

Kate: Yeah, I also think that’s an important point. One of the defenses of payola that was raised earlier, which is that people are used to seeing advertising all the time and so they’ve naturally built up these defenses and ways to recognize advertising, that still doesn’t address the fact that there’s information that’s not being reported, and so on one hand, a promotion may be something that people can defend against, but people can’t figure out bad things about companies if journalists are not willing to uncover those bad things because they’ve been supported in other ways by companies.

Luigi: And actually, what is positive is our academic journals that we normally publish in and read in economics and finance tend not to take ads in any major way, and so at least this distortion is not present, but when you go to medical journals, medical journals do take ads, and most of the ads are from pharmaceutical companies, and there is literature documenting some concern by the editors about the influence of the ad companies or the companies that produce the ads, mostly pharmaceutical companies, on actually the articles that get published in scientific journals. So this is even worse than the bias in the normal newspapers, because this is the academic community that should decide what is good for us in terms of what medicine we should take when we’re sick being distorted, and the major episode, hopefully it’s isolated, but there’s a major episode of the executive editor of the transplantation and dialysis journal that rejected a paper in spite of a favorable peer review, and he said, and I quote verbatim, that “The author went beyond what our marketing department was willing to accommodate.”

Kate: So Luigi, you’ve written a ton in many different news outlets about your opinions about the economy, about politics. Has anyone ever approached you and asked you to accept money?

Luigi: Yes, actually. It was many years ago. It was during actually the Parmalat bankruptcy. You’re an expert in bankruptcy, so you might enjoy that.

Kate: Actually, Parmalat means a lot to me, because my first job having anything to do with finance was looking into the Parmalat bankruptcy, but yeah, go on.

Luigi: So at the time, the international creditors were afraid to be taken for a ride by the Italian judicial system, probably not completely without reason, and so I got a US lawyer who came to my office, and when a lawyer actually comes to your office, you know there is something pretty important, because their time is very valuable and they generally don’t come to your office, they ask you to go their office. So he came to my office actually with a colleague, so two lawyers in my office, and they were trying to convince me to write a piece defending the interests of international creditors, and I said, “Look, you might be right, but because you offered money for this, I’m not prepared to do anything.”

Actually later, I discovered this is more diffuse than you think. For example, after the Iraq war, Qaddafi, then a dictator in Libya, was trying to show himself to the West as a reformed guy, and hired a consulting firm in America. This firm hired a lot of famous academics. One was actually a former dean of the London School of Economics. And these academics started to write articles all over the world where they were celebrating how great the changes in Qaddafi’s regime were, and nowhere to be seen was any disclosure that they’d taken money for that.

Kate: Yikes.

Luigi: If it wasn’t for the fact that eventually Qaddafi was killed and this stuff was exposed, we would never have known about this.

Kate: So the FTC explicitly has rules against unfair or deceptive business practices, and we may think that, “All right, it’s a government organization, it’s slow moving, it’s not up with the times,” but actually just recently, they sent out 90 letters of censure to what they called influencers on Instagram and YouTube, saying, “You’re not disclosing your endorsements or your sponsorship. You need to be doing this,” and they even followed up with 21 of them who didn’t listen to the FTC. So these investigations are going on. I don’t think that the FTC has been harsh enough in enforcing actions against people who may have accepted payment for endorsements, but I imagine ... I mean, these rules have existed for a long time and they’ve applied to journalists, as well.

On top of that, there are plenty of organic rules within journalism that maintain codes of ethics or maintain the quality of the journalism that’s produced. Like for the first time, I published a few weeks ago something on The Hill, and I had to sign a contract to be an independent contributor with The Hill, and very clearly in a couple paragraphs of that contract, it said that you cannot have accepted any money for this, “We have the right to state in your article that you have accepted money in order for sponsorship, or we have the right to just not publish anything altogether if you’ve accepted money,” and I would’ve had to disclose that. I mean, I didn’t, but it was there in the contract, and also, if you’re working for a reputable news organization, then your ass is going to be fired if your bosses find out that you’ve accepted money from anybody, and I think that they maintain, at least at the highest levels, very strict codes of conduct.

Luigi: It’s true, but those codes of conduct were not able to prevent, for example, those articles I mentioned about Qaddafi. So I’m not so sure that they’re so effective, and now, some mainstream media accept endorsed or sponsored content written by actual journalists of that newspaper. If you on one article write sponsored content paid by somebody, how can you be independent on the other articles you write?

Honestly, the newspapers made a mistake in the early 2000s thinking that they will make money with online ads and that the only game in town was to conquer eyeballs and you will be done. What they didn’t understand is that there were two or at least three major trends that killed them. Number one is the supply of ads increased tremendously. The media industry used to be a fairly oligopolistic industry with ability of some market power. With the internet, you can reach customers in so many ways that you lost on market power.

Number two, that Facebook and Google can do targeted ads so much better than the traditional newspaper that it’s not even funny. So at the same time, the demand went down and the supply went up and prices of traditional ads went to the bottom, and this destroyed the traditional media industry.

And the last coup de grace, the last sort of killing aspect, was the fact that the media industry was living a lot out of classified ads, and Craigslist killed that goose with the golden eggs, and so now the media industry is competing on very thin margins, and the only way to resurrect it is to have people realize that content is valuable and you have to pay for it.

Kate: Yeah, there was an interesting survey conducted by some polling firm called Toluna. They asked people whether they agreed that there should be no charges to access news websites online, and 96 percent of people think that news online should be free, which is pretty shocking.

Luigi: But the point is, what is the quality of what you’re getting? I think that what we need to do is to educate people, and I think it’s a lesson that we all have to learn, which is if you don’t pay for something, it means you are the product. You are the one being sold, and there is an agenda underlying, and that’s a problem. And I think that we should all make an effort in paying for news, because if you don’t pay for news, you get what you pay for.

Kate: I agree with that, and I have noticed this trend in more paywalls, which can be a little annoying, but I think like five years ago, every article that I looked up, I could find some way to get it for free. Whereas today, that seems to be less and less the case, and I think it’s because it took awhile for major news organizations to get used to shifts in technology, and it wasn’t really obvious right away what the best way to preserve their integrity would be, and I think what’s arising is that these subscription models have become the way for news organizations to maintain their independence as well as the quality of their journalism. It’s really easy for people to be considered sources of news even if they aren’t actually, which makes it that much harder for actual news organizations to compete.

Like Snapchat is now under the FTC’s guidelines. Podcasts are not. Podcasts are still sort of a gray area, and as a result of that, if you listen to other podcasts ... So we haven’t accepted any advertising yet. That’s not to say that we won’t necessarily in the future, but other podcasts that do advertise, you’ll notice that when you hear an advertisement, oftentimes they’re read by the host him or herself. Right? They’ll just be like, “I use Harry’s razors and Stamps.com because I love it so much for my small business and my armpits,” or whatever, and it doesn’t need to be disclosed. So I think that it’s important for the government to pick up on this and to pull in podcasts, as well, under their supervision.

Luigi: Full disclosure, I’m not being paid by Wine Advocate. I wish I were. No, I’m just joking, and by the way, Kate is not paid by the famous makeup artist.

Kate: Yeah. I promise.

In the brave new world of cryptocurrency the latest frenzy involves Initial Coin Offerings (ICOs), which make Bitcoin look tame by comparison. Luigi and Kate explore this volatile, largely unregulated market and consider creating their own ICO.

Speaker 1: Bitcoin crossing the $14,000 mark.

Speaker 2: Cryptocurrency passing $15,000 for the first time ever.

Speaker 3: Now it looks like we may hit the $17,000 mark.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And this is Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Speaker 6: If you think the DOW had a bad day, Bitcoin’s was worse. The price is now hovering around $7,000.

Speaker 7: What do you think of the volatility of Bitcoin and the chance that it could lose all serious value?

Speaker 8: How do you regulate the cryptocurrency market?

Speaker 9: It’s a fair question.

Speaker 10: In terms of cryptocurrencies, generally, I can say almost with certainty that they will come to a bad ending.

Luigi: Everybody’s talking about Bitcoin these days, but a phenomenon which is related to Bitcoin but is actually broader and quite important is this new phenomenon called initial coin offerings. What we’re going to try to do today is try to understand what is this phenomenon and to what extent this is a fraud, to what extent it is for real, and what you should be aware of.

Kate: You’ve probably heard about Bitcoin, and maybe you’ve also heard about Ethereum or Ripple, even. But there are certain types of cryptocurrencies called tokens that you probably haven’t heard of.

Luigi: My favorite one is Bananacoin. A token whose value is linked to the price of a kilo of bananas. This is actually a ICO, initial coin offering, that took place last month and raised a significant amount of money to actually finance an investment in a plantation of bananas in Laos to export bananas into China.

Kate: My favorites are a little more salacious. I’m not sure, but maybe you’ve heard of Groincoin or Tittycoin or Lust. There’s a whole bunch of them out there.

Luigi: Sorry, I sound like a dork, but what are all those coins?

Kate: As you can imagine, they are linked to online porn.

Luigi: I think it’s important that our listeners understand that ultimately what money is is simply a trusted ledger. I know that most people have in mind money as gold because historically, that was the way the trust in the ledger was created. But even today with the US dollar, there is no relation between the US dollar and gold or silver or any other valuable metal. The ultimate ledger is kept by the central bank, which is the Federal Reserve Bank.

To make this point, I think in a very clear way, I want to tell a story that is described by Milton Friedman in a paper in the early ’90s. He talks about a group living in Micronesia, the Yapese, living on the island of Yap. One characteristic of this group is that in order to transact among themselves, since they didn’t have any precious metal on the island, they used pieces of stone, gigantic pieces of stone that could not be actually transferred from one guy to the other, but could be reallocated in property from one side to the next. If I want to buy some milk from Kate, I simply reallocate one stone or piece of that stone to Kate in exchange for milk. Kate and I agree that that’s a transaction, and we write on the piece of stone this transaction, and everybody on this small island knows each other and they trust that this is the actual transaction.

The irony that makes this point very clear is that they were trying to mine for this stone on a far away island, and as they were bringing back one of these gigantic pieces of stone, the stone ended up falling at the bottom of the ocean. But everybody in the Yapese community knew that this stone existed at the bottom of the ocean. They used this piece of stone that nobody could see as a means of exchange without even seeing the piece of stone. This makes it very clear that what money is doing is simply keeping track of transactions in a way that everybody trusts.

Now in a small community like the Yapese community, the trust is given by the social network of social pressure. Once you start to have exchange at a distance, you either give a bond in this transaction, and that bond is the value of the metal associated, or you have a superior authority that maintains this record in a trustworthy way. That’s what the dollar is about. Or, and this is the innovation, you have a currency that keeps track of all the transactions without a central authority in a way that it cannot be modified by anybody—that’s what Bitcoin is about, it’s a currency based on the decentralized ledger that is not mutable because of a combination of cryptography and the distribution component of this ledger.

Kate: The history of Bitcoin, every single transaction that’s ever taken place, sits on everyone’s computer who’s mining Bitcoin. Everyone has the same exact copy of this ledger that accounts for all transactions. If you want to change a particular transaction, if I want to say, “Oh, I paid Luigi 10 bitcoin,” and then take that 10 bitcoin back and give it to myself again, I would have to find the block that contained that transaction and alter it. But if I alter the transaction in the ledger, that then changes the link to all of the other blocks in the chain. That makes it really hard for people to go in and hack or alter the ledger.

Why do I use dollars? I mean, yeah, sometimes I have actual, physical dollars and I use them to buy stuff. But for the most part now, I use my debit card or a credit card to purchase stuff. I trust that Bank of America, when I buy something, it’s going to keep track of the transaction that I’ve made. And then it’s going to deduct the amount of what I bought from my bank account and it’ll give it to whoever I purchased that thing from. Likewise, if money is transferred into my account, I trust that Bank of America is keeping track of that money and that Bank of America isn’t going to be hacked—or American Express or whatever credit card you use. I trust that they’re not going to be hacked to the point where they no longer have any track of who’s purchasing what. That’s the idea and the importance of a secure ledger.

By the way, there’s a TV show, a socialist dystopia TV show, called Mr. Robot, which I highly recommend. The whole premise of the show is that they hack credit card companies and therefore destroy all credit because people can’t keep track of who owes who.

Luigi: Yes, but given that something is not hackable and so potentially could be a currency doesn’t necessarily mean it will be a currency because what determines the success of a currency in part is driven by how many people are willing to use it. The irony of the Bitcoin in this moment is that people who invest in Bitcoin, invest in Bitcoin in the expectation that this will become a standard currency for exchange. However, the more they demand this currency for speculatory reasons, the higher is the value of this currency and the more it will appreciate. And the more it will appreciate the less people are tempted to use the Bitcoin for transactions because whether I want to buy a pizza or sell a pizza, if the price of the bitcoins in dollars fluctuates wildly, I don’t want to use that for transaction purposes. In fact, at the last Bitcoin conference, they did not accept Bitcoin as payment. They did not accept it as payment because it was very volatile.

Kate: We’ve talked a little bit about what cryptocurrency is and what currency is in general. But we started this episode by saying that we want to talk about tokens and initial coin offerings. What distinguishes a token from a cryptocurrency? I like to think of this example of going into a video game arcade. You take your dollars and you purchase the currency of that particular arcade. These days it’s like a card that has some tokens on it and you use those tokens to play games. One game may be three tokens and the really good games may be six tokens. That’s kind of the same idea behind the coins that are being issued in these ICOs. They are a virtual means of exchange that are linked to a particular company. This idea of a token has become super popular.

Luigi: I don’t have a lot of experience on video game arcades, but when I was a kid in Italy, in order to make a phone call you had to use a token. Let’s say that the token was worth 25 cents. Instead of using a quarter, you would use the token. Now, because that token was so widespread, people will take it in exchange for a quarter because the telephone company was selling tokens for a quarter, was accepting tokens for a quarter, so it was basically providing a liquidity for having a token worth a quarter. People started to accept the token as money. The difference between the two is not that big as you make it to be.

Kate: I’m not saying that there couldn’t exist some bizarre state of the world where tokens are so popular that they actually end up being used as currency themselves. But I don’t think that it was the initial purpose of the phone company or the telecom utilities in Italy that these tokens were then going to replace currency. It was just that they happened to be that popular.

Luigi: I agree. That was not the intention of the telephone company in Italy. But I think it is the intention of many of these cryptocurrencies to become a substitute for money. When you look at Ethereum, Ethereum is a cryptocurrency like Bitcoin and was created to enable a set of transactions. We use it as currency within the universe of Ethereum, but ideally they want this universe to be the entire universe.

Kate: Yeah. This is, I think, a little bit of a confusing point. But you’re absolutely right. But it doesn’t need to be a currency company that ICOs. For example, you could have Bananacoin that’s intended to be used for purchasing and supplying bananas. I don’t think whoever ICO’d Bananacoin was intending for Bananacoin to become like the world’s premier virtual currency. They intended it to be used within a certain, more limited context. The point that I’m trying to make is, yes, even though cryptocurrency companies can ICO, non-cryptocurrency companies like any regular company can try and raise money through an ICO, and that’s what becomes dangerous.

Luigi: Disney could raise money by selling Disney Dollars. Those are tokens accepted in Disneyland and they could raise money this way. Now, they don’t need to raise money. But if they needed, they could. However, I think that part of the confusion is exactly this is the reason why so many companies now are raising funds this way is because people are very excited about the increasing value of Bitcoin and they want to jump on the new Bitcoin wagon. They are buying Bananacoin because, I don’t think they’re speculating on the price of bananas, they are hoping that this coin will become more accepted and will be more valuable. That’s, in my view, the reason why so many people buy these tokens from unknown companies with unknown track records and with very vague projects.

Kate: What blows my mind is that these tokens are actually really easy to create. Luigi, if we were to start a company what would it be?

Luigi: It would be the Capitalisn’tcoin.

Kate: OK. This is our podcast coin, and you need these coins to be able to listen to our podcast. If I wanted to actually issue some of these coins to raise money to, let’s say, invest more in our podcast, I could do that relatively easily. Let’s say I’m going to start with Ethereum, which is another popular cryptocurrency. I’m going to link it to that. First I need some Ethereum. I need an Ethereum account and I need a virtual wallet that has my Ethereum in it. And then I need to be able to code just a tiny bit. I just need to be able to edit some code.

What I do is I go online, I download what’s called a smart contract, which was written by this person named Bokky Poobah. I edit a couple lines of the code that say, “All right, this is owned by Luigi and Kate. It’s called Luigi-and-Katecoin. This is the amount that I want issued.” I just hit enter. And then within a few minutes, we would have our own tokens that would potentially be linked to our podcast. And then all we would need to do is create a website, write up a 12-page paper that says this is what we’re going to use these coins for, and then give it to some exchange, some other website that’s selling these coins off to the public, and we would probably raise millions of dollars doing that. That’s exactly what these companies are.

Luigi: But the crucial part to understand is why people are willing to pay millions. Certainly if we produce a piece of paper with, let’s say, Katedollar—I think that sounds better than Luigidollar, Katedollar, a big picture of you in the middle—I’m not so sure people are buying that for a huge amount of value. But in many situations they do. Why? Because the companies promise to use those tokens in the future for some valuable purpose. For example, I have a student who actually is in the process of doing an ICO as we speak who invented a new way to store your cryptocurrency in a digital wallet that is very secure, and is trying to finance the production of this through some tokens. He promises that people can use these tokens to buy this crypto wallet or to pay for transactions in the exchange he will establish.

That’s what is interesting with ICOs because it’s in between some kind of crowdfunding. We know that people have raised money in crowdfunding by promising to give at a discounted price, or at zero, a product to the people who contribute to their endeavor. Here, instead of promising necessarily the product, you give immediately some tokens that can be used to buy the good or can be used for something else.

Kate: I’m sure there’s some completely legitimate businesses out there that have good business ideas and a team put together to actually use the money that they’ve raised to create good products. But what’s concerning about ICOs right now is just that a lot of investors think that this is an easy way to make a quick buck. They’re so interested in trying to double their money or make 1000 percent ROI right away that they’re not really doing much research into what these startups are.

For example, there is a token called UE Token. You can look at it at uetoken.com. When you go to the webpage, it says immediately, “You’re going to give some random person on the internet money. And they’re going to take it and go buy stuff, probably electronics to be honest, maybe even a big screen television. Seriously, don’t buy these tokens.” They raised $40,000. I mean, yeah, $40,000 isn’t a whole lot. But there are still people who are not paying attention to the extent that they didn’t even read it. They just gave that person money. Hey, I would like $40,000 if I could. That was like a hack. That was obviously not real. But there are a lot of people across the world, like in Russia for example, who are trying to make websites and descriptions of companies that look very real that are raising hundreds of thousands, if not millions, of dollars from American investors through these tokens which will never be put to good use.

Luigi: If you’re saying that there is a speculative frenzy and things are out of whack, I completely agree. But this is not limited to the ICOs. We are of the view that we’re not there to regulate stupidity. To some extent, people can take a gamble as long as they are aware that they are taking a gamble.

Kate: Whoa, whoa. The US government is absolutely in the business of regulating stupidity. That’s why we don’t have casinos everywhere. And that’s why most forms of online gambling are illegal. That’s why even sports betting is probably going to be highly regulated soon. That’s why the Consumer Financial Protection Bureau exists. The government doesn’t want people who have worked really hard to earn $15 an hour and put away $3,000 in savings, the government doesn’t want that person to try and go triple their money by investing in cryptocurrencies in the same way they don’t want them betting on a horse. I think that the risks in cryptocurrencies, particularly in ICOs, are a lot worse. There’s a lot more potential for just outright fraud.

Luigi: I agree. But I don’t agree with the strong position that, for example, China or South Korea took to say every ICO is illegal. Some ICOs can be legitimate. We want, with the proper amount of protection, but we want people to experiment. I think that in some situations, the ICO could be a very effective way to raise money. Why do we allow crowdfunding of products by financing the purchase of future products and we don’t want to allow ICOs?

Kate: Here I think it’s important to talk about what exactly the SEC did. A few months ago the SEC took the position that they’re going to start regulating ICOs and tokens that are created by them. And the way they’re going to start regulating is that they’re going to distinguish between tokens that are utility tokens versus tokens that are security tokens. A utility token might be something like, OK, Luigi and I want to raise money for our podcast. We create a token. We issue it to people who want to purchase them. And if you buy a token then you can listen to one of our special podcasts because that token is linked specifically to a good that you’re going to get in the future.

But some startups are also creating tokens that are linked to, say, cash flows of the start up. A company might say, “Oh, we’re going to raise tokens. And if we make money in the future, you’re going to get like one tenth of one percent of the cash that we make each year.” That looks an awful lot like just a regular stock that people could purchase except the way that the stock was issued was behind the back of the government. Most companies when they issue stock, they have to comply with a bunch of regulations. And issuing security tokens is a way of doing this without government oversight. The SEC is saying you can issue these utility tokens, but you can’t issue security tokens.

Luigi: The problem is that this is a world market. The United States can prohibit the ICO. You can do the ICO in other countries. My student has organized the ICO in Singapore. We know that you can pay with bitcoins for an ICO, bypassing the banking sector. You’re an American investor. You can buy an ICO with bitcoins in Singapore. There’s very little you can do in the United States unless you ban Bitcoin and you put in jail everybody that even touches one.

Kate: You think that we shouldn’t try and regulate anything on the internet?

Luigi: No. But I think that there are some things that are easier to regulate than others. I think that the problem we have here is the fact that the internet is creating a world market for securities. Up to now the market for securities has been quite segmented. It’s been segmented by regulation. It’s also being segmented by the difficulties in subscribing across the border without using the traditional banking network. And the traditional banking network is supervised by the US authorities because this network works in dollars.

Now, with Bitcoin, this banking network can be bypassed. And that opens really a new world in terms of regulation because the power of the United States is dramatically reduced as a result of that. The power of the United States to nudge regulation all over the world has been reduced. And now we are in a world of more competitive regulation that will probably tend to go to the so-called race to the bottom because competition will lead to regulation to be lower and lower everywhere.

Kate: If anything, I think that regulation of ICOs right now is leading a race to the top. A lot of countries are trying to protect their citizens by enacting really strict regulations on ICOs. I think that the US should be part of that. I think that our citizens are only going to keep being hurt until we do that. But I also think that there is a point to be made about protecting people’s faith in well-established capital markets particularly in the US. The SEC regulates securities that are being issued by companies, and as you pointed out one of the problems with ICOs is that start-ups can make tokens that don’t really look like securities even though they may be securities. That will lead to an explosion of companies raising money through these ICOs and dodging the regulation of the SEC. That’ll be cheaper. It’s cheaper for companies to issue not under regulation than it is to issue securities while being regulated.

Right now we have faith that if you invest in a stock, you’re not going to be ripped off. There’s a sound system of corporate governance. And there is no guarantee with these start-ups that are issuing tokens through ICOs.

Luigi: I agree with most of what you said. I am, however, worried about throwing away the baby with the bathwater. Is there a lot of bathwater in ICOs? Absolutely. Is it all to be thrown away? No. It is an innovative way to raise money. I think it is possible—of course there will be litigation, but there is litigation in everything in the United States—it is possible to try to mark some boundaries of what is a security and what is not a security. And I envision that this method could be useful to launch new platforms, in the sense that we know that in a world of winner-take-all markets the rents tend to accrue to the creator of the platform and to some extent in a disproportionate way.

Let me make a concrete example. Suppose that now I want to compete against Uber or Lyft in the market for basically passenger services. The way I want to compete is by asking a lower percentage fee from the drivers and offering the same price to customers. Now, the drivers will come to me, but the customers will not see a lot of the benefits of coming to me, so without customers there will be no drivers and my platform will disappear. However, if I can incentivize customers to start using this platform by giving them some tokens and saying, “If my new platform will be very successful, these tokens are redeemable in free rides at some point,” then I have a very easy way to market it. That facilitates entry, facilitates competition, keeps lower the prices of Uber and Lyft. I think that overall it’s a great thing.

Kate: I acknowledge that tokens and ICOs represent an innovative way of raising money. But we don’t need some new-fangled cryptocurrency. We already have crowdfunding platforms that allow companies to easily raise money for a future product. Yeah, we would be putting a bit of a damper on companies that are legitimate that are raising money this way. I just think that the benefits of regulating it out of existence outweigh the costs. Also, by the way, I want to make an important distinction here. I think Bitcoin and blockchain technology is incredibly important. I think once the volatility that is in large part driven by ICOs dies down that it will be continually used as a medium for exchange. And I also think that blockchain technology and cryptography to secure ledgers and secure transactions, I think that that will start being used more and more by private institutions as well as potentially the government to make things more secure. We do need to worry a lot about cybersecurity. I think there’s a lot of value in blockchain. I just think that ICOs are too dangerous.

Luigi: Kate, we should rush to sell our Katecoin before you succeed in blocking all ICOs.

Kate: If you want to make Katecoin, be my guest. But I’m not endorsing this sort of activity.

‘Quitaly.’ ‘Italeave.’ Whatever you call it, Italy’s recent election results are stoking fears that the once staunch supporter of the EU may be the next country to exit. Kate asks Luigi, our resident Italian expert, how we got here and why it matters.

Speaker 1: The market is getting very spooked by what’s going on in Italy, and we know that-

Luigi: Hi. I’m Luigi Zingales at the University of Chicago.

Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Speaker 4: Italy officially becoming the next European country to deliver huge victories to far-right populist parties.

Speaker 5: The two biggest winners, the populist Five Star movement and the right-wing League, earned better than 50 percent of the vote.

Speaker 6: Some have said, in recent months, that the wave of populism is over, but it seems to be cresting again, at least in Italy.

Kate: On today’s episode, we’re going to be talking about Italy, its role in Europe, and the most recent Italian elections—whether we should be concerned about it here in the US. We really scratched our heads as to who we could have on the show to be an Italian expert. I think after some time, we realized that we’ve got our own expert right here. Also, what did you have for breakfast this morning?

Luigi: Avocado and grapes.

Kate: No prosciutto today?

Luigi: No prosciutto today.

Kate: Almost every time I talk to Luigi, he’s had grapes and prosciutto, which I think qualifies him to talk about all things Italy.

So, Luigi said something a couple weeks ago which really struck me.

Luigi: Yeah. I said for the European Union, the Italian elections were worse than Brexit.

Kate: That’s pretty crazy to me, because at least over here in the US, there was a ton of hype about Brexit when it was going on, and we’ve heard a lot less about the recent Italian elections. So, why is it so bad for the EU?

Luigi: There are two things that, in my view, can be worse than Brexit. The first one is this is an indication that a country that was super pro-Europe has turned around and become anti-Europe or Euro-skeptic. So you have to realize the that United Kingdom was always a marginal partner, at least in spirit, to the European Union. They joined relatively late, in 1973, and if you look at polls, the polls were always 50-50, 40-60 in favor of the European Union. So there wasn’t a sense that the European Union was really popular in the United Kingdom. Italy was a founding member of the European community that later led into the European Union. This was started in 1957 actually in Rome. The Treaty of Rome is the founding treaty of the European community. For the greater part of the last century and the beginning of this one, the support for the European Union in Italy was enormous. Like 80 percent of the people thought they benefit from being part of the European Union. This support, starting in the early 2000s, started to drift down. Recent polls are more like 50-50, and the vote gave a majority of the votes to parties that are anti-Europe. Not necessarily anti-Europe, but they are, let’s say, Euro-skeptic, if not anti-Europe.

The second is, this election could lead to what I prefer to call Quitaly, where Italy might leave the euro. By the way, according to the treaty, leaving the euro implies also leaving the European Union. So it will be similar to a Brexit but much more disruptive than the Brexit because it might involve the breakup of a common currency.

Kate: Right. This is a distinction that still confuses me, I’m a little embarrassed to say. Could you walk us through what you mentioned just now, the Treaty of Rome in 1957, but also how that led to the formation of the EU, as well as the eurozone and what the differences are between those things?

Luigi: Immediately after World War II, there was a very strong push to try to make France and Germany be allied to avoid what happened twice in the century, i.e. a major world war about the tension between France and Germany. The nutshell of what is now the European community started as a commercial deal, mostly between France and Germany, to make accessible to France some of the coal and steel in Germany, to make it more difficult for Germany to become powerful again militarily and start another world war.

That original agreement was formed by France, Germany, and then surrounding countries: Netherlands, Belgium, Luxembourg, and Italy. One of the big changes between the European community and the European Union was that when it became a European Union in 1992, it introduced also the free movement of people within the union. If you are an Italian, you can freely go and work in Belgium, and if you are from Poland, you can freely go and work in France. In the process, a lot more countries were admitted to this union, starting with Austria, that used to be a neutral country, and so on and so forth. Then, around that time also, some of the core countries signed a treaty called the Treaty of Maastricht to create a common currency.

Kate: So, to be clear, where the eurozone is the group of countries that adopt the euro, a single currency, whereas the European Union was just a broader set of countries with a centralized governing body that mostly oversaw ... What? Commercial deals? Trade agreements?

Luigi: The centralized part is very weak. We do have a European parliament, but it’s not very powerful. Basically, think about there is a commercial union that is called European Union, and then there is a common currency that is called eurozone. However, and this is important, in principle, the idea is that every country that belongs to the European Union eventually should belong to the euro. And, this is crucial for the discussion we’re going to have today, there is no way to exit the euro without exiting the European Union. So the two things, at least on the way out, they are connected.

Kate: So let’s go to Italy after the financial crisis. How has the economy been doing? What’s been going on politically since then? What are other factors that are leading up to the Italian election that just took place?

Luigi: So, the global financial crisis had, as a first-order impact, a strong reduction in international trade. Italy was hit by this much stronger than most countries. Just to give you a sense, German exports dropped by 10 percent. Italian exports dropped by 20 percent. The United States in 2009 had a recession, I go by memory, of 3 or 4 percent. Italy, 5.6 percent. So Italy was hit very, very hard. Then, by the time we’re slowly recovering, we are 2010, 2011, people started to doubt that the Italian government could actually pay its debt. Whenever there is a doubt like this in a country with an independent central bank but a sovereign central bank, the central bank tends to come to the rescue of the government. In the eurozone, this did not happen until late in 2012. In the meantime, Italy experienced a dramatic rise in interest rates, a fiscal crisis, had to cut the budget deficit in a major way, at the time we were just slowly recovering. It’s as if, let’s say, in 2009 the United States, instead of adding a gigantic stimulus package, had to cut their deficit by a huge amount.

That triggered a second recession that had a dramatic impact, also, on the stability of the Italian banks. Over the period 2008 and 2015, 35 percent of the loans to firms got into default.

Kate: That’s crazy.

Luigi: Three major banks basically collapsed, unemployment shot at 12 percent, and youth unemployment shot to 35 percent.

Kate: So what does this feel like for an Italian? Do you have friends and family who are really suffering from these two recessions?

Luigi: Yes. I have my parents. My father passed away in 2015, but at the time, both of them were alive. One of my concerns was, what happens if banks fail and they can’t buy food? One of my concerns was, I want to make sure that they have enough cash at home that if anything happens, they could actually go to the grocery and buy. The possibility of a generalized bank failure was not out of the feasible set. I have a lot of friends who lost their jobs and are unemployed or were unemployed for a long time. I have nephews and nieces who find it very difficult to find a job. I think the typical Italian of the generation of my kids looks forward to expatriating somewhere else. My son, who lives in the United States, got married at age 25, and when he announced this at the family gathering at Christmas, everybody thought he was joking. How could somebody at 25 support himself and actually start a family? In Italy, it’s inconceivable. Generally, you leave your parents’ house when you are 35. It’s not a coincidence that fertility in Italy is one of the lowest in the world. People don’t have kids, because generally, you don’t have kids when you stay in your mother’s house.

Kate: So, did Italy ever recover?

Luigi: Now, Italy is going again, but in 2017, people were celebrating that we grew at 1.5 percent after years of recession or growth below 1 percent. This is not enough, because Italy’s GDP, in real terms, is below what it was in 2007. We still have to recover from the beginning of the Great Recession.

Why the recovery was so slow, a number of things. One is we couldn’t devalue like, for example, the United Kingdom did to recover. The other one, which was quite important, is Italy had a banking crisis due to the fact that when you have 35 percent of your businesses defaulting, basically, it’s very hard for banks to stand. The Italian government found it very difficult to intervene in this banking crisis because there were a bunch of European rules that made this more difficult. That delayed the recovery in a major way. Now, the recovery slowly is taking place, but there is still a huge amount of discontent.

Kate: All right, so now let’s talk about the Italian political system and bring this to the recent election.

Luigi: First of all, it is important to understand Italy is a parliamentary system, not a presidential system, so our president is kind of the Queen of England—decides who to appoint but not much more. I’m exaggerating a bit for simplicity. What decides who rules is basically the set of parties, the coalition, who can get a majority in parliament. Traditionally, you could think about the party being divided into two major blocks. One called, not surprisingly, the Democrats, and very similar to the US Democrats. Another was a coalition of center-right parties, kind of the Republicans, but until very recently, led by Berlusconi, which is not that different from Trump. It’s just a kind of nicer version of Trump.

Kate: Then, more recently, I know that there’s been some turnover in your political system, but Matteo Renzi has been more powerful. He’s more of a Democrat, right? At least, more centrist?

Luigi: Yeah. In 2013, there was some elections in which the Democrat got a majority but not enough to rule. After some internal in-fighting, eventually Matteo Renzi, a young fellow, became the leader of the party and got a coalition with some of the conservatives in order to run the country.

Kate: Can we think of Renzi as like a Macron or a Justin Trudeau in Canada?

Luigi: Actually, the better example is Obama. If I may say, he turned out to be like Obama in that he was better at giving speeches than running the country.

Kate: Yikes. We’ll save that for a different discussion. So, then what happened?

Luigi: Two things happened. First of all, back in 2006 or ’07, a comedian, a professional comedian, started a movement. The first gathering of this comedian was a day that was called Vaffa Day that, I don’t know whether I can say it on air, but basically translated, I’m sorry to say, is ...

Kate: Just say it.

Luigi: Go eff yourself. This was basically a protest movement against the perception, and I will say also reality, of a country that was stuck with old politicians, old businesspeople, most of them corrupt. Just to give you a sense, the leader at the time, Berlusconi, was in his late 70s and had been in politics for more than 20 years. The largest banks were run by people in their 80s. The president of the republic was in his late 80s. It was what we call a gerontocracy. That is a fancy name to say ruled by old people.

Kate: A bunch of geezers.

Luigi: The great feature of this movement is it was appealing to both sides of the political spectrum. One some issues, it was more on the left side, like environment, like anti-corruption. On some issues, it was more right-wing. For example, concern about immigration.

Kate: All right, so I sort of like the idea of this guy. He at least sounds fun to listen to. Was there some expectation that he would actually do well?

Luigi: No, at the beginning, he was considered like a caricature, as you can imagine. He has a degree in accounting, which is something you don’t expect from a comedian.

Kate: From a comedian, yeah.

Luigi: But that puts him better than most politicians. Actually, the right example is like John Oliver. So imagine a John Oliver starts a political system.

Kate: So, what is this Five Star movement?

Luigi: The answer is we don’t know yet, but this is the interesting thing, is the movement, first of all, called itself a movement, not a party, because they try to be post-ideological. If you take away the jargon, they are trying to get people to express their opinions from bottom-up. So they tend to be less strict ideologically than most parties.

Kate: So in addition to Brexit, something that got a lot of attention in the American press was the refugee crisis from Syria, which involved a lot of provocative images of people washing up on beaches, boats full of people immigrating to Europe. To what extent has immigration and potentially anti-immigration sentiment been as strong in Italy as it was in England and Britain?

Luigi: It’s interesting that you mention Syria. You don’t mention Libya. There was a major refugee crisis from Syria that went through Greece and, eventually, to Germany. That was stopped by an agreement between the European Union and Turkey. There’s still an open crisis, actually, through Libya. Italy is at the front line of this crisis, and this is a crisis, you’ll be happy to know, that is not being caused by American interventionism. There was a major attack to Libya that destabilized the Libyan regime, and now, Libya is a failed state that favors illegal immigration to Italy. In case you don’t get your geography right, little Italian islands are very close to the shore of Libya, so there are a lot of people that make money by bringing potential immigrants to the border of the Italian sea border and then dumping them there and Italy rescues them. Then, this is the interesting thing. The European treaties say that if you rescue an illegal immigrant, that illegal immigrant must remain in the country that receives it. It’s as if all the illegal immigrants in the United States went through New Mexico, and New Mexico was responsible, out of the state budget, to pay all the costs of all the immigration. So Italians are mad about the situation, but they are not so mad against the immigrants. They’re mad against Europe.

Kate: Wait, but I thought the whole idea of the EU was that people could move freely between countries.

Luigi: Except if you are an illegal immigrant. The rules say if you’re an illegal immigrant, you have to remain in the country that accepted you. Of course, all this immigration created a huge resentment against the European Union that added up to the economic discontent. I want to be very clear: the economic discontent is not only the responsibility of Europe, but certainly, Europe did play a role. The rest of the role, I think, was played by the Italian establishment. The combination between the two created a perfect mix to have parties that are antiestablishment and anti-Europe to win the election.

Kate: OK, but as of right now, it seems like since no one has the majority, Italy is sort of stuck at a stalemate. Couldn’t this be good for the eurozone, then?

Luigi: Depends what you mean by good. Is it good in the sense that it postpones problems? Absolutely. It’s going to be more calm, and the markets seem to be very calm at the moment. I have to say that even Germany took six months to form a government, so it will not be surprising if it takes six months to form the Italian government. There is a possibility of new elections. So we don’t really know what is going to happen in the near future. The question is, can the eurozone reform itself in a way that makes it more viable for countries like Italy to be there? Or at some point, do we need to conceive a breakup? At some point, I conceive a breakup in which Germany will leave from the top. It’s much easier to leave a currency union from the top rather than to leave from the bottom. If Germany wanted to leave and create a northern euro, that I will label the neuro, it will be a strong currency and will make it much easier for the rest of the union to go along.

The problem of this is, seriously, where will France fall? This has always been the dramatic question in the European Union, because France is more like a southern European country than they want to admit, but they want to be in a coalition with Germany in order to avoid another world war. If Germany were to leave the euro from the top, France would be forced to either join the German currency union and basically destroy its economy or be with what they call, with a lot of contempt, the Club Med, and be with the southern European countries. I don’t think that any French president will allow that to happen, because it will touch their national pride.

Kate: It sounds to me, actually, like what happens in Italian elections don’t really matter for the eurozone or for the EU. If Italy is so screwed if you leave because that will trigger bank runs, which will just plunge Italy into another very deep recession, then, in some sense, you’re stuck. So Germany can just treat Italy however it wants, right?

Luigi: I think that we can look at the example of Argentina. Argentina was in a unilateral currency union with the dollar. For many years, the currency union worked very well. Then, there was an increasing problem in Argentina to export and an increasing problem in Argentina to pay the debt. All the governments have promised that they will never exit the currency, and eventually, they did, and they defaulted on the public debt. It took five presidents in two months to do that. It’s extremely politically disruptive, because the person doing it is not going to survive.

There is this famous line that if something is not sustainable, eventually, it will not be sustained. It’s not that deep, but it’s actually quite important in thinking about this thing. Is the euro sustainable for Italy long-term? I have my doubts. In many ways, the last few years have been the best possible world for Italy because interest rates were incredibly low, the euro, until recently, was relatively cheap vis-a-vis the dollar, and oil prices were quite low. The combination of these three, if you have to pick the best variables for Italy’s economy, those are the three variables. With this magic combination, we achieved 1.5 percent GDP growth. The upside, in my view, is limited. The downside is quite serious.

Kate: So, what should the leaders of Europe do, both the leaders of Italy after the most recent election as well as the leaders of the EU and the ECB?

Luigi: I think that in Italy, it’s relatively simple. Simple to say, very difficult to do. You need, really, to turn over the existing establishment. The message was very clear: Get out of the way. I think that, potentially, in terms of votes, the parties that won the election have the force to do that. Now the question is, it’s easier to send home people. It’s not easy to find qualified and competent and better people to replace them in a short period of time. I think that is their first mandate, and they should work on that. The second one is trying to do a good-faith effort in renegotiating the situation in the euro. For example, pushing for a European unemployment insurance, to me, should be a first priority. I think that negotiating hard on this, if they succeed, possibly, the situation is fixed. If they fail, I think they will have a stronger mandate to say, “You know, we can’t continue like this, so maybe we should think seriously about breaking away from the euro.”

The European leaders should pay attention. I think there was a sense in which people thought that you could govern Europe from Frankfurt. The perception was once we control the common currency, we can control the politics on all the European countries. I think the message from Italy is people are sick and tired of this. Part of the aversion toward the euro is that people are starting to see this game. So I think it’s very important for both the political authorities but also the monetary authorities to understand that the game has changed, and they have to change the way they play it.

Kate: So I don’t know if I speak for all Americans when I say this, but at the end of the day, I’m pretty selfish. I care about what happens here. So why should America care about what’s going on in Italy?

Luigi: I think for two reasons. First of all, if Italy were to exit the euro, probably the euro will break up in a major way. This will create economic and political turmoil in Europe with dramatic repercussions in the United States, as well. I think that just for those spillovers, you should care about it. Second, many people, after the 2016 election that brought a lot of populism to victory in the UK and in the United States—2017 sounded like a pretty stable year with Macron winning France and, in the Netherlands, the populist is not gaining too many votes, and in Austria, the right-wing candidate did not win, and so on and so forth. So people thought that was the end of it and things will subside. The Italian election suggests that, no, that people are upset. When they get to vote, they vote very strongly antiestablishment. In the grand scheme of things, the Five Star movement is not the worst thing that can happen, because they are pretty moderate in many policies, except for their anti-European bias. If they were to fail at the government this time, we could have more radical movements. I think that the easy way to manage Western democracy that prevailed for most of the period after World War II, I think is broken and is broken in Western Europe, is broken in the United States.

Kate: All right, well, Luigi Zingales, it was a pleasure having you on the show.

Luigi: Thank you, Kate.

10 years after dark pools of derivatives contributed to the Great Recession, former Commodity Futures Trading Commissioner Sharon Bowen tells Kate & Luigi how she helped bring transparency to the market and visited a few grain silos along the way.

Speaker 1: You know what, right now, breaking news here. Stocks all around the world are tanking because of the crisis on Wall Street.

Speaker 2: It was a historic day with Wall Street shaken to its very foundation today.

Luigi: Hi, I’m Luigi Zingales, at the University of Chicago.

Kate: And I’m Kate Waldock, at Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Kate: On today’s show, we have the great pleasure of welcoming Sharon Bowen. Sharon served as the commissioner of the US Commodity Futures Trading Commission, or the CFTC, from 2014 to 2017. Before that, she was vice chair of the Securities Investor Protection Corporation and before that, she was a partner at Latham & Watkins. Welcome to the show.

Sharon Bowen: Thank you, thank you for having me.

Luigi: Let’s start by going back to 2008. In September of that year, the world was coming to an end. On Monday, Lehman filed for bankruptcy. On Tuesday, AIG asked for the government to rescue them.

Speaker 6: What in the world is happening on Wall Street?

Speaker 7: Two-year note yields went from 190 to 166 in the blink of an eye.

Speaker 8: I have never, live, looked at the DOW Jones Industrial board and seen a 600-point loss.

Speaker 9: Who knows where this is going to end up? This is volatility we haven’t seen of course, since way before you and I were born.

Speaker 10: By what Warren Buffet once called financial weapons of mass destruction.

Luigi: Sharon, when was the first time in that ominous fall that you got a sense that this was really big and this was really scary?

Sharon Bowen: I would say it was the weekend before, I was starting to get emails to basically say don’t be surprised if you see numbers being thrown out about some investment banks being sold for $2 or some of them possibly going out of business. There were a lot of rumors over that weekend. When I woke up that morning and just saw the market just go straight, straight down, it was scary. It was absolutely scary, and I don’t think any of us really knew what it really meant. We just knew it was really bad. It was really, really bad. And you saw the pictures on the news of people packing up their boxes, businesses closing down, the restaurants that used to rely on the businesses to come to eat lunch were closed, and the dry cleaners that used to clean were closed. The taxi services and car services that used to be there closed.

Being in New York City, I saw sort of the ugly parts of the financial crisis pretty much up close and personal.

Kate: Are you allowed to talk about your clients at the time, and whether any of them were particularly affected by what happened to Lehman and AIG?

Sharon Bowen: Well, all of them were affected obviously. Lehman had been a client of my former firm.

Kate: Oh, wow.

Sharon Bowen: We knew people who actually worked there.

Luigi: When you were invited by President Obama to serve on the CFTC, did you feel like a sense of mission that here we are many years later, and we tried to prevent what happened in 2008 and as we will discuss with the listeners in a second, the CFTC plays an important role in preventing a repeat. Did you have a sense of mission?

Sharon Bowen: I did, but it actually started with my being the acting chair of SIPC, Securities Investor Protection Corporation. SIPC traditionally is a sleepy organization, but during my time, we had the Lehman Brothers bankruptcy, we had the Madoff scandal, we had MF Global. We had some of the most notorious–

Luigi: An easy time.

Sharon Bowen: Yes, and through that lens, I got to meet with many investors who were severely harmed financially from the marketplace, and as I mentioned before, seeing the devastating effects on family members and people’s retirement savings. I actually did, I really felt a calling to do it, plus as it turned out, I was the first African-American commissioner of the CFTC.

Kate: That’s amazing.

Sharon Bowen: It was quite an honor to play in that role, but as I said then at the time of my confirmation hearing, that I wanted to be a voice of the voiceless, those who traditionally had never had a seat at the table.

Luigi: That’s exciting because most people probably don’t know what the CFTC is, and you said giving a voice to the voiceless, and when people think about giving a voice to the voiceless, I don’t think they think of the CFTC as the primary place, but I think it’s a very important role. How do you explain to your kids, to your mother, to your friends what is the CFTC and why it was so important what you did there?

Sharon Bowen: There are two different ways that I explain it. For the everyday person, I try to explain how the electricity in your home, your heating bills, the gasoline you put in your car, the milk that you drink, everyday products are financed through instruments that we regulate in our commodities markets. We have our roots in agriculture. Initially, the CFTC really started as a means for farmers and ranchers and manufacturers to hedge against the future prices of products, so it’s a way for farmers and ranchers to mitigate the fluctuation of prices going up and being able to lock in today the price of a particular ingredient so they would have some certainty in terms of that price.

For other people, I will sometimes say it’s things like how much you pay for your mortgage. Interest rates, everybody’s tied to it, credit default swaps are tied to it, financial currencies are tied to it, so they’re financial instruments and obviously, derivatives, some of them a little bit more esoteric instruments, but again, they’re used for hedging.

Virtually every corporation uses it. Everyone is really affected by it, frankly, every day.

Kate: You gave the example of let’s say a farmer using commodities futures or derivatives to hedge the future price of some input, let’s say it’s like feed for their livestock, but one of the dangerous things about derivatives, correct me if I’m wrong, is that you don’t have to be a farmer in order to buy let’s say those derivatives. You could be like a regular person. It could be me, and if I want to take a bet on the price of feed going up, I could buy a derivative that will pay off if it goes up by a lot, and if it goes up by a huge amount, in let’s say like an unlikely event, chances are I won’t have to pay much to take that bet. Is that part of what makes derivatives so risky?

Sharon Bowen: Well obviously, there is speculation in our markets. You’re correct in the sense that we did hear, while I was at the agency, from some of the farmers and ranchers who really were concerned about the volatility in their markets and who thought that the high-frequency traders were in their markets and making price discovery much more difficult for them. Whenever we hear things like that from end users, we take those kinds of things seriously. We take a look at the markets, but speculation in and of itself is not bad. That is part of price convergence and price discovery, but it’s the excessive speculation and the manipulation of the market that we protect against.

Kate: By end user, you mean people who are truly using derivatives in order to hedge against risk, right?

Sharon Bowen: Correct.

Luigi: It will be useful to de-mystify the term derivatives, because people use it all the time and many listeners might say, “What exactly is a derivative?” Now, a derivative takes its name from the fact that there is a security whose payoff derives from the payoff of something else. If you own a house, hopefully you have insurance on that house and that insurance is a derivative because the payoff of that insurance derives from the payoff of the house. In that particular case, the insurance is a hedge, it protects you against the possibility of fire, earthquake, something that might destroy the value of what for many of us is the most important asset, which is your home.

Like for insurance, there are many derivatives that are meant to hedge, to cover the risk of what people do, from people planting in their harvest, to people using livestock to feed their animals, and so on and so forth. However, as Kate pointed out, in order for the market to work properly, you don’t have only hedges, you have people that provide the service with the hedges that have the terrible name of speculators, and those speculators in part serve to make the market liquid, in part may actually destabilize the market.

In the last 10 or 15 years, the number of participants in these markets has increased dramatically. And especially in many commodities markets, there used to be mostly final users, and around 2004-2005, we saw an impressive entry of the typical financial institutions, the Goldmans and Morgan Stanleys of this world, and not surprisingly, the final users started to complain because the volatility went up. What is your view on that, if you have one?

Sharon Bowen: Right, well see, taking it to the extreme, we can talk about the financial crisis, when in fact, we were not regulating those derivatives. We had no idea what was happening in those dark pools in the market, and as a result of the financial crisis, as you know, the Dodd-Frank Act came into place, and that expanded greatly the powers of the CFTC to regulate the so-called derivatives, the esoteric transactions that clearly exacerbated the financial crisis at the time. With that, extensive rules were put into place to require, for example, capital to be there that normally was not required by some of the financial institutions.

We required that they be cleared in a much more transparent way and executed on platforms. For the swaps and derivatives that were not subject to what we would call margin, we made sure that the cost of capital was even higher, so we really wanted to force onto a lit exchange those very transactions that were really dark and opaque. We had no idea what they were at the time. Through Dodd-Frank, we were able to bring some transparency to the market and to try to mitigate the systemic risk that those kinds of instruments really posed.

Kate: To clarify what you just mentioned about clearing, which was an important part of Dodd-Frank, yes, there were a lot of derivatives that were cleared prior to the financial crisis, but there were some derivatives that were sort of operating in the shadows. Let’s say I was a speculator and I wanted to just make some money by making a bet that locked in the future price of let’s say corn feed. If I were to make that bet one-on-one with my investment bank prior to the financial crisis for certain derivatives, the government might not know about it at all. This could’ve just operated in the shadows.

Part of what clearing did was not only to bring these transactions into light, make sure that somebody was monitoring them, but clearing or clearinghouses also make sure that whoever was taking the other side of the bet, whoever would have to pay out in the future, potentially, has enough money on hand, enough capital in order to meet let’s say what would happen if I were to receive some money in the bet. Is that an accurate way of describing the role of clearinghouses?

Sharon Bowen: That’s a really good job of it, I think. To bring onto the markets those transactions that were otherwise opaque. Most of those that got us into trouble were the credit default swaps and interest rate swaps and those kinds of transactions that were kind of off-exchange. You’re correct, one of the mandates was to introduce central clearing of standardized products into the market, and because of that, I mean at that time it was something like a $700 trillion notional amount market. It was a huge market that we really, frankly, didn’t know how big it was.

We have now created a whole new structure where these transactions take place in clearinghouses, and those transactions as you say are subject to margin, which is collateral, i.e. cash or highly liquid instruments to support the payment of those obligations. The clearinghouse stands in the middle of the buyer of the trade and the seller of the trade if you will, they stand in the middle and their job is to mitigate the risk that the trade would fail. That’s the purpose of the clearinghouse. Whereas before, people had to depend on each other’s credit as to whether or not they were worth the transaction.

That was the major difference in bringing clearinghouses and the transparency. At the same time, the participants in the clearinghouses were required to be registered. The third thing that happened was data had to be reported.

Luigi: Sharon, you mentioned the magic word, credit default swap. This word was unknown to the large public until 10 years ago, when it became a matter of conversation all over the country because they were one of those derivatives that might have caused or exacerbated the financial crisis. Let’s first explain what they are: credit default swaps is basically nothing else than insurance against the possibility that a borrower may default and not pay the actual amount. Instead of being an insurance written by an insurance company, it is actually an instrument traded on the market.

Here, I need to bring you back to history because historically, the CFTC did not have any authority to regulate these kind of derivatives, and a very courageous woman, Brooksley Born, in ’98 tried to actually ask for the authority to do so because she realized that these instruments were traded over the counter, which means between banks, and there wasn’t really a good understanding of what was happening, and in particular, there was a fear that too much risk was taken and this risk might materialize as it unfortunately did in September 2008.

When she insisted that, she found herself surrounded by a bunch of angry men, can I say that, starting from the Federal Reserve chairman at the time, Alan Greenspan, to the Secretary of the Treasury at the time, Larry Summers, and they actually said that this was a terrible idea and made everything possible to stop this from taking place, and so she ended up resigning. Did I tell the story correctly, Sharon?

Sharon Bowen: I wasn’t there at the time, but as I understand the story, you’re right. Former commissioner Born was one of the first to signal the problem that could be inherent in these types of products. My understanding at the time was that some of the other potential regulators, the Fed and the Treasury, thought because the transactions were between highly sophisticated investment banks trading with each other, they were sophisticated enough to be big boys playing in the same field, if you will.

Luigi: Yeah, you used the right term, big boys.

Sharon Bowen: Right.

Kate: One of the, I guess, concerns I think voiced by Greenspan and Summers and others against bringing these sorts of derivatives and swaps onto centrally cleared exchanges was that there’s some cost to having to do that, correct? You have to pay some sort of fee. You aren’t allowed to operate privately anymore. Also, you have to comply with the rules of the clearinghouse or the exchange. I think one of their concerns was that if the US started imposing these rules, a lot of these transactions would go offshore to potentially riskier domiciles. Do you think that that’s actually a legitimate concern?

Sharon Bowen: It was a concern and, you know, as a result of the financial crisis, we had the meeting of the G20 in Pittsburgh, which is really sort of the beginnings of the creation of Dodd-Frank, where the major financial centers and countries said, “We need to work together to make sure that our markets are protected globally,” because these markets are global markets, the transactions don’t stop at our borders. It’s really important, and at that time, a number of working groups, international working groups were formed to try to create standards across jurisdictions. I think our agency at the time with the CFTC, and I’m sure it’s the case today, works really closely with international regulators, particularly those in Europe, where things like interest rate swaps and CDSs are traded in a large percentage outside of the US.

You’re absolutely right, it was expensive. Industry did have to invest a lot of money, but I think it was well worth the cost to mitigate the kinds of risk that we would have such a devastating effect again. At least with the margin, having margin there and collateral—sort of the two defenses, if you will, to a failure of a clear member—that, I think, gives us the possibility that we’re less likely to have another taxpayer bailout, which was the whole point.

Luigi: Some people, not of course all, but some people interpret the cost benefit analysis as, I see a cost, I don’t see benefits, let’s get rid of all of it. That, of course, is wrong. It’s also wrong that any regulation is useful because as we were discussing earlier, there are a lot of pieces of regulation that are more burdensome than useful. Cost benefit analysis is useful, but it’s challenging, and particularly when the benefit is preserving the trust of investors in the marketplace, which–

Sharon Bowen: It’s priceless.

Luigi: It’s priceless, exactly.

Sharon Bowen: Yeah, it really is priceless. I mean you do want to have investors have the confidence to be in our markets. If they think it’s a rigged system, that’s not a good system. I think that transparency is always the key. Having fair, transparent markets, as long as we can keep our markets fair and transparent, I think you’ll have investor confidence. That works for all participants, not just investors, but competition is competition. The brokers, they compete against each other so they’re not going to want to see one person game the system over someone else either. They want to see a level playing field.

Kate: I want to switch gears, if I may. If I’m correct, when you resigned from the CFTC, you cited your lack of ability to form a quorum amongst commissioners as part of the issue. In order for there to be a quorum, there’s supposed to be five commissioners, there have to be three for there to be a quorum, but there were only two commissioners that were even standing at the time that you resigned, right?

Sharon Bowen: When I left, two new commissioners were in place. In June, I had announced my intent to resign, I didn’t give a date certain. Part of my announcement of my intent to step down was my hope was that I would add a little pressure if you will to Congress because if I left, it was questionable how much chairman Giancarlo could do by himself. And you’re right, it should be a five-person commission, and whichever party is in charge in the White House gets to pick the chairperson of the agency, and the majority would be three Republicans, two Democrats.

I can tell you, my experience is the CFTC is not a partisan agency. There is no Republican answer or Democrat answer, it’s that we all are trying to achieve the right answer. During the time I was there as a commissioner, I think the number of times that all of us voted unanimously was like over 95 percent. For the most part, we pretty much reached consensus.

Luigi: Should we take from this, I don’t want to put words in your mouth, but should we take that maybe some of this anti-regulatory stand that we hear in the newspaper that seems to destroy this is a bit excessive? That in reality, this is a normal process of pendulum that after a crisis, you tend to regulate and when you regulate, sometimes you tend to overdo it, and then you go a little bit back and you try to find what is really important and dismiss the parts that might be excessive or excessively burdensome?

Sharon Bowen: No, I think that’s right. Also, not just us, but the Europeans with MiFID II, they’re also going through a review of their rules to see how they can make their rules better at the same time but yes, no, you’re absolutely right, and that makes sense. These rules are complicated. Some of them did have unintended consequences that we really attempted to try to eliminate those cases where we were putting undue costs and burdens on particularly end users who were not posing a systemic risk to our market. The kinds of changes we made were to try to correct some of those unintended consequences.

I think at the same time, the industry is fully invested in the protections we now have in place and you would be hard-pressed to find, you’ll find them complaining about the cost but you’d be hard-pressed to find one who would not say that we’re not better protected today than we were before 2008.

I think that makes us more competitive. In fact, some of them will tell you, that makes us more competitive and it makes our financial markets, frankly, the envy of the world because in fact, our markets are safer.

Kate: But there are still derivatives out there that are relatively opaque, right? There are derivatives that aren’t cleared, particularly ones that are more complicated. Is there any way to know whether they pose systemic risks?

Sharon Bowen: All swaps, whether they’re cleared or uncleared, are reportable and subject to margin, but are there dark pools out there? I’m sure there are dark pools that are out there but-

Kate: What is a dark pool exactly? Can you just define that really quickly?

Sharon Bowen: Yeah, that’s off-exchange. I call it dark because it’s not on an exchange—there’s no transparency, which is why it’s dark. I’m not sure why it’s a pool, it could be a park.

Luigi: The name sounds very ominous but why are you afraid of those dark pools?

Sharon Bowen: We got bit by one in 2008. It was like an avalanche. It hit us in a way that we had no idea, it was a pretty bad bite. We should all be afraid of dark pools.

Luigi: I think then the major problem is you don’t see them coming because-

Sharon Bowen: Correct.

Luigi: The reason why they’re called dark is because you don’t see the data, and transparency is a big help in those situations.

Sharon Bowen: Yes, absolutely.

Luigi: Going back to the decision-making process, you are saying that there is a procedure of course ...

Sharon Bowen: Yes.

Luigi: ... where you hear all the sides but one of the concerns is banks have very good lawyers and lobbyists that are representing their side, and farmers and individual users are not as well-organized and they tend not have good lawyers and good lobbyists. What do you do to-

Sharon Bowen: You’d be surprised by that, actually.

Luigi: How do you make sure that you’re not fooled by this imbalance? It’s kind of you are a judge in which on the one hand, you have a slick lawyer, on the other hand, you have somebody defending himself?

Sharon Bowen: Right. Well, it’s interesting, so all three of us had Wall Street backgrounds, and none of us had an ag background. And so we all met the farmers and ranchers. We went out to the grain elevator here outside of Chicago, we made trips to see the whole process, which really, frankly, I encourage everyone to do that. You will view food a lot differently after you go through that-

Kate: Can you just show up at a farm and ask to be on a grain elevator?

Sharon Bowen: It’s a lot more sophisticated than you can even imagine, the use of GPS and the use of technology to tell you how often to water. I mean it’s just fascinating, but because of our financial backgrounds, I think people were, they knew they couldn’t pull the wool over our eyes, frankly. We had represented some of them in past. We had the business background and Giancarlo also had represented the wholesale markets, former chairman Massad had worked on derivatives when they first started, as I did too in my career. So we were pretty familiar with the financial part of it, so there was no hocus pocus with firms being able to pull a fast one on us.

Kate: The Intercontinental Exchange, ICE, isn’t that one of the clearinghouses that regulates derivatives?

Sharon Bowen: They do have a couple of the clearinghouses that we regulated at the Exchange.

Kate: With all due respect, are you concerned at all about going from the CFTC to a clearinghouse that you were formerly regulating?

Sharon Bowen: Yeah, so the way I would view it is, I bring a level of expertise, obviously as a board member, I’m not a part of the management with the day-to-day operations of any of the subsidiaries. Frankly, the things I’ve always stood for, transparency, which is really key, investor protection, those are the kinds of traits and qualities that ICE really stands for.

Luigi: I suspect you’re probably one of the toughest customers on that board.

Sharon Bowen: That’s correct. It takes guts for someone to want to have a former cop on the beat, if you will, on your board, it means you have confidence in your operations.

Kate: Sharon, I have a term for you, it’s a little bit of a jargony term: you’re a BAMF POC boss lady, which is a very specific economics term that stands for badass mofo person of color, extraordinary woman.

Sharon Bowen: Oh, OK. That’s a good one.

Kate: Yeah, it’s a term that we throw around a lot in academia.

Sharon Bowen: OK.

Kate: I wanted to ask you if you could tell us a little bit about how you got to where you were, what the toughest parts of your journey were, and also whether you have advice for young women and young people of color for how to make it in law and finance?

Sharon Bowen: That’s about three books that you just asked me.

Kate: OK.

Sharon Bowen: I can give you-

Kate: Well, can you give it to me in two minutes?

Sharon Bowen: I can give it to you in two minutes. I had an interest in markets pretty early on in college. Majored in economics at the University of Virginia. Didn’t know what I wanted to be when I grew up. Applied to business school and law school. Northwestern and the University of Chicago were the only two schools that gave me full scholarships to both the business school/law school. Went to Northwestern for law school/business school.

Luigi: Sorry you made the wrong choice.

Sharon Bowen: Yeah, you know, what can I say?

Kate: It’s pretty rare.

Sharon Bowen: Yeah.

Kate: I mean I’d never heard of anyone who had a full ride at both.

Sharon Bowen: Yeah. No, I got academic scholarships to both schools, but wasn’t really sure what I wanted to do. I spent summers at Goldman Sachs, Chicago Board of Trade. Started my career at Davis Polk & Wardwell. Like most young people, thought I’d work for two years, retire at the age of 30 at Goldman Sachs. Loved the practice of law a lot, and as a fifth-year corporate associate, as Latham was growing its New York office, became a partner, had great clients, great work. Just really fortunate.

The advice I would give to people is to follow your passion in terms of the things that motivate you to want to get up every morning, and treat it like a marathon.

Kate: Well Sharon, it has been a great honor and a great pleasure having you on the show. I learned a lot today about the CFTC. I think I maybe understand what it does now.

Sharon Bowen: Pleasure to be here.

The U.S. economy may be booming, but despite a recent uptick wage growth remains stubbornly flat. Kate & Luigi examine the effect of monopsonies in the labor market among concentrated industries like Big Tech. Are companies colluding against workers and driving down wages?

Academic articles

- Labor market concentration is pervasive and associated with lower wages: http://www.nber.org/papers/w24147

 

News articles:

- On the decline of labor mobility: https://democracyjournal.org/magazine/42/getting-people-where-the-jobs-are/

- Personal emails between Steve Jobs and Eric Schmidt about poaching: https://www.theverge.com/2012/1/27/2753701/no-poach-scandal-unredacted-steve-jobs-eric-schmidt-paul-otellini

- Fast food no-poach agreements: https://www.nytimes.com/2017/09/27/business/pay-growth-fast-food-hiring.html

- Some statistics and opinion on non-competes: https://www.forbes.com/sites/omribenshahar/2016/10/27/california-got-it-right-ban-the-non-compete-agreements/#560ab28f3538

Speaker 1: 200,000 jobs added last month. That’s a big number. The bigger headline though is that paychecks, wage growth, is way up, and it’s the fastest pace we’ve seen in years.

Luigi: Hi, this is Luigi Zingales, at the University of Chicago.

Kate: And I’m Kate Waldock, at Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Speaker 4: I mean, if you’re somebody who is working in this American economy, you want your wages to go higher. So yes, we saw wages increase at the fastest pace as we’ve seen since the recession, since eight years ago.

Speaker 5: The wage growth number, it looks like we’re finally starting to see a tight labor market give workers more bargaining power.

Speaker 6: The wage growth jumped from 2.5 percent to 2.9 percent. That’s a huge jump, and you can attribute that for a couple of reasons. For one, the tax plan. We saw dozens of companies hand out raises and bonuses …

Kate: All right, I think we should slow down for a second. The fact that there has been a slight increase in wages over let’s say the past month or two has been encouraging for some of us. But for those of us who have been looking at long-term wage stagnation over the past couple of decades, I don’t think it’s time that we can celebrate yet.

Luigi: What is interesting, of all people, the ones who are concerned about wages not growing enough are central bankers: the head of the Federal Reserve, the head of the European Central Bank, the head of the Bank of Japan. Why are they concerned? Because they have some inflation target to reach, which is 2 percent per year. Without some wage pressure, they cannot reach that target. The irony is, you think about central bankers as always being on the side of trying to keep the wages down. But now, they are wondering themselves: what is keeping wages down?

Kate: I think also another part of this story is that low wage growth has been juxtaposed against pretty high corporate profits. This has been an issue for a lot of advanced economies, not just the United States.

Luigi: So the question we’re trying to understand is why that’s the case. We need to understand first how wages do rise in general. The idea is, when there is a booming economy and firms are looking for more employees, they start to bid up the wages of people who are employed in other places, or they are unemployed and they need to get in the labor force, to attract more people to work. This is the fundamental law of demand and supply. When demand for labor is increasing, as it is now in most parts of the world as a result of a continuing expansion, then you should see a rise in wages as well. The puzzle is that we don’t see that enough. Just to give you a sense, from 2009 to 2014, wages went up only by 8.7 percent, when inflation went up by 9.5 percent. So the real wage-

Kate: Is that in the US or globally?

Luigi: In the United States, yes. So the real wage of a US worker during those five years went down, rather than up, in a phase in which the economy was expanding.

Kate: What could be one reason for these wages going down? As you just mentioned Luigi, we have in mind this model of employers competing with one another. Maybe that’s not the case. In some markets, maybe there is only one employer. The fact that there’s only one, or only a couple employers not perfectly competing with one another, could mean that they have power over labor, or they have power over people that they’re employing, and therefore they can keep wages low.

Luigi: Let’s introduce this name that is not probably familiar to many listeners, the term of monopsony. Many people understand what a monopoly is. There is only one producer. Monopsony is when there is only one buyer. In particular, we’re interested about when it’s only one buyer of labor. In this extreme form, this is relatively rare. People have in mind the famous mines in West Virginia, company towns in West Virginia where the mine was the only source of employment. Or they might remember an old movie, maybe it’s too old for you Kate, It’s A Wonderful Life, where-

Kate: Oh, that’s a classic-

Luigi: ... in the little town ... It’s a classic, yeah, so even you know that.

Kate: Even I know that movie.

George Bailey: Just remember this, Mr. Potter, that this rabble you’re talking about, they do most of the working and paying and living and dying in this community. Well, is it too much to have …

Luigi: This guy Potter, who owns everything in the little town where the corporate bank of Bailey and Company is operated.

George Bailey: ... well, in my book he died a much richer man than you’ll ever be.

Mr. Potter: I’m not interested in your book. I’m talking about the Building and Loan.

George Bailey: I know very well what you’re talking about. You’re talking about something you can’t get your fingers on, and it’s galling you. That’s what you’re talking about, I know. Well, I’ve said too much. I ... You’re the Board here. You do what you want with this thing. There’s just one thing more, though. This town needs this measly one-horse institution, if only to have some place where people can come without crawling to Potter. Come on, Uncle Billy.

Luigi: So I think that this extreme form is rare. But in the last two decades, the concentration of industry in the United States has gone up. As a result, in many towns, especially rural towns, the potential employers are few.

Kate: Yeah. When we think about monopolies, we usually think about a global, or a countrywide marketplace for something. But when it comes to monopsonies, or companies that have buying power over labor, we also have to factor in people’s limited willingness to move around. The United States is not what economists would call a completely frictionless labor marketplace. If I’m working in New York, and a similar job opens up that pays a dollar more per hour in South Dakota, it’s not a very obvious decision that I’m going to pick up and move to South Dakota. People, for family reasons, for personal reasons, for issues of the fact that it just costs money to move, it’s hard to move around. Often times, people just want to stay in the same place.

This means that monopsonies can exist on a very local level. So even though within a particular industry there could be a few, or many firms that hire people, in small localities, let’s say a town or a county, you can still have companies that are the only employers in a particular market.

Luigi: The point you’re raising, Kate, is very important. Mobility in the United States has gone down. People are discussing what the causes are, but I think it’s a combination of factors. One is the fact that now there are more dual-career families, so if your spouse is employed, and well employed in a place, you are more reluctant to move, because you have to break up the family. The other is that in many places in rural America, people are stuck with houses that are worth much less than what they paid for them, and sometimes they can’t even sell them at a positive price. Moving to a different location might cost them a fortune.

We know that the market for buildings in cities like San Francisco or New York is not very competitive. There are restrictions to entry, and so on, and so forth. It costs so much to rent an apartment in New York that you might not want to actually move to New York, even if in New York you have a better job, and better pay.

Kate: All right, so we have set the stage, but what we are here to do is to figure out whether companies having market power over labor actually plays a role in keeping wages low. Before we move on, I think we should insert a quick caveat, that we’re not trying to answer the whole story about why wages have been stagnated. There’s a bunch of different variables that go into this. Part of the solution, or part of the reason could be globalization. Part of it could be the way that labor contracts are written. There’s a bunch of different explanations for this. We’re not going to try and address the whole picture. We’re just going to focus specifically on employer power.

Luigi: We know that concentration of industry in the United States has gone up. Unfortunately, we are discovering that in an increasing number of cases, the bidders do collude. The most egregious of these cases is actually the one that was brought out by litigation a few years back, the one that affected Google, Apple, and other tech firms in the Silicon Valley, that was filed in 2010. Now you don’t think about software engineers as employees that have particularly low wages, but it is important to look at this case, because we have some smoking gun emails about the existence of this no poaching list, in which you are not soliciting the employees of the other group.

Let’s read one of these exchanges, just to set the facts straight. In early March 2007, an employee of Google made what was considered a career-ending mistake. She cold contacted an Apple engineer by email, violating a secret, and by the way illegal, no-solicitation agreement between the two firms. Now let’s read what the exchange between Steve Jobs and Eric Schmidt, who at the time was the CEO of Google.

Kate: OK, so I’m going to read one. This is by Steve, to Eric, “Eric, I would be very pleased if your recruiting department would stop doing this. Thanks, Steve.”

Luigi: After receiving this email, Eric Sch