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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 Schmidt immediately sent an email to the top HR person at Google. In this email he said, “I believe we have a policy of no recruiting from Apple. This is a direct inbound request. Can you get this stopped and let me know why this is happening? I will need to send a response back to Apple quickly, so please let me know as soon as you can.” Just for context, in this email Eric Schmidt admits that there is an illegal restraint of trade, and is actually enforcing this agreement by asking his HR people to figure out why they violated this agreement. He wants to report to Apple that they are behaving well.

Kate: Then finally, one of the senior staffing strategists is really apologetic. He writes back to Eric, “Please extend my apologies as appropriate to Steve Jobs. This was an isolated incident, and we will be very careful to make sure this does not happen again.”

Luigi: Schmidt eventually writes to his friend Steve Jobs, “Steve, as a follow-up, we investigated the recruiter’s action, and she violated our policies. Apologies again on this, and I’m including a portion of the email I received from our head of recruiting. Should this ever happen again, please let me know immediately, and we will handle. Thanks.”

Kate: Then they sent back and forth some smiley faces.

Luigi: If you have this image of capitalists conspiring against workers, this is a pretty good exchange.

Kate: In fact, they were sued. This was one of the first major cases brought by the Department of Justice against a consortium of firms for colluding against labor, essentially. The name of this lawsuit, I’m not sure if this is official or colloquial, but the name of this lawsuit was High-Tech Employee Antitrust Litigation. It involved, as you said, several other tech firms. The original amount of the damages was on the order of about $3 billion. That amount, if the plaintiffs had won, could have increased up to $9 billion.

At the end of the day, the whole case was settled, originally for what was supposed to be $325 million. A judge stepped in, which by the way, in this sort of case is pretty rare, to say that that number is not high enough, that the plaintiffs actually need more in the settlement. So the final settlement number was $415 million, which may sound like a ton of money. But it only translated to a few thousand dollars for each of the claimants.

Luigi: What is important to stress is, this is a case in which there was a smoking gun. The emails that we read are pretty clear on the existence of this. If the worst that can happen to you when you’re caught with your pants down is to pay one-sixth of what you will have saved by colluding, the incentives to collude are pretty high.

Kate: I do think from a legal perspective, prior to this case, I don’t think there was a whole ton of precedent that the collusion by Apple, Google, etc., necessarily violated the Sherman Act. But I think after this case, I mean, it sparked a revolution essentially against these sort of non-poach agreements. Ever since then, there have been several other class-action lawsuits that have popped up, to the point where the Department of Justice in 2016 issued a statement for HR professionals, saying that this type of non-poaching agreement is explicitly illegal. So I think that there is room for a little optimism. Things are changing.

Luigi: I think that things are changing. But there is explicit pressure from the political system to make a change. Senator Cory Booker of New Jersey wrote a letter at the end of last year challenging the federal antitrust officials to be more active on that front. I think that traditionally, the antitrust has focused mostly on the product side, not on the worker side. I think that these anti-poaching agreements are clearly, in my view, a restraint of trade, and the antitrust should be more active on those.

Kate: Can I just be the devil’s advocate for a second here though?

Luigi: Please.

Kate: There is something that doesn’t really fully jive with me, in terms of how this whole thing is working, which is that you can either have monopsonistic power in high-skilled labor marketplaces, or low-skilled labor marketplaces. In both of those marketplaces, it doesn’t really make sense to me that there is necessarily a problem, because on the high-skilled end, I mean even though the plaintiffs involved, I’m sorry the defendants involved, in this high-tech case were Google and Apple and etc., I’ve been to the Google office in New York. I’ve been to some of these ... I mean, like the Facebook campus in Palo Alto. These places are essentially playgrounds for adults. They have ball pits, and they have perfume making stations. Life is pretty rosy. They’ve got famous architects coming in, making sure there’s grass growing from the walls. If these were truly monopsonistic employers, then we shouldn’t see all of these perks in these sorts of jobs. So on one hand, I feel like on the high-tech side, it doesn’t make sense that these employers are keeping wages down.

On the low-skilled side, by definition, low-skilled labor can transition more easily into other types of jobs. So if you are working for a fast-food restaurant, it may be relatively easy for you to transition to working as a driver, or for some sort of delivery service. Therefore, employers don’t have as much power over you. So where is this actually happening? It’s hard for me to imagine.

Luigi: It’s funny you mention, because one place where it does happen Is probably for young assistant professors.

Kate: Oh yeah, that’s for sure.

Luigi: Don’t you notice that everybody is paid roughly the same price at entry? The same price could be the result of two things: either a perfectly competitive market, or a perfectly colluded market. I would not be surprised if the deans of the top schools had some informal conversation about where the market is going, to basically de facto fix a price at entry. I think this is much more diffuse than you think it is.

Kate: I don’t know, I mean I would love for someone to negotiate on my behalf a higher wage, but to be honest, I think that at least in my field, at least in our field, wages are more than fair.

Luigi: I agree. I’m not saying that we’re underpaid in any possible form or shape. But I’m saying that at entry, there is some form of tacit collusion to agree on the same wage, which is an anti-competitive practice. While this may not be a major issue for a well-paid professor of finance, it is an issue, for example, for nurses. You talk about specialized labor, or low-skilled labor. I don’t know where you put nurses, but certainly they are specialized—

Kate: I think they are considered high-skilled.

Luigi: They are high skilled, but they are not very highly paid, to be honest.

Kate: Yeah.

Luigi: One of those legal suits that were brought is precisely in the direction of ... It was in Detroit, where there were only a few employers, and they seemed to collude in keeping down the wages of nurses. You mentioned fast food. Actually, there are now explicit anti-poaching agreements among franchises of McDonald’s. So you can’t compete with other franchisees of McDonald’s, to hire their workers. I consider this also restraint of trade. It seems like this is a pretty diffuse practice among franchisors to do that with their franchisees.

Kate: Yeah, I think this is another interesting case. So to be clear, fast food restaurants have these anti-poaching agreements within the same company. For all of McDonald’s franchises, they’re not supposed to poach labor from other McDonald’s restaurants, even if they’re located in the same region. So there’s a case is currently in court right now. I think the plaintiff is fighting really hard to not have the case dismissed, but that’s still ongoing. As a result of the case, even though McDonald’s is not going to want to pay up, they have removed these anti-poach agreements. So again, jurisprudence is moving us in the right direction.

Luigi: Yeah, but it needs to be nudged, because without the nudging, it will not operate. You’re right that you can consider these people as part of McDonald’s, but they’re not really, because those are independent franchisees, so technically they are not employees. As the number of independent contractors increases, the risk of these anti-competitive agreements increases as well. If I’m a driver of Uber, I’m an independent contractor. I’m not an employee. But can Uber restrict my ability to be a supplier for Lyft as well? As far as I know, they don’t do that. In fact, when I take Lyft or Uber, I ask, and many are providers of both. But suppose that they were to do that, then that is in my view a restriction on trade, because if you are an independent contractor, you are independent. You can do whatever you want.

Kate: I think the independent contractor issue is slightly different. It’s a whole separate reason for why wages may be low, but I don’t think that it’s necessarily part of this monopsony argument.

Luigi: No, I’m not saying that. I’m saying that the ability to restrict your mobility and your outside options has an impact in equilibrium on the wages that people receive. While it’s perfectly fine that if you are my employee, you cannot work for somebody else at the same time, if I hire you as an independent contractor, why do I have the right to restrict your outside activities as an independent contractor? It’s called independent for a reason. If you want to hire me as an employee, you take also the responsibility. If you don’t want to hire me as an employee, you should give me the freedom to do what I want in the rest of my time.

Kate: I think that this is a good segue into a different type of agreement that limits competition in the labor market. We’ve talked about no-poach agreements, which are issued by the firms themselves not to hire employees of other firms, or employees of other franchises. But there’s a different sort of agreement called a non-compete, which is on the part of the employee, him or herself. These type of agreement say that the employees are not supposed to use private information that they acquired as a result of working for a particular company, later on in their career, by working for another company. The purpose of this sort of agreement was to protect trade secrets, but now they’re basically ubiquitous in all sorts of contracts, including in high-tech firms.

Luigi: Let’s be clear, there are potential efficiencies in consideration for non-competes. As Kate said, it is a way to protect the trade secrets of a company, because there is a possibility of suing for stealing trade secrets, but the problem is, when you sue, you have to reveal the trade secret, and so this avenue is not particularly attractive for many high-tech firms. However, the non-competes are diffuse also among known high-tech firms. They do restrict the mobility of workers, so much so that for example, in the state of California, those non-compete clauses are considered non-enforceable. If you’re working in Silicon Valley, you can move from one firm to another without risk of being sued. In fact, the company will try to sue you anyway, but if you fight in court, you’re going to win.

Kate: So one thing that interacts very closely with this issue of employer market power is how much employees can actually move around. If you’re free to move around wherever, then it’s easier for you to find a job somewhere else. To this point, non-competes restrict labor mobility. If you have signed a non-compete agreement with your current employer, and you then want to move to a higher-paying job at a similar employer, then you may decide not to do that, because you’re afraid of violating your non-compete agreement and getting sued by your old employer. So to the extent that non-compete agreements interfere with the labor mobility and restrict labor mobility, then they’re making this monopsony problem worse, in the sense that they could be depressing wages.

Luigi: While only, only maybe is not the right word, but 20 percent of the labor force today is covered by a non-compete agreement, the impact of these non-compete agreements can spill over to other employees. The fact that Kate is not willing to move to my firm because of a non-compete agreement makes workers in Kate’s firm have lower wages. This might impact also other wages outside, because people look at what is the prevailing wage, and the prevailing wage is lower, and so they end up offering less to other workers as well. So this spillover effect can be quite important in explaining why wages aren’t rising fast enough, even in a moment of a high demand for labor.

Kate: I think one thing that we can do more to address this issue, is to support the people who are taking risks in their lives and their careers to actually file these class-action lawsuits. For example, if you decide that you want to sue McDonald’s for having these non-poach agreements amongst all their franchises, you were probably a McDonald’s worker before that. You probably are struggling to support yourself and your family. It’s incredibly costly to go through years and years of litigation, to try and fight these sorts of agreements. Even if it’s on behalf of a bunch of people, and even if there’s a chance that you’re going to get some money at the end. Even though lawyers tend to do this sort of work pro bono, or they get funding from other sources, I think that we should band together and create pools of funds, to support people who are willing to go after companies in these ways, so that they can earn a decent wage while they’re battling through these lawsuits.

Luigi: Kate, I think we should all support you for starting a class-action suit against business schools, for colluding in keeping your wages low.

Kate: Whoa, whoa, whoa, the University of Chicago is the one with all the cash sitting around. Why don’t we do this at Chicago?

Luigi: I’m not an assistant professor. You said that we should support the people who are hurt by these collusive agreements, so I argue that you are hurt. You are the first one who should start this class-action suit, and I will support you.

Kate: OK, thanks. I’ll think about it.

Are doctors and pharmaceutical companies to blame for the opioid epidemic? Kate & Luigi look at the role of supply and demand in fueling the distribution of prescription painkillers, and discuss the regulatory ramifications for medical marijuana.

Main papers discussed during episode:
- Anne Case and Angus Deaton, 2015. “Rising morbidity and mortality in midlife among white non-Hispanic Americans in the 21st century.” Proceedings of the National Academy of Sciences, 1-6. https://scholar.princeton.edu/deaton/publications/rising-morbidity-and-mortality-midlife-among-white-non-hispanic-americans-21st
- Justin Pierce and Peter Schott, 2016. “Trade Liberalization and Mortality: Evidence from U.S. Counties.” NBER Working Paper 22849. http://www.nber.org/papers/w22849
- Jessica Laird and Torben Nielsen, 2017. “The Effects of Physician Prescribing Behaviors on Prescription Drug Use and Labor Supply: Evidence from Movers in Denmark.” Working Paper. http://www.idep.eco.usi.ch/torbe-paper-319809.pdf
- Kevin Boehnke, Evangelos Litinas, and Daniel Clauw, 2016. “Medical Cannabis Use Is Associated With Decreased Opiate Medication Use in a Retrospective Cross-Sectional Survey of Patients With Chronic Pain.” Journal of Pain, Vol. 17, Iss. 6. http://www.jpain.org/article/S1526-5900%2816%2900567-8/abstract
- David Powell, Rosalie Liccardo Pacula, and Erin Taylor, 2015. “How Increasing Medical Access to Opioids Contributes to the Opioid Epidemic: Evidence from Medicare Part D.” NBER Working paper 21072. http://www.nber.org/papers/w21072
- Jane Porter and Hershel Jick, 1980. “Letter to the Editor: Addiction Rare in Patients Treated with Narcotics.” The New England Journal of Medicine, 302(2). http://www.nejm.org/doi/pdf/10.1056/NEJM198001103020221
- Anderson, Green, and Payne, 2009. “Racial and Ethnic Disparities in Pain: Causes and Consequences of Unequal Care.” The Journal of Pain, Vol. 10, No. 12 https://www.sciencedirect.com/science/article/pii/S1526590009007755
- Christopher Ruhm, 2018. “Deaths of Despair or Drug Problems?” NBER Working Paper 24188. http://www.nber.org/papers/w24188

Articles:
- New Yorker Article on Sackler Family: https://www.newyorker.com/magazine/2017/10/30/the-family-that-built-an-empire-of-pain

Speaker 1: Opioid abuse in the United States is at epidemic levels.

Speaker 2: This is probably the worst drug situation in our country in decades, if not a century.

Kate: Hi, I’m Kate Waldock, and I’m a professor at Georgetown University.

Luigi: And I’m Luigi Zingales, and I’m at a professor 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 1: The impact of the opioid epidemic is stunning, with 300,000 American deaths since the year 2000.

Speaker 5: Despite decades of advancements in healthcare, diet, and safety, middle-aged white Americans are now living shorter, not longer, lives.

Speaker 1: Oxycontin’s maker, Purdue Pharma, announcing it is cutting its sales staff in half. And starting today will no longer have reps visiting doctors’ offices to discuss opioids.

Kate:  On today’s episode we’re going to be talking about the opioid crisis. I am positive that this is not the first time that you’re hearing about this. It’s been all over the news. In fact, maybe you’re sick of hearing about it, but we’re going to try to look at this issue through the lens of economics. Through the lens of supply and demand.

On the demand side, was it the case that people just wanted a bunch of opioids, and that’s what drove the crisis, or on the supply side was it the case that doctors and pharmaceutical companies were pushing opioids onto people? There’s some evidence that there could be a link between these painkillers and the use of illicit opiates like heroin and Fentanyl, which are also very dangerous, but we’re focusing more on the prescription drugs.

Luigi: So just to be clear, the demand story is not just people take opioids as a recreational drug. Some they might, but I think that the aspect we want to understand is to what extent this a result of economic despair.

Kate: We want to start today’s episode by going back to October of 2015, when Angus Deaton, a professor at Princeton University who was renowned for his research, his economic research about poverty and health, won the Nobel Prize in economics. And in the same month that he won the Nobel Prize, a groundbreaking paper written by him and Anne Case, also a professor at Princeton, was released about how opioids were on the rise and the people who were suffering from opioid deaths were primarily concentrated amongst white, non-Hispanic people and people who were in the middle class.

Luigi: The way I remember the paper is that he shows that for the first time in basically a century the life expectancy of white people was not going up. The life expectancy of most groups was going up, but the life expectancy of white males was not going up and the reason was that many of them were dying of overdose or suicide and this was mostly concentrated in the 40–55 group.

Kate: That and it was in people who were suffering from these deaths, opioid-related as well as suicide and alcohol-related, were in lower-income counties. So this paper made a huge splash. I think it was partially because he also concurrently won the Nobel Prize, but it was also positioned pretty well in the cultural narrative. So if you remember back to, I guess, September/October 2015, this fit in very well with the idea that Trump was becoming popular.

Luigi: Besides the Deaton and Case paper, there is another interesting paper that pushes the idea that this is an economic reason, your sort of demand-driven hypothesis, and this is a paper by two economists, Pierce and Schott, that looked at the so-called China Shock, i.e. the impact that the different treaty that we introduced with China in 1999 led to a massive increase in imports, especially in manufacturing, and this increase in imports had very negative effects in areas that were big in manufacturing, most importantly the Midwest. And so in these studies it’s difficult to establish causality, but there is certainly a strong correlation between the areas that got hit the hardest and the areas that suffered the most in terms of opioids overconsumption.

Kate: So the demand story makes a lot of sense. People were losing jobs. People were unhappy. They became addicted to drugs. What is tough about the supply story is that it’s more complex. There’s many different links in this chain. So starting with the people who were prescribed opioids themselves, there’s a question of exactly how addictive they are. And there’s been a lot of contrary evidence over the past few decades about whether opioids are indeed addictive.

And then you go up a level to doctors. What role did doctors play in their prescribing habits and who they were prescribing these drugs to? Then you go up a level to pharmaceutical companies. Were they marketing too aggressively? What tactics could they have used to influence the opioid market? And then finally, you get to the level of regulators. And there’s a question of whether there was jiggery-pokery going on, on the part of the regulators as well.

And so to really understand this whole story you have to understand the fully vertically integrated spectrum of the opioid production chain.

Luigi: Absolutely. And what might seem obvious to many people is to what extent the habit prescription of doctors have an impact on how many people get addicted to the opioids. We know that doctors have different preferences to how they are prescribing different medicines and this preference might be driven by personal preferences, different beliefs, or by how much the representative of the pharmaceutical industry is pushing hard on those doctors. Suppose that I am a patient of a doctor who is more prone to prescribe opioids. Do I get more likely addicted to opioids if I have a doctor who’s more inclined to prescribe opioids?

Kate: What’s tough to answer about this question is that it seems so obvious that, if you’ve got a doctor who’s pushing opioids on you, you’re probably going to be more likely to become addicted, but correlation doesn’t prove causation. Just based on the rough statistics, it’s hard for us to get a sense of whether there’s a causal relationship here.

Luigi: So to answer these questions, two researchers used data from Denmark. Why Danish data? Because in Denmark it is very easy to trace everybody through their social security number, and access to this very confidential data by researchers is very easy. So you can trace people very well. And what they do is they look at what happens to people who move from one area to another. And so they move from an area where the doctor does not prescribe very much opioids to an area where the doctor tends to prescribe opioids. And they see when you move, also your tendency to become addicted increases. Increases in a significant way. And that allows us to separate the story that “Oh, doctors prescribe more opioids in places where people are more desperate, and that’s the reason why you see the correlation.” No, this is like the fact that you have a doctor who prescribes opioids caused you to become more addicted, at least in probability terms.

Kate: So not quite as what we would call well identified, or clearly causal, but also in the same vein are a few studies that look at changes in regulation in the United States. There are some that look at states where medical marijuana is more available under the idea that marijuana can be a substitute in some sense for opioids. And there’s evidence that states where marijuana can be more easily obtained, opioid use was less. Another set of studies look at Medicare part D and the role that the set of laws had to do in opioid prescription. They find similar results: that there is a causal relationship between the prescriber and addiction.

Luigi: Now why does the FDA allow the use of opioids when we know that opium is a drug, we know it is highly addictive, and you cannot buy opium in the pharmacy because we know it is very dangerous? So why do we have a legitimate drug and an FDA-approved drug that contains large doses of opioids?

Kate: So even though we may know that a chemical is addictive, it’s much harder to tell whether its derivatives are also addictive and have the same sorts of properties. And to this point medical research is incredibly important because for people who, like the pharmaceutical lobby, who are looking for an answer that says it’s OK to sell this drug, even the least scientific of papers can lend legitimacy to this argument.

So to give you a good example of this: There was this 1980 letter. It was just a letter to the editor of a journal, and it only had five sentences in it, where basically a doctor looked through some old patients who had been in a hospital, he looked at those who had been prescribed opioids and those who hadn’t, and he found very little statistical evidence in terms of just like a pure one correlation that opioids were related to later addiction.

And this letter was not only like five sentences long, but also it was never intended to be taken seriously as a piece of clear scientific research. It was just a note. And yet this letter has been cited—now if you look it up on Google scholar—over 1,000 times. And it was heavily cited by the pharmaceutical lobby when they were trying to push the case that Oxycontin was a legitimate non-addictive drug. And it was also part of the training seminars for Purdue Pharmaceutical when they were training their sales representatives and teaching them that Oxycontin in fact was not addictive.

Luigi: Because here there is an important trade-off in the sense that many things that we use daily can be dangerous. Knives can be dangerous. But we’re not forbidding people from using knives even if sometimes they can be overused or used in the wrong way. And the question is what do we do with these drugs. And there is a discussion, a bigger discussion, of to what extent you want to legalize various type of drugs. I’m certainly in favor of legalizing marijuana. For more addictive drugs like opium and cocaine, that’s a different story.

But let’s assume, at least for this episode, that we want to limit the sale of these drugs in some way. Then there is the trade-off to say what are the benefits, and what are the costs? And the benefits are that these drugs are certainly useful in reducing pain. So if you have surgery or major back pain, the use of an opioid can be useful. So the question we’re trying to figure out is, in deciding between the benefit and the cost, did the regulators look at the public interest, or were they overly affected by the industry that of course stood to profit handsomely from the drug?

Kate: You may have read an article in the New Yorker by Patrick Radden Keefe about the Sackler family, who was the family behind Purdue Pharmaceuticals, the company that created and distributed and spread Oxycontin as well as a few other opioid-based painkillers. This article is just completely shocking in terms of how powerful and interconnected this single family was with every part of the opioid regulation industry, from the doctors who were prescribing this medicine to the regulators in the FDA who were supposed to oversee it.

And they would hold these training conferences essentially for doctors that were at resorts and spas, and they would fly doctors in free of cost. If this company is treating you in this really swanky way of course you’re going to be in favor of the drug that they’re promoting, especially if they’re citing research that says that that drug isn’t dangerous.

Luigi: So the good news is that Purdue Pharmaceuticals has recently announced that they are going to cut down on these aggressive marketing practices. The bad news is, the fact that they are cutting it down suggests that probably before they were being excessive.

Kate: Obviously it’s a step in the right direction. But it seems to me like putting lipstick on a pig. I know that that’s not perfect. But it’s just sort of like smoothing over something that’s already terrible.

Luigi: Yeah, but to be fair, I think that the problem is just bigger than Purdue Pharmaceuticals. It is a system that does not seem to be good at selecting things in the interest of consumers.

Kate: Yeah, and to be fair, the FDA is in charge of monitoring advertising as well as marketing of pharmaceutical products. But there’s evidence that at least historically the staff members who are in this department for overseeing this were drastically undermanned. So like in 2002, for example, there were 39 FDA staff members who were supposed to be reviewing 34,000 pieces of promotion. And there’s no way that they could have fully monitored this whole marketing strategy on the part of Purdue as well as other opioid manufacturers.

Luigi: But the producer of the drug is not the only one responsible for the situation because a lot has to do also with distribution, in the sense that the beneficiary of the drugs are not only the producers but all the channels that distribute the drugs to the individual doctors and individual pharmacies. And they in principle have a responsibility of monitoring the excessive use of the drug. The FDA knows that this drug is potentially very dangerous and as a result they require the distributors to keep track of abnormal spikes in the prescriptions. Because sometimes it’s not just a doctor influenced by the industry that prescribes too many drugs, it is somebody that really becomes almost like a drug dealer by distributing massively these opioids.

Kate: So this is all completely mind-blowing, that the pharmaceutical lobby and these pharmaceutical companies as well as distributors have such an iron grip on regulators as well as just the way that these drugs are marketed. But in doing research for this episode there was this missing link, going back to the Case and Deaton paper, about why is it that it was white people in particular, non-Hispanic white people, who were affected by this opioid crisis disproportionately relative to other races.

The demand story makes sense from that perspective, but the supply story doesn’t. Because imagine that you’re a pharmaceutical company, you would want to sell your drug to as many people as possible. But I was confused about what the differential in racial exposure to these opioid-related deaths could be. And so I looked at some scientific articles from the 2000s about this. And doctors were much more likely to prescribe opioid pain relievers to white people in any part of the prescription process, whether it was people who were receiving the pills at home or post-operative therapy, whether it was people—like, conditional on the same level of pain that people were reporting, doctors systematically were more likely to prescribe opioids to white people. And in the 2000s this was seen as a huge problem. There were a bunch of scientific articles trying to talk about how we could remove this problem of racial discrimination.

Luigi: So Kate, is this really racist or racial disparities? Because my understanding, but I’ve not read as much as you did, but my understanding is part of it is due to access to, for example, medical insurance or Medicare. You’re more likely to be prescribed if you have a richer insurance, and white people tend to have better access to medical insurance.

Kate: I think that there’s no doubt that that is true. And that’s part of the story. But just in terms of the patient-doctor relationship, another thing that really startled me about findings from the mid-’90s were that doctors were more likely to prescribe prescription opiate painkillers to patients with high-status occupations as well as patients with whom they had a close relationship. And so obviously there’s some element of trust here, but it certainly seems to be the case that doctors had in the back of their minds this idea that there was an addictive element to opioid prescription, and so therefore they were only prescribing it to people that they thought were trustworthy. And those tended to be white people.

Luigi: So in this sense this is another piece of evidence that the epidemic is actually dominated by supply. Because if it’s really economic despair driving it, there’s plenty of economic despair among black [people]. It is not a privilege or restricted to the white people who experience economic decline because black [people] experience economic decline as well. But the attitude of doctors that is different across races indicates that it is actually the supply. The more easy access you have to Oxycontin, the more addicted you get, regardless of your economic conditions.

Kate: So while you’re right that minorities, particularly black and Hispanic minorities, at the same time that this opioid epidemic was increasing, they were experiencing greater economic decline relative to their white counterparts—and so you could argue that that’s one reason that it doesn’t make sense that we would see a rise in deaths amongst middle-age whites only—but I think that the argument that many made was that it wasn’t the absolute decline in economic circumstances that mattered but it was the decline relative to the opportunities that they thought that they would have when they were younger. So it’s the decline relative to the expectation that previous generations set for them. And that was the problem.

To separate out this demand-side despair argument from the supply-side manipulation-by-pharmaceutical-industries argument, there’s a paper by Christopher Ruhm, who’s a professor at UVA, and he tries to disentangle these channels. Most of the economic variables, the economic reasons for the Case and Deaton argument, they become less significant. Even to the point where they become insignificant. So that’s a way of saying that if you include more data, then the economic reason for the increase in opioid-related deaths amongst middle-age whites, it starts to go away. And so it seems like actually the supply story is dominant.

Luigi: So to be fair to our listeners, I don’t think that there is a definite answer in this line of research, which is very recent. But the other thing we have to be careful of is we are in the process of legalizing marijuana. I think that that is great because marijuana is not as addictive, in fact is probably better than many of the drugs that are in circulation. However, at the moment this legalization happens without strong lobbying pressure by the marijuana industry, because there is not a marijuana industry, and the little that exists now is very fragmented. And in fact one could argue that the delay in the legalization of marijuana is driven by the pharmaceutical industry, who has alternative drugs more expensive and less effective, but they can be prescribed by Medicare and Medicaid.

But in the future this might change. So as we are legalizing the marijuana business we should think about do we want to put any restriction on the ability of marijuana producers to lobby the FDA or to market marijuana in the public domain and so on and so forth. I think that that ... or lobby with doctors to use more marijuana. I think that all these questions need to be addressed, and the sooner the better.

Kate: Yeah. Look, I’m in favor of legalizing marijuana as well. And by that I mean at the federal level. But I will admit that I think people can sometimes turn a blind eye to potential issues with marijuana. There are studies that establish maybe a causal link between marijuana and cognitive dysfunction, or at least cognitive impairment. And so marijuana is not a perfectly safe cure-all, and to the extent that it may be legalized in the future, we should be careful about the possibility of a powerful and influential marijuana lobby that distorts people’s perceptions of how safe this drug is, or at least perceptions of what the cost may be.

Luigi: So, Kate, suppose you were appointed the drug czar, what would you do to reduce this problem?

Kate: My ultimate objective would be for prescription opioids to still exist in very, very small quantities only available to people with extreme pain, for whom the pain is so bad that it outweighs the near certainty that they’ll become addicted to opioids. For example, people with terminal illnesses. How to do that? You have to think about, if you’re the drug czar and you want to cut back on the availability of opioid pills, you’re going to sit down at the table with people from the FDA, people from the DEA. You’re also going to get representatives from like the American Cancer Society. You’re going to get representatives from the pharmaceutical industry. And you have to have the manpower and the machinery to be able to have authority at these meetings.

And so again I know that it may be sort of a cop out of an answer, but if I were in charge I would just say like, “I want to hire a bunch of people. I want to hire a bunch of smart people. I want to make sure that everyone who’s working for me on the regulatory side is extremely well-informed. And I want to make sure that, when we go to the meetings on how to regulate this, we can face the lobbyists and the people who are on the side of the opioid industry, and make them back down.”  I don’t know. Maybe that’s too optimistic or too rosy a view. What do you think we should do?

Luigi: If you want to put on our economic hats, I think that the way to solve the problem is first figure it out, how much people are willing to pay to have their pain reduced through Oxycontin versus other drugs. So you figure out what is the best alternative available, including, by the way, marijuana. And ask them, the ones who are in extreme pain, how much are you willing to pay for that difference. And then you compare to the cost in terms of lives lost due to addiction, not to mention all the cost in terms of less employability and reduced labor supply and so on and so forth.

And I’ve not done this calculation of course, but my guess is the second term would way overweight the first. And so any reasonable policy will restrict massively the availability and the prescribability of Oxycontin, and by the way, will also push for legalization and adoption of marijuana that seems to be a very cheap alternative and relatively safe alternative in this dimension.

Kate: Even though this wouldn’t cut to the heart of people’s preferences, and the costs and benefits of changing the supply of Oxycontin and other opioids, I would love to see an economic study that had very detailed data of all of the distributors in this industry, of all the pharmaceutical companies that create opioid-related pills, to know exactly how much they were spending in promotion and advertising, to know what sorts of promotion and advertising they were engaging in. And then to see the relationship between them, doctors’ prescription practices, and then people getting addicted to these drugs.

Now that data I’m sure is not available. I’m sure that the pharmaceutical companies would protect it very carefully. But if only there were an economist who did this sort of research into lobbying and special interests. I mean, gosh, who’s a person who could do that, Luigi?

Luigi: But, Kate, you have a brilliant idea. Why don’t we challenge the industry? If you have nothing to hide, show me the data.

Kate: Show us. Show us the data.

Luigi: Yes. Exactly.

Kate: I’m sure we’re going to have a bunch of pharmaceutical companies knocking at our doors.

Are elite MBA programs producing morally bankrupt administrators? Duff McDonald, author of “The Golden Passport”, tries to convince Luigi & Kate that conflicts of interest and flawed case studies are giving MBAs an unethical education and harming society.

Duff McDonald, The Golden Passport: Harvard Business School, the Limits of Capitalism, and the Moral Failure of the MBA Elite, HarperBusiness (2017)

Kate: Hi, I’m Kate Waldock, a professor at Georgetown University.

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

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism, and more importantly, what isn’t. On today’s episode, we’re joined by Duff McDonald, author of The Firm: The Story of McKinsey and Its Secret Influence on American Business, and Last Man Standing, a biography of Jamie Dimon, who is the CEO of JPMorgan. But today we’re here to talk about his most recent book, The Golden Passport.

Luigi: That has the subtitle, “The Limits of Capitalism, and the Moral Failure of the MBA Elite.” It’s a pretty aggressive title that implicates directly me and Kate, because we are the trainers of this failed elite. Duff, tell us a bit about this book, and what is the moral failure of our MBA elite?

Duff McDonald: If I had to summarize the takeaway from the book that led us to that subtitle, both the educators involved in the graduate business school phenomenon, and the graduates themselves, had a set of responsibilities that they have failed to live up to. They’ve dropped the ball. I fall into the camp that says, “The purpose of a corporation is to give us a way to work communally, to achieve our communal objectives.” The system that we have today, that came about as a result of the way things were done in the ’80s and ’90s in particular, is just tilted toward the shareholder in an obscene, and unfair, and unsustainable way. The capital experiment has been a failure, except for the few for whom it hasn’t. While it’s still probably the best idea out there, in terms of economic systems, another generation of this kind of division of the economics of this country, and we’re headed for a revolution, or civil war.

Kate: I want to point out that you’ve talked about defining the corporation, ideally as this body that would maximize communal welfare, as opposed to shareholder value. You’ve talked about the rise of inequality. You’re sounding a little bit like you’re just a communist. We haven’t talked about the MBA at all, or the role of business education. It just sounds more like you have a problem with capitalism itself as a system.

Duff: Or like a Canadian; I’m from Toronto.

Luigi: What’s the difference?

Duff: No, I don’t have a problem with capitalism. I don’t have a problem with business schools. I have an undergraduate degree from Wharton. My first job out of college was on Wall Street; I worked in corporate finance at Goldman Sachs. I have many friends who work, both on Wall Street, and who have MBAs. My problem is that the notion that we have a system that is perfect, and that we do not need to look at its foundational assumptions, to do so is heresy, and endangers the welfare of us all. The fact is that there’s no reason that we can’t reinvestigate the assumptions that we built it on.

Luigi: Duff, you’re absolutely right, but to be honest, we are running a podcast about what is working in capitalism, what isn’t. So we are recognizing there are a lot of things that don’t work in capitalism, and we are from two business schools. So I think that maybe you are misrepresenting, or confusing the rhetoric of business, which is clearly very strong, but they’re lions, and they want to eat, they defend their own interests, and what is discussed in business school, and by academics.

Duff: Good point, but I also think, having studied and written an institutional history of Harvard Business School, that I could sit here for you and name 50 things in very short order that they are not doing, that they should be doing, both in terms of their own relationships with the corporate benefactors, as well as the way they teach their students, which ultimately leads to how those students think about what it is they do.

Luigi: Why don’t we start with three?

Kate: Let’s start with one, and let’s start with the relationship between business schools and corporate benefactors. Do you think that that’s broken?

Duff: Broken according to who? With HBS, which I’m most fluent in, you have corporate donations to the school. Those corporate donors invariably end up being the subject of case studies, which are studied by the students, and supposed to be realistic representations of the way that things happen in the corporate world, and give them the tools to make decisions when they ultimately go out into it themselves. In its sort of basic description, that all sounds like it makes sense. But you immediately run into a question of, “Is it difficult to write a critical case study about a corporate donor that’s given you tens of millions of dollars? Are you inclined to positive bias? Are you inclined to any kind of revisionist history?”

You have a system that by design maybe was supposed to help students in a really reasonable and interesting way, to prepare them for how the choices, and how they’re going to have to make the choices that they face in their managerial lives. It’s been totally corrupted by money, to the point where it’s almost embarrassing.

Luigi: I think you’re absolutely right, but let’s recognize that this is not unique to Harvard Business School. It’s not even unique to business school. So why pinpoint just Harvard Business School?

Duff: Well that’s easy, I had narrative objectives and constraints. The goal of the book was to tell the history of the MBA, through the prism of its most dominant brand. There is another excellent book on the history of the MBA by an HBS professor, Rakesh Khurana. It was called From Higher Aims to Hired Hands. It’s an excellent book, but it’s a different kind of book. Khurana was writing for an academic audience, which doesn’t demand or require the same kind of narrative thrust or approach, as a more mainstream one would. At the same time, there is no other school that comes even close to its long-term and enduring influence. So it was both an obvious choice, because who else were you going to use as the central character in that narrative, just because it’s easier to hang onto?

Kate: OK, I want to go back to this point about case studies, and the topics of case studies, and who is writing them, and whether they are actually doing an accurate job of depicting the characters in those studies. I’m teaching a financial management class this semester. This is the first time that I am actually teaching some cases in a class. So I had to look through HBS’s case study repository and pick out some that were appropriate for my class. We care about teaching these ideas of discounting cash flows, and understanding systematic risk, and capital budgeting. So I simply wanted to pick out the easiest studies that could get those ideas across.

Also, it happens to be the case that when you’re putting numbers into a model, it’s easier if those numbers are positive. Are there case studies out there that are about complex financial transactions, and scenarios in which people did things that were maybe morally questionable? Yes, but those wouldn’t have really gotten across the basic ideas that I was trying to teach in my class. I think that at least from a pedagogical perspective, there’s just not much demand for those types of tools, those types of teaching tools, because most people, they take basic finance classes. So the reasoning for why people write case studies is relatively benign.

Duff: Sure. I’m of two minds on the case method. One, it seems like it’s obviously a great way to teach that is memorable for students. Every single graduate I spoke to from HBS credits the case method for making them better decision makers and managers. I’m not going to question their word on that. I believe them. At the same time, there’s all sorts of downsides to the method: some moral ambivalence, positive bias, CEO hero worship, and you could go on. As I point out in a number of instances in The Golden Passport, not only is HBS not that concerned about guarding against some of the obvious ones like the corrupting effect of consulting fees on professors writing those cases, but on any number of the other ones.

I think one of the most tragic things that I saw in The Golden Passport is the fact that students tend to come out of HBS believing in their hearts that there really is no one right answer to any business situation. But I think that in many corporate situations, there are answers that are more right than others. Sometimes, there is only one right answer. So I think they are failing their students, and therefore the rest of society, by even giving them the inclination to think that.

Luigi: Let me step in here, because I think that you’re mixing two things. One, I think you’re absolutely right, which is the fact that, of course everybody tries to do their best, tries to produce the best cases, et cetera. But there is a sort of corruptive influence of closeness to sources, in the sense that even in your own experience, when you wrote the book about Jamie Dimon, you had more access to Jamie Dimon, the book ended up being more positive about Jamie Dimon. You did not have access to HBS, and the book came out more negative about HBS. Not necessarily because you are set up to have an agenda, but it’s simply because of closeness to the sources.

Duff: It’s harder to criticize someone when you know them.

Luigi: Number one, and number two, many of these executives, to be honest, they are there because they’re super charming and super smart. I think this is a problem, because we don’t have enough objectivity. I got interested in this topic of how the closeness to sources might distort things. Actually at the time, I had a co-author at Harvard Business School, so I heard a story that back in the days when Enron was still a powerful company, one good professor at Harvard decided to write a case about a controversial action that Enron did. They created an electric plant in India, and rumors were that they actually corrupted some local sources. While the case did not say that explicitly, because there was not a smoking gun, it was hinting enough that that was the case.

Enron did not directly complain about the case, but went to another faculty at HBS and said, “We want you to write a case about this topic, and we will provide you all the sources.” I should have said that the first case was written from public sources, so it was interesting, but was not juicy. There’s not all the elements, the things that are typical of the Harvard cases. The result was that the second case was much nicer, and sold much better. At some point, the first faculty was approached and asked, “Do you really want to keep that case on the roster, given the fact that it doesn’t sell very well?” He said, “OK,” and so the case was removed, and there was no record of the more controversial case. Now, if you were to look in the roster of Harvard, you will not find now any case about Enron, because after Enron blew up, they actually took them all away.

Duff: Enron is a great example, because as you know, in the lead up to the fall of Enron, there were five overly positive case studies out of HBS that purported to explain exactly why Enron was one of the greatest companies that ever was. What we found out later, obviously, was that the secrets to Enron’s success were deregulation, political influence, and fraud. Those were three of the central ones.

Luigi: Market manipulation also.

Duff: Market manipulation, OK. So the contents of the five Enron case studies leading up to that really didn’t touch on those things. Right? There was an HBS professor who served on an advisory board of Enron at the time, and right up to the demise of the company. His role was later explained as, “We let guys serve in that role, paid roles, so that they can get so close to the action that they understand it in such a way that we are giving our students this kind of insight.” His name was Pankaj Ghemawat. He never pointed out the frauds. Whatever access he got did not reveal to him what was actually happening at this company. We don’t need to condemn him for failing to discover the fraud, but stop letting professors get paid by the companies they write cases about. Let them consult for money, but don’t write cases about those companies.

Kate: Yeah, I mean, that’s just seems obvious. It seems to me like you are caught up, and extremely annoyed by how much bullshit there is out there, in HBS case studies, in the curricula of business schools. But I do think there is a broader value to what’s taught in business schools. There’s a reason that business schools exist. Students don’t sign up to pay hundreds of thousands of dollars, just to be patted on the head and to make themselves feel good about wanting to make money, or the prospect of making money in the future. I mean, there is something that they learn. They learn how to make investment decisions. They learn about the time value of money. They learn about financing investments through debt, or through equity. These are things that are valuable to society. It seems to me like ... To use a phrase that Luigi likes to use a lot, “You’re throwing the baby out with the bathwater.”

Duff: I hear that, however, I take issue with the suggestion that I am throwing the baby out with the bathwater. I’m not calling for the abolishment of business schools. I am not calling for the abolishment of Harvard Business School. What I’m saying is, you have obtained a position of great influence, and with influence comes responsibility. You are exactly right about what drives me crazy about the place, but I’ll use a more specific word for it. It’s hypocrisy. I totally get the guy who steals money to feed his family. You hope he doesn’t hurt someone while he’s doing it, but you get the motivations and the desperation. None of these people are desperate. They are in fact extremely fortunate, because the effects are the way that the managers who run a huge chunk of our country’s companies think about how the world works, and why they do what they do. I ultimately end up saying, “Shame on you. You don’t have to be this way. You don’t have to do this. Shame on you. Are we not better than that?”

Luigi: What was the response of Harvard Business School, or other business schools, to your book?

Duff: Harvard Business School officially didn’t really acknowledge it, except for once. Nitin Nohria, the dean, did an interview with The Harvard Crimson, a college newspaper, and said, and I paraphrase, the author—he didn’t mention me by name—misses a lot of important points, understates all the good we do, overstates a bunch of things, and by the way, I haven’t read the book. So that response was infuriating, if still to be expected.

Kate: My take is that the causality is going in the opposite direction. That things were great, growth was great in the 1950s and 1960s. You even mention in your book that back then, most people who were at HBS were going into manufacturing. But the economy has changed now. Growth is slower. When you’re working at a mature company, the areas of growth that you look for tend to be in squeezing margins and cutting costs and looking for synergies. Those are the types of things that business school students are well trained in.

Duff: An overly analytical approach to decision-making that can affect thousands of people, to favor one constituency over others, that you can try and explain away in the context of global competitiveness, but you can say to yourself, “No, the reason that I put these 50,000 people out of work, on a day that we reported record earnings, is because this is what I was taught was the way that you do this.” So who taught you that? Who told you that? You may actually ultimately believe it, after serious self examination, but I would venture to say that not every MBA student out there has the capacity for this kind of introspection. Therefore, you need to be very careful about what you teach people.

Kate: But they have a responsibility not to be overly analytical? I mean, that seems to be cutting straight to the core of what business school should be. It should be teaching people how to be analytical. It seems to me that you’re suggesting that in the process of studying a company, and trying to figure out what’s right to do, and putting together a model, and projecting cash flows into the future, if you realize that the company is employing too many people, and it can’t afford to continue to employ them, then at some point, a business school professor should step in and be like, “But also, you should be thinking about the moral side of things,” and that we should insert, somehow, something that offsets some of the analytical skills—

Duff: That’s called humanity. Otherwise, let’s just install a bunch of computers to make the decisions for us.

Kate: But how do we actually insert that into a curriculum, without undercutting exactly what we’re trying to teach?

Duff: I think that’s your problem, not mine—

Kate: No, it is your problem, because you wrote a book about it.

Duff: I do not suggest that I know the perfect business school curriculum. What I suggest is that the academy seems to have taken its eye a little too far off the ball of the humanity of it all.

Luigi: I think what we don’t realize is that today, corporations have an enormous amount of power in society. If you were to stack up the hundred largest organizations in the world, including governments, 69 of the top 100 are corporations, not states. Walmart has more power and more revenues than all but nine countries in the world. These organizations are run in a pretty autocratic way by the CEOs. Yeah, there is a board of directors, there are some checks and balances, but it’s nothing with respect to the checks and balances of modern democracies in the political system. So the people at the top matter tremendously. The value system, the objectives, is shaped by basically business school, because most of these guys went through business school. They are shaped as businesspeople by, of course, their experience, but even before, their education. So the way we teach them, and the cases are a big part of it, affects the way they run those large corporations. The way they run those large corporations affects our lives in a tremendous way.

Duff: Yeah, it’s like, “This is America, we play to win.” But do we want to win at all costs? No. While I’m not asking you guys to start teaching philosophy, there is a philosophical underpinning to everything we do. It would be great if the academy, the business academy could remember that, and refocus on it.

Kate: So Duff, you’ve talked about things like social unrest, and layoffs, and not being accountable to various stakeholders in a company, a CEO or a manager not being accountable to stakeholders. You’ve talked about humanity itself. Do you think that these problems that you’ve discussed, are they just symptomatic of a flawed system? Is capitalism itself too flawed to fix this idea that greed is good?

Duff: I hope not, and I don’t think so. If you look at the, say, executive pay gap, is it even the free market that’s determining that? Or do we have an insider’s game going on, whereby CEOs justify other CEOs’ salary? It’s sort of everybody is in the club, and they’ve designed a system that works for them. Can we talk about ways that we can keep compensation more equitable? We can always be having that conversation. It’s manmade. Of course it can be improved. We just need to decide how we want to try to do it.

Kate: Thanks so much for coming on the show, Duff. This has been a great conversation. I really enjoyed your book, The Golden Passport. I recommend it to everyone.

Duff: Thanks for having me. I think one of the things we can take away from here is, this, by its very nature, is not going to be a fun conversation every time we have it, right, because what we’re talking about is fairness, and human relations. Everybody has a different point of view on that, but thank God for podcasts like yours, because otherwise, I think a lot of these things would go unasked, and therefore, unanswered. So I appreciate the opportunity to be on.

Five years after Thomas Piketty’s surprise bestseller captured the zeitgeist of an anxious age, Kate and Luigi revisit the book to see how it holds up in the current political and economic climate. The verdict? Intriguing analysis, but limited impact.

– Thomas Piketty, Capital in the Twenty-First Century (2014)
– A criticism of Piketty, including a discussion on depreciation: Matthew Rognlie, “Deciphering the Fall and Rise in the Net Capital Share: Accumulation or Scarcity?”, Brookings Papers on Economic Activity  https://www.brookings.edu/wp-content/uploads/2016/07/2015a_rognlie.pdf

Stephen Colbert: Welcome back, everybody. My guest tonight has a new book that blows the lid off income inequality. But don’t worry: it’s 40 bucks. Poor people will never know. Please welcome Thomas Piketty.

Kate: Hi, I’m Kate Waldock, a professor at Georgetown University.

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

Kate: This is Capitalisn’t, a podcast about what’s working in capitalism today and, more importantly, what isn’t.

Luigi: Kate, you’re talking about capitalism, and it’s almost like we are forced to discuss this book that has become famous by Thomas Piketty, about capital in the 21st century.

Speaker 4: Where is the middle class going? That question is part of the reason why the surprise bestseller of the season is not a teen novel or a thriller, but an economic textbook of all things.

Speaker 5: It is being hailed as the first economic classic of the 21st century—

Speaker 6: A book written by a French economist, why is that book getting all this attention?

Speaker 7: Piketty? How do you say it?

Thomas Piketty: Piketty.

Speaker 7: OK, everybody is talking about this book—

Speaker 9: ... because it tries to answer what is perhaps the most pressing question of our time. What do we do about the fact that so few of us have so much, while so many of us have so little?

Kate: Yeah, I was in grad school when this book came out, and I remember seeing it everywhere. It was all the rage. If you didn’t have the book on your coffee table, or on your Kindle, if you couldn’t talk eloquently about it, then you weren’t cool. So in preparation for today’s episode, I discovered that I am in the 1 percent.

Luigi: 1 percent of what?

Kate: The bottom 1 percent of the wealth distribution, and that’s because I still owe a bunch of money in student loans. As I earn income from having a job, I plan on paying that debt down, and then eventually I will be in the black one day. But I feel like I deserve a T-shirt that says, ‘I’m in the bottom 1 percent.’

Luigi: I don’t know whether you deserve a T-shirt, but I think it’s very useful to indicate that some of these statistics are misleading, especially because they are temporary. Probably, a year and a half ago, before you started your job at Georgetown, you were not very well also in the income distribution.

Kate: Right.

Luigi: I’m sure you remember.

Kate: Definitely. I remember that all too well.

Luigi: But in expectation, you were worth a lot. You weren’t somebody poor in any sense of the word, even if you did not perform well in the statistics.

Kate: Yeah, that’s totally fair. But the point of this episode is not to talk about the permanent poor from a labor perspective. It’s actually to talk about the permanent rich, from a wealth perspective. People who are born, or inherited a lot of capital, a lot of wealth, and the ease with which they can just hold on to that. Piketty believes that inequality is something that can naturally arise as a result of capitalism. A lot of the reasons that people support capitalism are because they lead to higher growth and higher productivity, and those are good things. Those are things that benefit the whole society. But Piketty, according to his historical analysis, actually finds that except in several rare circumstances in history, most of the time, capitalism has been pushing us towards an unequal society.

Luigi: I would like to divide the book into three parts. There is a first part that reports studies on income distribution in the US and France and some other countries, certainly over the 20th century, sometimes even longer, showing that the fraction of income earned by the top 1 percent has changed dramatically, and was very high in the early part of the 20th century, up to basically the Great Depression, then went down constantly until the beginning of the 1980s, and then started to pick back up, and especially in the United States, that percentage has grown a lot. These are studies that have been published in many academic journals, and are very thorough, and I think contributed to our perception today that income inequality has gone up.

Then there is a second part of the book that looks at what Kate was referring to as the inevitability of this increasing concentration. The idea behind this is that if the return on capital is higher than the rate of growth, who has capital today will end up having more capital tomorrow. This leads inevitably to a higher concentration. Then there is a third part that is more about what to do about it. Let’s discuss this in stages. On the first part, I don’t have a lot to say, because those are facts, and I agree with the facts. There are only two caveats that I would like to bring up front.

In the United States, there has been a large rise, between 1980 and today, of the share of the top 1 percent. However, one-third of that rise, it has been shown, is due to just one thing, which is the tax reform of 1986, that changed the way people report things. I’m not saying the entire rise is explained by this, but one-third is explained simply by reporting standards. So I think we have to be careful when we mention this huge rise that takes place, because it’s affected by this.

The second is that the threshold for being rich is uniform across the United States. But if you make $250,000, you feel super rich in Chicago. You don’t feel as rich in New York, where the cost of living is twice as much as the one in Chicago. So I think that this common element is a bit misleading, given the enormous variation in income that there is within the United States, and the enormous difference in cost of living within the United States.

Kate: A lot of people, when they think about this book, they think of two letters, R and G. There’s R, which is the rate of return on capital. What is capital? According to Piketty, it’s anything that generates a return for you that’s not coming from labor. If you hold any type of asset, if you hold a bond, if you hold a stock, if you own a house, if you hold a valuable painting, anything that you own that earns money for you, that’s considered capital in his book, except for the job that you have. If you make income from your job working at a PR agency, that’s your labor income. But any other form of money that you’re making, that’s coming from your capital.

The other letter is G. G stands for growth. That letter represents growth in the overall economy. We think about GDP growth. This is something that we hear a lot about today in the policy discussion. You can think of that as the general rate at which everyone in your country is experiencing growth. If growth in China is 8 percent, and growth in France is 1.5 percent, you can think that on average ... I mean, it may be true that people in France on average are better off, but the rate at which people in China are getting better off is higher.

What’s really important to Piketty is the difference between these two variables. If R is greater than G, then that means that the people who have wealth—and wealth is usually saved in things that earn people a rate of interest—it means that they’re making more money than the average person in society, who is just growing at this general growth rate of G. Not only that, but if you have wealth, if you have a trust fund, if you are one of those few people who is lucky enough that mom and dad left you $5 million, you don’t need to live poorly. You can go out. You can go skiing. You can go to fancy restaurants. You don’t need to save all of that money. But even saving just a tiny fraction of that can actually grow your wealth, whereas this isn’t the case for most people. Most people are pretty hand to mouth. It’s actually hard to save on a regular basis. There’s this idea that once you start with wealth, it’s relatively easy for you to become even wealthier.

Luigi: A couple quibbles here. First of all, it’s not the standard economic approach to clap together all these different forms of capital. Your collection of stamps is not the same thing as your machinery that you’re using in your factory. In fact, the traditional thinking of capital is as a means of production. Your collection of stamps, or your van Gogh painting, is not part of this capital, so this is one distinction. When it comes to understanding the rate of return, as economists, we know and can predict much better the rate of return on means of production than the rate of return on van Gogh paintings.

The second is, we need to be careful when you talk about rate of return. What is the gross rate of return and the net rate of return, where the difference between the two is the depreciation? You might have a large increase in the return on the house, but you need also to fix the house. That capital depreciates over time, and needs to be factored into the equation.

The third aspect, which maybe is the most important, is there is no doubt that there is persistence in wealth, but if we look, especially at the tail of the wealth distribution, look at the big billionaires in the United States today, very few actually inherited wealth. You go from Gates to Zuckerberg to Ellison, and these people, to Bezos, all these people made their money. They didn’t make their money because the economy grew that fast. It’s because they were able to appropriate a lot through innovation. So I don’t think that the two things necessarily go hand-in-hand.

Kate: That is true. I mean, that’s kind of why he set out to answer this question, is because it’s not an obvious question, I don’t think. It’s not obvious that capitalism necessarily makes the problem of inequality worse. That’s something that you need to sit down and test. To your point about the people in the Forbes 400 list, 1 through 10 are basically all entrepreneurs. But 11, 12, and 13 are all Waltons, and especially as you go down that list, there’s more and more inherited wealth.

But I want to get back to this point of how do you test this question? You have this hypothesis. You have Marx on one end of the spectrum who thinks that capitalism is going to necessarily make inequality so bad, or he thought, that this would lead to an uprising of workers that would undermine capitalism. On the other end of the spectrum, you have someone like Kuznets, an economist, who thought that capitalism was great, because it leads to innovation, and it leads to growth and productivity. Therefore, it makes everyone better off. So I don’t think the answer is clear, and to come up with an answer to this question, you need data. I guess what we need to figure out as economists is, what’s the best data to be able to answer this question.

What we usually do in a micro-level analysis is to try and come up with these natural experiments. ‘Let’s come up with a setting where you randomly have some people who are endowed with wealth, and you randomly have some people who don’t. Let’s see if we can figure out whether the ones who were randomly given some wealth, that accumulates over time, and that leads to more inequality between them and the people who weren’t randomly given wealth.’ But there’s just zero way in which we can prove this causally. We can’t just randomly give some families $10 million and have them be super wealthy, and randomly make some people worse off, and then have this persist over generations.

Luigi: Actually, there are some studies like this, based on lottery winners. Basically, lottery winners is you randomly give some people $10 million. The way I remember the studies is that most people waste their money. There’s not a lot of persistence among lottery winners. They must come also with education on how to spend it, or connection on how to multiply that, or other things, because the wealth by itself is not enough to be persistent.

Kate: But anyway, I guess what I was getting at, before you came up with a pretty good counterargument, which is that, an alternative method of studying this question is let’s say we didn’t have lotteries, or let’s say we can’t necessarily trust what we know from lotteries, from an external validity perspective. What’s another way of answering the question? Well, you try and gather as much data as possible. You gather as much data as you can about the rate of return on capital. You gather as much data as you can about growth rates. You gather as much data as you can about inequality. Then you look at the correlations between those three variables. That’s essentially what Piketty did in his book.

Luigi: It’s true, and I certainly admire his effort. I’m certainly liable of trying things similar, so I’m the last one to throw stones. But I think we have to be very careful in going from this exercise that inevitably has a lot of shortcuts. I’m not criticizing that he did not do a good job, but when you have to collect data over 150 years in three or four countries, the data are not going to be very precise. Most importantly, a lot of things happen in 150 years, so it’s very hard to generalize. Now I think that what we need to understand is what are the economic forces at play that generate this inequality—

Kate: Not just economic, but also political, right?

Luigi: Absolutely. I say the two are quite connected with each other. I think that this is where I’m less excited about Piketty’s book, because I don’t think he spends much time in pointing out the complexity of this. He focuses mostly on capital, and I’m not even sure the capital is the biggest source.

Kate: Capital isn’t.

Luigi: Exactly.

Kate: Sorry, too easy—

Luigi: But you’re right in pointing out that the 11, 12, and 13 of the Forbes list is part of the Waltons family. But who knows, pretty soon Walmart might not be worth much, with the Amazon competition, and so much of their wealth might disappear. So there is a lot of—

Kate: Bezos needs to start having babies—

Luigi: ... there is a lot of variability that is not really factored into the equation. I think that there is persistence in wealth. It’s not as big, in my view, especially in a country like the United States. But part of the reason is the United States, at least traditionally, had a fairly big inheritance tax, much bigger than the one of most countries in the world.

Kate: I thought he said in the book that inheritance taxes are lower in the US, even before the tax cut, than in other countries.

Luigi: I recently read a paper showing that the United States has one of the highest inheritance taxes in the OECD countries.

Kate: All right, I have the book right here.

Luigi: Wow.

Kate: Look at all this underlining. There’s stars ... OK, so maybe not in that part.

Luigi: OK, so here I found, this is a study of the Tax Foundation, and it says that the US has the fourth-highest estate tax in the OECD, at 40 percent. The world’s highest is 55 percent in Japan, followed by South Korea and France. Fifteen OECD countries levy no taxes on property passed to lineal heirs, which means direct descendants.

Kate: Yeah, I guess what I was thinking of in the book was not estate taxes, but he does have these graphs of the inheritance flow. He defines this as annual value of bequests and gifts, I guess to your kids, as a percentage of national income. Last he measured, in 2010, in England was 8 percent, in France was more like 14 percent, and in Germany was around 11 percent. Then the definition of inheritance in the US is a little different, but he says that inherited wealth accounts for 20 to 30 percent of total US capital. Note that that’s a fraction of capital, and not of national income.

If we go back to his comparison of rates of return on capital to the growth rate in society, he argues that throughout most of human history, the rate of return on capital has been significantly higher than the growth rate, which means that if you have a lot of capital, then you will continue to have even more capital in the future, assuming you don’t just consume everything that you make. I think that that is fair to assume. Then where I think he extrapolates a little too much is that he thinks that growth rates are going to fall in the next 20 to 50 years.

Luigi: As an economist, you should know that both the return to capital and growth are endogenous, so they are part of an equilibrium. If you invest more capital, the return on capital will go down. If you invest too little capital, the return to capital will be higher.

Kate: Yes, this is exactly his point. This is the fundamental point that he is trying to make, is that economists have these models and these theories for how the rate of return on capital should evolve and should potentially go down if it’s too high. But he finds that that is not the historical reality. The historical reality is that the rate of return on capital has been much higher than the growth rate for pretty much all of human history, except a few years in the mid-20th century.

Luigi: But this is where his aggregation creates problems, because as economists, we know the return of physical capital invested in productive activity should go down the more you invest. We don’t have the same theory for—

Kate: It doesn’t.

Luigi: ... van Gogh paintings. It depends on the future demand for impressionist paintings. We don’t have the same theory on housing. It depends on population growth. When you aggregate everything together, then you are basically missing the point.

Kate: I don’t think you’re missing the point, because no matter what, no matter what asset class you’re looking at, whether it’s van Gogh paintings, or housing, or machinery, the rates of return on all of those asset classes are still higher than the rate of growth. So whether you’re looking at a 1 percent return, a 3 percent return, a 6 percent return on stocks, they’re all higher than historical rates of growth, which have typically been less than half a percent. So it’s not an aggregation issue.

Luigi: It is an aggregation issue, because if you separate—the return on capital depends on how much capital there is. There are situations where the return on capital is very high and situations in which it is very low. Growth has been, in some period, especially over the 20th century, has been very high. Once you bring in also the depreciation of capital, then the things change. If he’s saying that he’s trying to refute neoclassical analysis just by using aggregate data over a century, or a few centuries, I think it’s not going to work. I think that he did great work at the beginning. Then he wanted to arrive at some conclusion and skipped the stuff in between.

Kate: I think you’re being too persnickety about Piketty.

Luigi: Let’s talk finally about his policy recommendation. His policy recommendations are nothing more than sock the rich.

Kate: No, I think that’s the one that the media has focused on. That’s the one that the critics have focused on. Yes, he also has chapters on a global wealth tax, and so we can talk about that if you want. But I think it is unfair to say that his only policy recommendation has to do with taxing the rich.

Luigi: It’s certainly his main policy recommendation.

Kate: I disagree.

Luigi: OK. I don’t think there is much ... What did he say, tell me, besides saying, “We need more education,” what does he say about how to reach a better education?

Kate: I knowledge that he does not have very concrete recommendations for how we should to improve our educational system, other than having it be accessible to everybody.

Luigi: OK, I grant that he believes in that. But in terms of recommendations, I think the wealth tax is the major one. I think that—

Kate: OK, fine, so let’s talk about the wealth tax.

Luigi: The problem with this is, number one, it’s difficult to implement. But number two, I think that the emphasis of his book, and that’s the reason why I dislike it, the emphasis is not on how to give more opportunities to people and basically elevate the vast majority of American people or French people to a high level of income. It is how to make sure that somebody does not have more than I have, because I’m very envious.

Kate: I think he believes that some inequality is good for society. I mean, that’s what capitalism is. It’s that if you’re smart, and you’re hard-working, and you contribute to society, you should be allowed to make more. But I think that what he doesn’t believe in is being able to sock all that money away, to earn a 6 percent return, and to have his legacy, and his children, and his grandchildren, continue to live off of that wealth ad infinitum.

Luigi: I think that for people who make more money and want to accumulate that return to allow themselves a better retirement, I don’t see why they should be heavily taxed. What is the rationale for that?

Kate: I think his rationale was that in the periods when we had really high marginal tax rates, that we experienced a lot of growth in those periods. So it’s not necessarily true that high taxes are inconsistent with growth.

Luigi: Oh, so correlation is equal to causation? Is that the basis of his thing?

Kate: No. He obviously doesn’t think that correlation is equal to causation. There is no way, at a very high level, when it comes to macroeconomics, when it comes to big questions of wealth and capital and rates of return, to know what causes what. The best that we can do is come up with the longest time series as we can and the most consistent numbers as we can. That is what he has done.

Luigi: I disagree that it’s the best that we can do. I think that microeconomic analysis can provide a lot of insights on what works and what doesn’t. Two of my colleagues, Zidar and Zwick, have a paper documenting where most of the 1 percent income is coming from. If you go through the list, you see those are doctors, they are car dealers, they are dentists, they are financial traders. Many of them rely on a lot of restrictions in the local market. Doctors have a license, have a healthcare system that is designed to give them a large source of income. The financial industry, as I’ve written, is too big and not sufficiently competitive. You can go on a lot of sectors to realize that what is the source of the problem is not necessarily that capital grows faster than the economy. It is that there is not enough competition. He’s completely silent on these important points.

Kate: Why are those necessarily incompatible?

Luigi: I didn’t say they’re incompatible. I’m just saying that he misses the point. Out of whatever, 600 pages of book, he misses the most important point for capital in the 21st century. A book called Capital in the 21st Century? It’s kind of a big miss.

Kate: So you’re saying the reason that inequality and the concentration of wealth persists is because of monopoly power and barriers to entry and regulation that favors one group over another. I don’t think this is necessarily inconsistent with his main findings. It’s just that he doesn’t have data on that. He doesn’t have a historical time series on shifts of bargaining rights and power and monopolies. I mean, that’s not his point. He wants to focus on the data that he does have, so he just points out a historical regularity. It could be entirely true that the mechanism through which capital is concentrated is the mechanism that you’re talking about, and not necessarily just the reinvestment of your capital income. OK? So maybe you’re both right.

Luigi: I think the real reason why this book became so popular is because there is a big sense of dissatisfaction in the average American. Not so much because there are a few people very rich, like Steve Jobs, or like Steve Jobs was, but it’s because the median worker has not seen an increase in real salary in the last 40 years. So there is a sense in society that something is not working, that the system, that capitalism is not working. I think that this book came at the right time, with a message that was appealing, even if, in my view, it was the wrong message. It’s not been a message that has brought a lot of useful political debate. In fact, if you look at the latest moves by the Trump administration, they go exactly in the opposite direction. They are trying to reduce the taxation of capital. They are trying to eliminate inheritance tax. So they’re going completely in the opposite direction, suggesting that his narrative has not been very convincing.

Kate: I think that his point is that yes, exactly, when growth is high, things are better for everybody. But we can’t just rub our hands together and deliver high rates of growth, especially rates of growth that we’ve seen in China, or in the United States in the mid-20th century. We simply cannot just fabricate high growth rates. I think it’s more reasonable to think that growth rates will converge to their historical averages, which have been pretty low. If that’s going to be the case, then that means that inequality is going to get worse.

Luigi: Actually, if the historical average is even before the Industrial Revolution, I think there is a change in regime. I think that the great thing about capitalism is the fact that it creates always new incentives to innovate and grow. This was not true in the pre-capitalistic world. It was not true in the rest of the world before they became capitalists, and it is true in the Western world. You know the famous joke about economists is they look for a lost key under the light, not because they lost the key under the light, but it’s the only place where they can see. For somebody like Piketty who makes fun of the economics class in general, you’re saying basically he follows the stereotype. He looks where there are the data, even if they are completely irrelevant to today’s 21st-century America. But this is the data he has, what he can measure, so he looks at that.

Kate: I think it’s a little rich to say that the history of humanity is irrelevant to today’s 21st-century America.

Luigi: The history of the last 300 or 400 years in three countries. I understand that that’s the world for you, but—

Kate: It’s more than three—

Luigi: ... it’s not the world for most people.

Kate: Hey, he talks about Italy, too. You’re just upset that Italy isn’t featured more prominently.

Luigi: Yeah, in the period where Italy was actually more prominent, at the end of the Middle Ages—

Kate: See, now the truth is coming out.

Luigi: Yeah, absolutely.

News reports and academic research indicate that the Fed's relationship with certain journalists and financial-market participants may be quite cozy. On this episode of the Capitalisn’t podcast, Kate and Luigi debate the pros and cons of those relationships, and what they mean for the American financial system.

Main papers discussed during episode:
– David O. Lucca and Emanuel Moench, “The Pre-FOMC Announcement Drift,” The Journal of Finance Vol. 70 Issue 1 (Feb. 2015) http://onlinelibrary.wiley.com/doi/10.1111/jofi.12196/full
– Anna Cieslak, Adair Morse, and Annette Vissing-Jorgensen, “Stock Returns over the FOMC Cycle”, Working Paper (2017) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2687614
– David Andrew Finer, “What Insights Do Taxi Rides Offer into Federal Reserve Leakage?”, Working Paper (2018) [Manuscript not yet available for release]

Fed transcript:
– Transcript from August 16th, 2007: http://www.federalreserve.gov/monetarypolicy/files/FOMC20070816confcall.pdf (Page 13)

Speaker 1: Breaking news from the Federal Reserve: Richmond Fed President Jeff Lacker resigning immediately from the Federal Reserve.

Kate: Hi, I’m Kate Waldock, a professor at 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 and what isn’t.

Speaker 2: … back to business news—some major business news by the way—the president of the Federal Reserve Bank of Richmond abruptly resigned a few hours ago after admitting that he’d leaked confidential information.

Speaker 1: … is what Mr. Lacker apparently didn’t do was tell the people at the Fed the next day or that afternoon.

Speaker 2: It is a major blow to the reputation of America’s central bank because essentially investors could profit if they know specifics about the Fed’s actions before the rest of the world.

Kate: On today’s episode we’re going to be talking about information coming out of the United States Federal Reserve. The Federal Reserve is this big, powerful, shadowy entity that’s somewhat outside of the governmental system. And it’s in charge of setting interest rates and controlling monetary policy. So we should expect to have utmost faith in this institution. And yet what we’re finding is that there actually seem to be a lot of information leaks coming out of the Fed at a regular basis. And not only are there leaks, but these leaks may even be encouraged by Fed officials.

Luigi: So let me be clear here: what Jeffrey Lacker, the president of the Richmond Fed, has been accused of is not like being Deep Throat and revealing all the secrets of the Fed to a hedge fund manager. What he is accused of is not answering properly to a question by a reporter. The reporter implied in his question some information that was confidential, and Jeffrey Lacker would have to say, ‘No comment,’ and he failed to do so. And he failed also to immediately disclose to the Fed that this conversation had taken place. So if you want, it might seem like a minor lapse except for the fact that there is a building amount of circumstantial evidence that the information of the decisions that the Fed makes seem to leak into the market before the official announcement. And this is what we’re going to discuss in this episode.

Kate: So the Fed is made up of a bunch of different leaders. First of all, there’s a few regional Feds across the country, and they oversee regional economic activity and they’re also given specific economic tasks—like they have to oversee certain segments of the economy. But there’s also this umbrella organization that’s in some sense more powerful than each of the individual regional Feds, and that’s called the Fed board. Now the group of people who decide to set interest rates are called the Federal Open Market Committee, and they’re made up of the seven members of the Fed board, the president of the New York Fed, and then some other regional Fed presidents. And they meet to determine interest rates and other parts of monetary policy, and then they announce these results in what are called minutes or notes on what happened in the meeting.

Luigi: I think it is important that our listener appreciates why these potential leaks from the Fed are so disturbing. The Federal Reserve is in charge of setting the discount rate, which is the rate at which banks can borrow from the Fed. And this has a big impact not only on the structure of interest rates in the marketplace but also indirectly on the value of the stock market. Because if the discount rate is cut, money is more easily available, and stock prices tend to go up. And if the Fed, on the other hand, increases the discount rate, then money’s less easily available and the value of stock tends to go down. So knowing in advance or potentially knowing in advance what the Fed does is a bit like knowing what the weather will be like in Florida for the price of orange juice. And if you know in advance that there’s going to be a hurricane in Florida and that oranges will go through the roof, you can buy in advance and make a lot of money. And that’s exactly the reason why there are procedures to make it difficult for these to happen. And in particular, the Fed makes the most important decisions about the discount rate in official meetings called Federal Open Market Committee meetings, and in advance of these meetings, there is a blackout period—a period in which the Fed officials cannot talk to market participants.

Kate: It’s not necessarily the case that we have no idea what the FOMC did or decided or discussed in their meetings. They have an announcement once the meeting is over. But that announcement is usually pretty short. It’s a quick summary of what happened, and then a little bit later—Luigi, correct me if I’m wrong on this—but a couple months later they have an official transcript, but the full minutes are not released until five years later.

Luigi: And what some researchers have noticed is that actually, on average, there is a big return on stock the day leading into the FOMC meeting announcement. So it’s not that after the announcement there is a big variation, but before it’s as if the market anticipates what the Fed is doing or maybe the market knows in advance what the Fed is doing.

Kate: And this is particularly shocking because the Fed put special provisions in place to prevent people from knowing what’s going to happen before the FOMC announcement is made. This blackout period exists for a week before the FOMC announcement, and during this blackout period, Fed officials are especially not supposed to talk to anybody. And yet, as Luigi just mentioned, all of the run-up in stock prices occurs before the announcement is made—like during the blackout period, which is a little concerning.

Luigi: In fact, there is this recent paper by Cieslak, Morse, and Vissing-Jorgensen showing that there is a cyclicality in stock market returns exactly around the time of these less-known discount meetings, and they attribute this to some kind of leak coming out from the Fed. But they document a number of strange—if you want—facts. For example, they show a cyclicality in articles written by journalists that are Fed experts. Until recently, probably the most famous Fed expert was David Wessel that was writing for the Wall Street Journal. The paper points out that the articles by Wessel appear with the same periodicity as the discount rate meetings take place. Now one possibility is simply that David Wessel writes when he knows decisions are made, and he’s trying to second-guess these decisions. To be fair, in the paper there is not any smoking gun that he knew what was decided inside the Fed. But the fact he writes at the same time is considered, if you want, a strange coincidence.

Kate: I mean the thing is that we don’t really know. They surmise that this has to do with the timing of the discount rate meetings, because increases in stock prices coincide with the timing of the discount rate meetings relative to the FOMC meeting. But we don’t know exactly what’s going on. Another alternative hypothesis is just maybe that there’s different macroeconomic news coming out around the FOMC meeting, and so they quantify and tabulate other sorts of macroeconomic news and they show that this isn’t describing the results, but I’m not sure that they specifically pinpoint information leakages directly from these meetings.

Luigi: Actually, yes and no. In this sense, is there a smoking gun? No. But there is a lot of circumstantial evidence in this direction. First of all, we need to remind listeners that for most of this period, the Fed has been very generous with its monetary policy, i.e. very expansive, with low-interest rates that tend to boost the stock prices. So the fact that around every meeting the stock price tends to go up is an indication that the Fed is trying to even support the stock market in its behavior—which might be wrong or right, that’s a separate question—but the interesting question is this effect does not come out at the time of announcement, but comes out before. And that is the concern of having some leakages. And they don’t prove that the leakages exist, but they do provide a lot of evidence that in many cases the information about decisions made inside the Fed was known to market participants, even reported in newsletters to market participants. And to me, the most shocking piece of evidence is actually the fact that during a meeting, the members of the Fed board asked each other whether this information has leaked to the market, and one member, which is actually Lacker, the one we heard at the beginning, asked Tim Geithner, who was then the chairman of the Fed in New York, whether he has talked to market participants about this, and he said no, I didn’t. And then Lacker comes back and says, “Wait a minute, I spoke with Ken Lewis, who is the president and CEO of Bank of America, and he actually knew about the decision we’re about to be making.”

Kate: So I think this is actually a pretty interesting transcript. It was just released.

Luigi: It was released after five years.

Kate: Yes. And it’s a pretty rare glimpse into how serious these information leaks can be. So Luigi, do you want to pretend that one of us is Lacker and one of us is Geithner, and then actually read the transcript?

Luigi: Sure. Which one do you want to be?

Kate: I’ll be Lacker.

Luigi: OK.

Kate: All right. Vice Chairman Geithner, did you say that the banks are unaware of what we’re considering or what we might be doing with the discount rate?

Luigi: Yes.

Kate: Vice Chairman Geithner, I spoke with Ken Lewis, president and CEO of Bank of America, this afternoon, and he said that he appreciated what Tim Geithner was arranging by way of changes in the discount facility. So my information is different from that.

Luigi: Well, I cannot speak for Ken Lewis, but I think they have sought to see whether they could understand a little more clearly the scope of their rights and our current policy with respect to the window. The only thing I’ve done is to try to help them understand—and I’m sure that’s been true across the system—what the scope of that is because these people generally don’t use the window and they don’t really understand in some sense what it’s about.

Kate: All right, so I don’t even really understand what Geithner’s explanation is there. I think he sort of is saying that all market participants can’t really fully process the importance of what the Fed does. And so, therefore, they need like extra explanation from him.

Luigi: I think that they’re actually to be sort of fair vis-a-vis Geithner, there is an important issue here, which is how do you do your job as a Fed board member when a lot of the outcome of what you do is mediated by the market, and you need to understand how the market reacts. So in this particular moment, I think that the question is ... Remember this is 2007, at the moment of extreme tight liquidity, and the banks are not really borrowing money from the Fed even if the Fed is cutting the rate. So Geithner wants to understand why the banks are not borrowing, and in order to do that needs to talk to the CEO of the biggest banks, and probably in the process of this talk, some information is shared.

Kate: So this notion of information exchange—the Fed and the markets and vice-versa—is actually something that the Fed has discussed before. And it’s somewhat of an open secret that the Fed actually conducts regular meetings with people at banks or with journalists. And the question is whether this is OK, whether this is encouraged, and whether it makes sense from the Fed’s perspective. And so the rationale is two things. There are two reasons that the Fed might actually want to leak some information. One is that they need information from market participants. So let’s say the Fed is thinking about cutting interest rates. They’re not sure about whether they should cut them by a quarter percent or half a percent. They want some sense of how the markets are going to react, and so they might leak a little bit of information and then see how the person at the other end of the table responds, or assuming that that information is then translated into the markets, they can then see how equity markets respond to the information leak.

And so that’s one way for them to gauge I guess the accuracy as well as the impact that their policies will have. And that, in turn, helps them fine-tune their policies. And another reason that they might want to leak some information slowly before they actually have an official announcement is that sometimes markets overreact to information and they swing around wildly, there’s lots of volatility, and so if information were only released at discrete times—let’s say eight times a year, when the FOMC announces its meetings and the results of those meetings—then maybe markets would overreact too much, and there’d be too much volatility. And so by slowly releasing information to banks or to journalists, this is a way to ease that information transfer in.

Luigi: But I see two problems. First of all, companies like to do the same or would like to do the same. If I’m a CEO of a company and there is a big change in earnings, etc., I don’t want to have my stock being too volatile. So there is at least the desire to soften it up and smooth it out and maybe sort of leak it out to some people first. But this practice, that was common until the late ’90s, now has been ruled out of existence by a regulation called Regulation Fair Disclosure. And the reason for this Regulation Fair Disclosure is to treat every market participant the same. Because if you are invited, if you are the channel through which the company provides information to the marketplace, you can make a lot of money on the side, and this creates a perverse relationship between CEOs and analysts. And I fear the same thing is happening here.

Kate: Yeah. I think that no matter what the sort of shady information disclosure ... A, it’s arbitrary. It seems arbitrary to me. Who’s the Fed picking as good journalists or bad journalists? Who’s the Fed picking as a friendly bank or an unfriendly bank?

Luigi: Can I suggest an idea?

Kate: What?

Luigi: It’s the journalist who writes very well about you.

Kate: Yeah. So that creates another problem. But on top of that, if you want to understand the actual mechanism by which information translates into stock prices moving—which, as we discussed, stock prices move very significantly with respect to these FOMC announcements—I want to know exactly how that information is being leaked and who it’s being leaked to. So, on one hand, let’s say the Fed is talking just to David Wessel. Someone calls up David Wessel like off cycle, and they give him some information. And so he then writes a news article about it in the Wall Street Journal the next day or something, and so that information goes from the Fed official to David Wessel to the public. That to me is very different than if David went to maybe a bank and gave that information to them first or maybe he went to his friends at a hedge fund and gave that information to them. And it’s also very different than if the Fed went directly to the banks, they went directly to Goldman or Citi or Bank of America and gave the information to them first. I mean then it creates this very unfair information, which basically is insider information that they can directly benefit from, and that to me seems very problematic.

Luigi: I agree. The part of the transcript we reenacted here seems to suggest that this transfer does take place. But to try to find more systematic evidence, actually, a student of mine, David Finer, had brilliant idea. The Yellow Cab Company of New York released all the cab rides in New York from 2009 to 2015. And so what he did, he went and looked at whether there was unusual cab ride activity between the Federal Reserve of New York and the major financial institutions located in New York.

Kate: The banks are Bank of America, BNY Mellon, Citigroup, Goldman, JP Morgan, Morgan Stanley.

Luigi: And what he finds is that there is a bit of an increase in direct rides, but the most shocking thing is there are coincidental rides leaving financial institutions and the Fed and meeting in the same location around noon, around lunchtime. And because there is this blackout period where the Fed is supposed not to talk to the financial markets, these meetings in a remote location at the same time seems pretty suspicious to me.

Kate: How does he know that it’s not just a coincidence? How does he know that it wasn’t just the case that someone from the Fed went to lunch at The Grey Dog café, and someone from Goldman also went to lunch at the same place, and they weren’t just coincidentally waiting in line next to each other but not interacting?

Luigi: That’s an excellent question, and to be honest, he spent basically a year doing robust statistical analysis to show to the most distrusting reader that this activity is unusual. So there is a pattern of rides that go from location to location, and this pattern changes with days of the week, with hours. So it first captures this normal variation and then looks at coincidental rides within a certain time period and space, and notices that around noontime leaving the Fed and the financial institutions there is a remarkable increase, which is outside of what we call in economics the normal confidence bounds. So there is some randomness. So can you say that you are 100 percent sure? No. But you are 95 percent sure that that outcome is not driven by sheer luck.

Kate: The most shocking thing about these findings is that there’s this increase in coincidental meetings at locations that are neither a financial institution nor the Fed during the blackout period, or the period during which Fed officials aren’t supposed to be communicating with market participants. But he also finds evidence that as soon as the blackout period is over, bankers rush to the Fed, right?

Luigi: So there is a rise in cab rides from financial institutions to the Fed. Now the irony is that the end of the blackout period is midnight. So this rise is between midnight and four o’clock in the morning. And so the reason why this researcher can identify that very well is, as you can expect, there are not a lot of rides going from financial institutions to the New York Fed that is in the financial district in Manhattan at that time of night. So it seems that a lot of people from financial institutions are trying to get some help in interpreting what the Fed announced and what the Fed has done. And the reason why I wanted to emphasize this is because again, what we are concerned with is not necessarily that there is illegal behavior; we are concerned about an excessively cozy relationship between the Fed and the financial sector, and in particular the traders. And this cozy relationship can potentially lead to a lot of distortion. And especially when then we see that most Fed governors, when they step down, they go on retainer to work for major financial companies and hedge funds.

Kate: So at this point, I think we should recap some of what we’ve talked about. So we’ve had some explicit quotations about Richmond president Lacker having resigned because of an information leak, about Geithner not being completely upfront about a potential information leak, about at least one economic paper documenting that equity returns or stock market returns are significantly timed before these FOMC disclosures, as well as around more secretive meetings, these discount rate meetings, in which there is very little information released to the public. And then we’ve also documented that your student has a paper directly tying cab rides to probably non-coincidental meeting places between Fed officials and bank officials when they weren’t supposed to be talking. So what should we be doing about all of this?

Luigi: As a policymaker, I think that’s more tricky, because as you correctly said, Kate, there is a benefit of this interchange. I personally think that this benefit is more than compensated by, number one, the cost of this policy, in particular the cost in terms of perception. A lot of people distrust the Fed, and many of them distrust the Fed for the wrong reasons. I don’t want to give them a right reason to distrust the Fed. If you’re already disposed negatively vis-a-vis the Fed, I think this could be really the kiss of death. And the Fed is an important institution of our market system, and we need to have the trust that is managed in the most honest and transparent way.

Kate: I agree. But from a policy perspective, let’s say you have some good reason to want to be sharing information slowly or to get reactions from the market. Then you should have an established mechanism for sharing information that doesn’t seem shady and arbitrary. You should have some sort of system for journalists to get a special designation so they can go to special meetings so they can be bound by some sort of rule that they don’t have to share that information or that they can’t share that information with banks and they can’t share that information with their friends. They have to go out and directly publish it in a newspaper so that everyone knows at the same time. But the system that they have where they sort of have a blackout period, it’s sort of not very well enforced, they talked to some banks but not others, some reporters but not others, that just seems like a terrible system to me.

Luigi: I agree. And I think that one way to help fix this problem is paradoxically raising the Fed salaries and restricting their ability to turn around and go work for other institutions. I think that honestly, given the level of importance of what they’re doing, they are very poorly compensated. The only solution, in my view, is to raise their salary. At the end of the day it’s not a huge cost for the government because those employees are not very many, and if that’s the price we want to pay for having a more fair system that does not allow the friends of the Fed to become rich at the expense of the rest of Americans, I think it’s a great step.

Kate: So the Fed is only a little over 100 years old. It had its hundredth birthday in 2013. I think that’s part of why the Fed ... It’s still pretty new. It still needs help and guidance from the markets. It’s not sure whether it’s doing a good job of lowering interest rates and raising interest rates and engaging in quantitative easing. And so that’s part of the explanation for why they need this, this constant interaction with market participants, because they’re still fine-tuning their policy decisions as a result of being a sort of young organization. But I’m not sure that fully gets them off the hook. I don’t know. I’m sad to be doing this episode. I’m not going to lie. I think that the people who work for the Fed are, for the most part, genuinely smart and motivated. And I agree with what the Fed did throughout the financial crisis. But these information leaks, sometimes they can be akin to insider trading, and the Fed should be doing something to stop that.

Luigi: Look, I agree with you that there are a lot of very nice and decent people working at the Fed. But I think it’s also important, in my view, to expose the problems, to fix them. And honestly, I think that the Fed should be held against higher standards than private companies. Precisely because it’s, broadly speaking, a government institution. I think that companies do have very strict rules against insider trading. They have now very strict rules about equal and fair distribution of information to everybody. I don’t know why a government institution should not be held to the same standard.

Kate: Absolutely.

As college enrollment goes up, social mobility continues its 50-year decline. Luigi and Kate look for answers in the latest research on the role of higher education. Are today’s universities engines of social mobility or simply bastions of privilege?

Main papers discussed during episode:
– All the work by Raj Chetty and co-authors can be found at http://www.equality-of-opportunity.org/documents/
– Hoxby C. and C. Avery (2013), “The Missing “One-Offs”: The Hidden Supply of High-Achieving, Low Income Students https://www.brookings.edu/wp-content/uploads/2016/07/2013a_hoxby.pdf

Papers using natural experiments:
– Twins Studies: Orley Ashenfelter and Alan Krueger, “Estimates of the Economic Return to Schooling from a New Sample of Twins,” The American Economic Review Vol. 84, No. 5 (Dec., 1994), pp. 1157-1173. http://www.jstor.org/stable/2117766
– Regression Discontinuity Design: Hoeckstra (2009) The Effect of Attending the Flagship State University on Earnings: A Discontinuity-Based Approach , The Review of Economics and Statistics Volume 91, Issue 4. https://doi.org/10.1162/rest.91.4.717
– Lotteries: Bulman, George, Bulman, Robert Fairlie, Sarena Goodman, Adam Isen (2017) “Parental Resources and College Attendance: Evidence from Lottery Wins” http://www.nber.org/papers/w22679

Kate: Hi. I’m Kate Waldock, a professor at Georgetown University.

Luigi: And I’m Luigi Zingales, a professor 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’re two economists who think that capitalism today is a sorry state of affairs.

Luigi: And we’re here to figure out how to make it better.

Kate: So we’re going to kick off today’s episode by talking about what’s fair and what’s unfair in college education in the United States. So, Luigi, a question for you, are universities in the United States engines of opportunity or are they bastions of privilege?

Luigi: I think they are a bit of both. They definitely are a big engine for opportunities if you get in. Access is not as equal opportunity as at least I would like it to be, and in that sense, they remain a bastion of privilege.

Kate: In terms of the actual college experience, we’re going to start by talking about the return on education if you view it as an investment.

Luigi: So until very recently, we knew relatively little about what happened to people when they went to college, and things have changed dramatically in the last few years, thanks to a very entrepreneurial researcher called Raj Chetty. He used to be at Harvard. Now he is at Stanford. He was very entrepreneurial, because he wanted to get the IRS data.

Kate: I think it’s important for me to interject here and say what this data set looks like. So it includes every tax-paying individual in the US, so people’s names, their social security numbers, and how much income they make, so it’s highly confidential.

Luigi: If you get that data and you can link fathers and children, you can get a sense of mobility across generations. Now to get that data is very difficult, because, as you can imagine, they are very, very confidential. And he had a brilliant idea, which was why don’t I do some work for the IRS so I can get ahold of those data? And so he posted a bid to actually work for the IRS, and he was rejected.

Kate: Are you allowed to be talking about this?

Luigi: Yeah.

Kate: He’s not going to get mad at you?

Luigi: This is all legal. It’s not that there was anything illegal here. He actually posted a bid to do some work for the IRS as a company, and the first bid was rejected, because he has no track record, and then he realized that if he bid zero, that he would do the work for free, the IRS will have to pay attention to him.

Kate: I’m sorry. Did he just create a shell company? Was this like a laundromat called Chetty, Inc., and he just applied to wash their uniforms or something? What is this company that he created?

Luigi: Actually the company is not a shell company. It’s a real company that does work for the IRS, data processing for the IRS, but he does it for free in exchange for access to the data. The taxpayers benefited from this, because they got the work done for free, and he benefited because he had access to phenomenal data.

Kate: Yeah. OK. This is brilliant.

Luigi: With this data, in the last ten years he has produced an enormous amount of papers that answer all the questions you want to know about how difficult it is to go into college, depending on your background, how much of a difference does it make. So, for example, 70 percent of an incoming class at Harvard comes from the top 20 percent of the distribution of income of parents, and 15 percent is from the famous 1 percent. So if you come from the top 1 percent, you are 77 times more likely to get in than if you come from the bottom 20 percent of the distribution.

Kate: Yeah. Another thing that Chetty finds is that there’s a lot of segregation across colleges, and by that, I mean some colleges are made up entirely of rich kids and some colleges are made up almost entirely of poor kids, and so there’s this idea that people go to college to mix and mingle with people from all walks of life, but that actually often isn’t the case.

Luigi: So the question is why there is this segregation. Is it because people who come from richer families are better trained and make it into better colleges? Is it because the legacy is important, and so if I come from a wealthy family, I’m more likely to get into a college because my parents and my grandparents donated to the university and went to that college? Or is it a combination of the two?

I think that this is a question that Raj Chetty has not been able to answer yet, but I think that’s very important for us to think about what’s wrong and what can we do about it.

Kate: Yeah. So econ-speak for this is there are selection issues, right? So maybe the best students are going to the best colleges, and the worst students naturally go to the worst colleges, and so when we’re comparing outcomes, it’s not really telling us anything about mobility. It’s just telling us something about their inherent differences.

One of the challenges in these studies in looking at the effect of education on your long-term outcomes, on your long-term earnings is that it’s hard to tell what’s causing things. Was it the actual education that benefited you, or was it just the fact that you were naturally smarter, you went to a good school, and that makes you better off in life?

So one trick that people use is that they look at identical twins, some who went to good schools, some who went to worse schools. They look at outcomes in earnings based on how much you’re making like 10 years out of college. Another trick that people use is that they actually go directly to the college and they get admissions criteria. So students often get scores by the admissions group. They take into account your SAT score, and your grades, and your sports and stuff, and they give you a number, and they just have a cutoff based on where you are as a student, as an applicant.

Some of these studies have looked at students who are right above the cutoff versus right below, and so they were basically similar on everything except that some happened to just meet the cutoff, and then they compare their outcomes in terms of future earnings. That is another method that people use to get around this question.

Luigi: If you look at people that were just above and below the cutoff, what is the impact of a college education?

Kate: All of these fancy experiments pretty much lead to the same point, which is that there are high returns to going to college, especially elite colleges. I think one of the takeaways from all of these studies is that there aren’t huge differences in what we know about the value of a college education, if you’re using a fancy experimental design versus if you’re just looking at the raw numbers.

Luigi: But what is the difference between going to Harvard and going to Texas A&M?

Kate: You bring up a good point, which is that one of the limitations of these types of studies is that especially if the researcher is getting proprietary information from a college, which is allowing them to look at these score cutoffs, then even though they can make specific causal statements about the impact of going to that particular school, they can’t really say anything that compares one school to another.

Luigi: Yeah. One thing that Chetty’s findings can tell us is that affirmative action does not seem to reduce the placement out of college. So the fact that you admit people from the lower part of the income distribution does not seem to impact the ability of these people to succeed in life. So in a sense, that’s the good news, and maybe something that we should think about whether we want to increase income mobility is other ways to increase access to college and to better colleges by people with low-income backgrounds.

Kate: Yeah. To put some numbers on this, let’s say your parents made nothing. Let’s say your parents were like incarcerated for most of their lives. On average, if you went to like an Ivy League school or an Ivy League Plus, you’re going to be in the top 30 percent roughly of earners, which is fantastic, versus if you are coming from the top 1 percent, your parents are owning the universe, then, on average, you’re going to end up coming out of college in the top 25 percent say of the income distribution, and so that’s not that similar.

It’s pretty reassuring that if you go to a good college, outcomes are similar across people who had bad backgrounds versus people who had good backgrounds, which maybe suggests to us—so this isn’t causal, we don’t know for sure what’s causing this—but it suggests to us that what college is doing for us doesn’t have too much to do with selectivity. It doesn’t have too much to do necessarily with network effects. If you went to a great college and you come from a really rich family, then you’re just mingling with other rich kids, and that’s where the benefit is coming from. It suggests to us that the benefits of going to a good college are pretty accessible across the poorest kids as well as the richest kids.

Luigi: I actually disagree here, in the sense that what he’s saying is that at least once you get in, you’re not discriminated in your networking, because it’s highly possibly that it is all return to networks, and these networks are also open to people coming from low-income families. I don’t think that the evidence we have is necessarily suggesting that it is the value added we give them by teaching. It might be really the value of being around other smart people, for example.

Kate: Yeah. That’s a good point.

Luigi: But, also, the other thing we need to think about is, as you said, I think the statistic you mentioned was very striking, but the chances of somebody whose parents were incarcerated to make it into Harvard is very slim. So I think that what I am personally worried from a social perspective is how can we make better colleges more accessible to a larger fraction of the population, and, again, is this the result of the fact that they get better training at home and with tutors, or is it the fact that colleges have really what is called white affirmative action, legacies.

When I visited Harvard, the students were telling me that their perception is that there are a third of legacy, a third of athletes and affirmative action, and only a third is admitted on the basis of merit. I don’t know whether this is true, but if it is true, it’s pretty scary.

Kate: Are you bringing this up to taunt me? I guess this is probably an appropriate time for me to talk a little bit about my background. I went to Harvard as an undergrad. Not only that, but I was born in New York. I was raised in Greenwich, Connecticut, and Greenwich is one of the wealthiest parts of the country. It’s where a lot of hedge fund people live.

I fit right into that paradigm of the top kids from the best schools go to the top colleges. Having said that, my parents were pretty solidly upper middle class. What they hinted to me, is that they were right around the top 20 percent of the income distribution.

Luigi: But let’s face it, your parents did not go to Harvard before, right, and you made it on merit, so you are one of the 30 percent who made it on merit. The problem is not you. The problem is the remaining two-thirds, and in particular, the people who could have made it if there wasn’t a legacy issue, and did not make it because others were reserved a spot. I think that, in a sense, is part of the issue.

Kate: Yeah. I don’t know if this is fair for me to say about myself, but I think that I’m the exception that proves the rule, and the reason I say that is because when I was applying to college, there was one college counselor for the whole class, because there were only like 60 people in my grade, and this person told me not to apply to Harvard, because I wouldn’t get in, and he said that the reason I wouldn’t get in was because there were 30 other people applying to Harvard and all of their parents went to Harvard, and so I didn’t have that, and so there was no chance for me to get in, so I might as well not waste my early application on this.

And I did get in, and I think the way in which I proved the rule is that it was very obvious to me right away that it conferred huge benefits upon me. It definitely had a material impact on my life, during college and after college. For example, within a few months of being there, I was taking a 12-person class with a former Secretary of the Treasury of the United States, and so it was very obvious that there are great benefits to going to an elite school, but that the legacy thing was a huge deal, and I just was one of the few people who got lucky enough to have it not hurt my chances of getting in, at least after the fact.

So I feel bad about talking about this, but kind of a legend that was pretty popular at Harvard was that there was a thing called a Z list. Apparently, if you are the child of a donor, like a very wealthy donor, but you may be a marginal case to get in, they admit you at the very last minute. They admit you in June, like once everyone has made their college decision, and so it’s too late for you to be part of that class, but they make you take a year off, and then you can join after that, and so these people are called Z listers. There’s a handful of them. They’re supposed to come from the wealthiest of the wealthy.

There’s no evidence. Harvard has never fessed up to this, but I will say that I happened to know a few kids who took a gap year between high school and college, and these kids just happened to have parents who were probably billionaires.

Luigi: What can be done at the level of basic education, so that more people have a fair chance to get in, because I have no problem with the smarter people getting in. What I do have a problem is that sometimes there are a lot of smart kids who don’t have a chance to even try, because they were poorly trained, and the poor quality of our primary education is a big issue.

Kate: I think the issue of what needs to be changed at the primary education level is a little beyond the scope of this episode. Personally, I think it’s probably a more complicated issue and maybe even more important.

But one thing that we can talk about is if you have a college senior who is low-income, what are the obstacles for that individual for getting into college or applying to a good college, and here there are a few different theories. One is that maybe people’s parents can’t afford it at the time that they’re applying to college. One is that they can’t even afford a college application. One is that students lack the information on where to apply to colleges, and another is that maybe there’s just anxiety on the part of the student in applying to a college where a bunch of wealthy kids would be.

One of the people who has done a lot of research in this area is Caroline Hoxby, who is also at Stanford. She identifies high-achieving students coming from low-income neighborhoods. Let’s say people who got a perfect score on their SAT, but are from poor backgrounds. And she separates them into two categories. So she looks at their application behavior and says these high-achieving students from low-income backgrounds, they’re applying to colleges as if they were regular high-income students. And then she separates out a different category, where their application behavior, even though they’re high-achieving, just looks like they’re low-income students.

And what she finds is that between these two groups, there’s not a whole lot of difference in their parents’ education. There’s not a whole lot of difference in their parents’ incomes. What the real difference is, is that kids who are high-achieving that don’t apply to good schools come from small towns. They’re relatively isolated. They come from backgrounds where they’re the only good student in the school for a few years, and so it sort of lends to this information hypothesis that people who are very high-achieving and low-income, and don’t apply to good schools, aren’t applying because they just don’t know that they’re even allowed to. They don’t know that the resources are out there. They don’t know which colleges to apply to. They don’t really have the access to the application process, and that seems to me like a pretty easy barrier to overcome.

Luigi: Yeah. I thought this was more of a problem in the past. There is this phenomenal story of a colleague of mine who is a phenomenal professor of biology, and she grew up in Colorado, and when she applied to college, she only applied to Yale, because Jodie Foster was going to Yale. And when she got rejected from Yale, she said, “I’m not going to go to college, because I got rejected,” and actually thanks to her mother, she applied at the last minute to Colorado Boulder, and she did so well, and she learned a lesson, that when she applied to graduate school she made 13 applications, and she got 13 admissions to every place, including MIT, Yale, and Harvard, et cetera.

So I think that this information hypothesis has some element of truth. I think that it was more important for my generation that grew up without the internet, than for this generation with the internet, but I think it is an important issue that we need to face.

I think the question that we should address is Harvard is a private institution, so they can do whatever they want. So why are we concerned about this, and in particular, what can we do as policy maker or concerned citizen to change the state of affairs? What is your idea, Kate?

Kate: Yeah. That’s a good question. So, to me, it boils down to what the value of education is. Why do we care that we’re going to college? What benefit does it give us? I think it makes a huge difference if you’re going to college and you’re just acquiring amazing skills, and you’re going out into the workforce, and you’re using these skills that you got from your college, because they spent a lot of money on you as a student. I think that’s really different than if the college is just standing by. They’re not doing anything. You get drunk for four years, and then it just happens to be that all the employers afterwards look at your resume, they see you went to a good school, and then they give you a job.

So I think it matters a lot whether colleges are doing things, making a material impact on your human capital, versus whether they’re just stamping your resume and then you go off into the world. If it’s the case that they’re actually adding a lot to your skill set, then I think it makes sense ... Or I think that’s some justification of this elitism. The colleges are spending a lot on their students. They’re training them really well, and so it makes it less abhorrent that they’re essentially picking winners and losers, because there’s actually some process in which they’re making people better off.

Versus if they’re not making any difference in your skill set, they’re just rubber-stamping you, then I think that it’s a huge problem that schools are able to charge like $50,000 a year, and make people go for four years for essentially nothing.

Luigi: But in a sense, isn’t that the free market? Forget for a second that they’re public institutions. Think about it as a private institution. You work for a private institution. I work for a private institution. Harvard is a private institution. They are private agents, and they try to do their best, and why should we, at some level, be concerned?

Kate: I guess what I’m trying to say is that there may be issues in the labor market itself that are causing universities to have to play this strange sort of role in society. So if there is an issue with the labor market, where potential employers have a tough time picking out who to employ, like who to hire, because they can’t get enough information about people or they can’t really process that information, then if we live in this world where the role of a university is just to signal to employers whether someone is a good candidate or a bad candidate, then the policy response should be that the government should intervene and make the employment system better. So the government should make it easier for low-income students to signal to employers that they’re of high quality. Maybe they can offer training seminars or resume writing seminars, something like that.

Whereas if that’s not the problem, if colleges are actually contributing to people’s skill sets and making people more employable, then I think the policy response should be that we should invest more money in public institutions, offering the same sort of education quality as good private universities.

Luigi: I think that my major concern is that all of these institutions are heavily tax subsidized, and to be honest, both of us benefit indirectly from this subsidization, but they receive a lot of ...

Kate: I think we benefit directly, too.

Luigi: We receive huge donations that are tax exempt, and universities have endowments and the return on this endowment is tax exempt. So the government, this is not really a free market, it is a very subsidized market, and so my idea, which will make me very unpopular even with my president, but my idea is the government could easily intervene by saying, “Look, if you want to retain these tax subsidies, you need to follow certain rules.” It’s a bit like with the subsidy for highways, that the federal government says, “If you want the subsidy for highways, you have to have a speed limit,” and in the same way, they say, “If you want to have the free tax status, then you have to have some rules in admission. If you don’t want to have the free tax status, you can do whatever you want. It’s a free country and you admit only your friends and your cronies, be that with you.” That’s not a problem to me, as long as you don’t get any dollar of the US taxpayers as a subsidy.

Kate: Yeah. That’s an interesting idea. I think something that complicates this discussion of tax subsidies is that huge universities are more than just education providers, right? The University of Chicago is doing a ton of research, and that’s part of why the government is subsidizing them, because a lot of the technology that has led to huge gains in productivity has come from universities, and so there’s a reason that governments may want to subsidize research.

At the same time, they’re also providing education, and through the provision of education, they’re picking which people may do well in the future and which people may not, and so there’s this weird link between what universities are doing, and it’s not obvious to me that we should have a single policy in terms of subsidization.

Luigi: I agree, but it’s very easy to separate the two, in the sense that think about liberal arts colleges. They provide basically just education. They don’t do much research, and they get subsidized with a tax subsidy anyway. So if you want to separate and motivate people to do more research, you can do grants, or you can do special provisions for research, and get rid of the tax subsidization in return to endowment, for example. I think that in my view, the endowment is a source of increasing inequality, because you have rich people donating to rich universities that eventually train their kids and make them richer. So if this is done without any taxpayer money, I’m much more laissez faire here. But if it is done with tax money, that irritates me a bit.

Kate: Well, actually as part of the new tax plan, some universities are going to have to pay taxes on their endowments. I think the rule is that if you have over 500 students and your endowment is so big that it’s worth over $500,000 per student attending that university, then you have to pay like 1.4 percent on the net income that you earn as a result of investing that endowment money.

But, at the end of the day, only something like 30 schools total actually meet those criteria, and so it’s a tax with a pretty small base, and it sounds like you’re suggesting something with a broader base, but some sort of tax scheme that a school could avoid if it had fairer admissions criteria.

I like that idea, but, at the same time, it opens up room for lobbying by larger schools to adjust the definition of fair admissions criteria, according to how they want it, but also, second, I’m pretty sure it’s going to get us fired and then we’re going to lose funding for this podcast, and we will have been around for four episodes before everything got cut off, and I don’t want that to happen. I’m having fun.

Luigi shops for an airline ticket and ponders how our retirement investments might be hurting our wallets. New research suggests that giant mutual funds with large stakes in the companies of one industry can lead to reduced competition and higher prices.

Luigi: Hello. This is Luigi Zingales, a professor at the University of Chicago.

Kate: And I’m Kate Waldock, a professor at Georgetown, and you’re listening to Capitalisn’t. This is a podcast about how capitalism is working.

Luigi: Or, more importantly, how it isn’t, because capitalism without competition is like religion without God. It doesn’t work.

So yesterday I was on Expedia trying to book a flight actually to go see Kate in Washington, DC. And I discovered that it’s super expensive to travel from Chicago to Washington, DC. So let me make a comparison: a return ticket from Chicago to Washington, DC, is $325, but if I want to fly to Boston, it’s only $151. Why is that the case? It’s not that Boston is closer; in fact, Boston is farther away from Chicago than Washington, DC, is. So a possible reason is that half of the flights into Washington Reagan are actually controlled by America Airlines. By contrast, no airlines control more than 18 percent of the flights into Boston Logan.

The risk that market concentration might lead to higher prices for consumers is a central policy concern. In computing this concentration, however, the Department of Justice or the Federal Trade Commission always treat American Airlines as a separate company, for example, from Southwest, which is the second-largest airline in Washington, DC. Yet, the same mutual funds appear as the largest owners of both American Airlines and Southwest. Why should these owners push these two airlines to compete aggressively for the benefits of consumers but to the detriment of their investors?

And if they don’t, why shouldn’t we consider companies with the same owners as just one big company?

Kate: On today’s episode, we’re going to be talking about how the way you invest your retirement money might actually hurt your pocketbook.

Luigi: We economists call it common ownership when the institution we invest our money in ends up owning a lot of the competitors in the same industry, and that common ownership might actually lead to less competition and higher prices.

Kate: Basically when there’s common ownership across companies in an entire industry, then the incentives might be sort of similar to the incentives of a regular monopoly. So that across airlines, across American Airlines and Delta and JetBlue, if they’re all owned by the same people then they can act together as if they were one industry-wide monopoly. So that might lead to the same higher prices and lower quantities.

Luigi: And while monopoly’s as old as humankind, this phenomenon is a really recent and surprising phenomenon: the result of the widespread use of mutual funds and also, another sort of recent trend, which is indexation of mutual funds.

Kate: And so even though you might not realize it, by having money in a mutual fund or by working for a company that automatically puts money away for your retirement savings, that money is probably invested in some part in the stock market. And it’s invested through these companies, mutual funds or IRAs, companies that manage IRAs, that have just become huge. So over the course of the past 15 to 20 years, the way that most people held stocks was that they invested directly. But the way that it works now is that through your retirement account all this money is pooled across half of all Americans into these huge funds that now manage four-, five-, six-trillion-dollar portfolios. This gives them a whole lot of power.

Luigi: For example, Vanguard, who is one of the cheapest and the best of these, controls more than $4 trillion in assets, and so owns companies, owns a large stake in most companies in corporate America. And the same is true for BlackRock. So this trend has really created these enormous institutions with enormous amounts of ownership everywhere in corporate America and the world.

Kate: If you have $4 trillion of assets under management, you’re not just going to pick one or two companies to invest in. You are essentially diversifying across all companies.

Luigi: Now, while Kate is a wealthy investor, she doesn’t control ...

Kate: I’m not a wealthy investor.

Luigi: … all that amount of money, so the fact she is diversifying this way is not a problem per se. However the fact that Vanguard, Fidelity, BlackRock owns so many shares in competitors raises a concern. Why? Because they are paid to deliver performance to the investor. And the easiest way to deliver performance to the investor is to have companies collude to increase prices. Because if they do, they increase profits and share price goes up. So, Kate is very happy, as an investor, of this result, but is very unhappy as a consumer.

Kate: Exactly. And what we’re going to be talking about today is whether this is actually a problem. Should we be concerned about this common ownership issue that comes about through the fact that these mutual funds are really huge and they’re holding entire industries.

Luigi: There are two issues here. One, there is an issue about inequality in the sense that there are more consumers than there are producers or owners of producers. So, while most people have some form of retirement account, they consume more than they invest. And as a result, if you allow concentration and collusion to go on ... I use the word collusion here a little bit loosely, there would be a redistribution from the many to the few. And we know that this is one of the concerns that people raise about capitalism. And I think this is a legitimate concern these days, so I think that that would make the problem, if this is true, it would make the problem only worse.

Kate: So this notion of common ownership has existed in the theoretical economics literature for many decades. But it was only until recently that we’ve been able to start testing whether it has a real effect on prices for consumer goods. Some of the research that has been groundbreaking in this area was done by Martin Schmalz and José Azar, and Luigi why don’t you tell us a little bit about the research that they’ve done.

Luigi: They really document that where there is more common ownership, where the same people own all the airlines, you also have higher prices. Now as economists we tend to be skeptical about this correlation because we know that correlation is not causation. In real science you can address this problem with a real experiment. Economists, most of the time, cannot do real experiments and so they resort to something close that is called a natural experiment. And the authors of this study use a natural experiment to try to see whether there is a causal connection between the two.

So in this particular case, Barclays, a British bank, shortly after the financial crisis found itself in desperate need for cash. So they ended up selling their investment arm, and they ended up selling to BlackRock. So BlackRock all of a sudden saw its holding of airline stock increase dramatically. These researchers looked at what happened not in general to airline prices but precisely on those routes where this merger, or this acquisition, made common ownership go up. What they document is precisely where there is this increase in common ownership, prices go up by 10 percent and not everywhere else.

Kate: This type of research ... I do want to say off the bat that these authors are incredibly precise. They are incredibly careful about how they measure things. The run a bunch of tests to test alternative hypotheses, I mean they cover all of their bases. But at the end of the day they define a market as a route between two cities. And they construct a measure of common ownership at the carrier level at each route. And then they say that this acquisition of Barclays Global Investors was a random shock that had nothing to do with anything else that might change prices at that route level.

To be honest, what I find confusing about this is that I don’t know what affects changes at the route level. I don’t know if airlines use some sort of pricing algorithm, I don’t know if there’s some person who’s actually changing prices at the computer as he sees supply and demand fluctuate. It’s just hard for me to get an intuitive sense of what’s causing prices to change. And so it’s hard for me to say whether this acquisition that happened during the financial crisis—when tons of other things were going on, when companies were going bankrupt, when supply and demand was changing—it’s hard for me to say whether that was truly uncorrelated with anything else that could be affecting prices.

Luigi: You are right, but let’s remind our listener that this is only one of the many things they do. In a sense they do find in general a correlation between higher prices and more common ownership. And this experiment, this natural experiment they use, is only one of many, many things that they do. Now, I understand that it’s hard to appreciate how this mechanism really works. However, as empirical economists, we see that there is certainly a motive to increase prices if you have common ownership, and you do see some evidence. So I do think it’s a phenomenon we should be very concerned about.

Kate: Yes they do run a ton of tests, and yes they are incredibly thorough. I mean much more thorough than you would see on a typical paper working with data in our field. But one of the other things that they acknowledge affects pricing in the airline industry is concentration in the industry itself. A little over 10 years ago, the top airlines held like 60 percent of the market share. And now it’s something like 85 percent. And that didn’t show up in the routes at all. I mean, there’s been a ton of mergers, there’s been a ton of bankruptcies, and none of this was reflected in the industry concentration measures. So it’s hard for me to imagine that maybe there was something else going on in industry concentration that they just weren’t picking up.

Luigi: Yeah, but remember, they don’t find this just in airlines. They have another paper looking at the banking industry. And they find that when there is more common ownership in the banking industry, actually banks pay less for your deposit. So I think it seems that it’s not just a problem of airlines, it’s a general problem.

Kate: OK, so let’s go to banks now. What they’re claiming is that at the county level, banks in counties in which there’s more common ownership charge higher fees and they give you less return for your CD investments. Say, your one- or two-year CDs. What is the actual mechanism here? I mean, is there some person at a regional bank in like Greenwood, Kansas, who is trying to figure out how much they should be charging for overdrafts and the way that he does this is to look at the ownership of all the other banks in town, the ownership of his bank, whether there’s common ownership, whether Vanguard owns 5 percent of his bank and 10 percent of CitiBank next door, and he’s like, “Oh, well there’s common ownership and therefore we should be acting cooperatively with the other banks and so we should be charging higher overdraft fees.” It’s hard for me to imagine that that could possibly be happening.

Luigi: I agree with you, I don’t think that the mechanism you describe is realistic. However, as economists we believe in incentives. And there are a lot of incentives that can go in that direction. Let me give you an example: in 2015 there was an activist investor that was trying to take over DuPont. DuPont is a big chemical company but also produces a lot of agricultural products and seeds. This investor really wanted DuPont to be more aggressive and gain market share over Monsanto. This investor was defeated in a proxy fight. Who voted against in this proxy fight? Vanguard. Fidelity. All those large institutional investors who own shares both in Monsanto and in DuPont. And as a result, actually DuPont ended up merging later without creating, again, more concentration rather than competing aggressively with Monsanto.

So the story is you don’t need to tell the little guy in the county to increase its fees. It is the incentives at the corporate headquarters that trickles down into a different behavior.

Kate: Yeah, but it’s a well-known fact that mutual funds typically side with management in these proxy battles. They’ve historically been very passive investors. They’re not like the David Einhorn who is out there sounding the bell and who is trying to get management replaced or who is trying to get huge changes in corporate strategy enacted. These big mutual funds like Vanguard and like BlackRock, whenever they vote for changes at the corporate level they’re usually pretty chill. They don’t want to rock the boat. They don’t want to disturb the CEOs because they generally trust that CEOs do a good job at what they do. And so it’s not like in that case they voted against the activist because they necessarily wanted more industry concentration or more cooperation amongst the industry. It’s just that they were doing what they always do.

Luigi: You’re only partially right here. It’s true institutional investors tend to vote with management but it’s also true that they tend to follow the indication of some proxy advisors. In particular, Institutional Shareholder Services, ISS. And in this case ISS actually recommended to vote in favor of the activist investor. And they did not follow this advice and voted in a different way. So it was not as passive a behavior as you describe. But even if we buy your interpretation that these guys are passive, this might lead to the same behavior. For instance, if I know as a manager that I am owned by the same guys, by Fidelity and Vanguard, etc., as my competitors. I know that nobody can take me over because they’re going to side with me. And so I don’t need to actually be very active in maximizing profits of this company. I can take a basically easy life approach. This leads to what we call in economics tacit collusion. Tacit, because it’s not a guy conspiring in a seat in a smokey room with my competitor and fix the price. But for all practical purposes the result is the same.

Kate: I think that’s an interesting point. Another way of putting this is that this is the crowding out theory of common ownership. That the way that big mutual funds that own a bunch of shares of all firms in an industry, the way that they actually get the industry to end up pricing in a monopolistic way isn’t that they’re encouraging collusion in pricing across the firms in that industry. It’s just that they’re not doing anything. They’re just sitting by and they’re letting the managers do whatever they want, and because they’re not actually trying to force the firm to compete aggressively, then managers end up just looking somewhat lazy. And I think that this has some validity. It makes a lot of sense in terms of a mechanism to me.

But if that is the case, if that’s the way in which common ownership leads to changes in pricing, then I want to see a paper on that. And I want to see how those mutual funds are actually voting against activist investors, such as hedge funds, or they’re not, and see if there’s a relationship between the extent to which they vote against activists and how much they hold shares across all firms.

Luigi: It seems you have a new paper to write, Kate.

Kate: I’m not in this field, I study bankruptcy. This is not my thing.

Luigi: Actually, that’s a pretty good field. Because many airlines go bankrupt, so you might have a synergy here between the two.

Just to give you an example of how this is pervasive, let’s look at drugstore pharmacists. Not only is there a huge concentration but basically three chains, CVS, Walgreens, and Rite-Aid, that control most of the local markets. And what you have to realize in most large corporations in the United States, you don’t need to own 51 percent of the stock to control a stock. So when we look at CVS there is nobody that owns more than Vanguard. Vanguard is the largest owner with 6.7 percent. And the second largest is BlackRock. You go to Rite Aid, it’s exactly the same. Vanguard is the largest owner with 7.2, and BlackRock is next with 4.2.

Kate: Yeah, so what that might end up translating into is this crowding out effect. That if you’re an activist investor and you’re looking around at all the pharmacies and you’re seeing that CVS and Walgreens and Rite Aid, the major investors to the extent of 13-14 percent are the mutual funds, then that’s going to deter you from purchasing shares in those companies because it’s just too large of an investment to try and purchase more than 14 percent. So even though 14 percent on an absolute level might seem small in terms of controlling the company, what’s important is that it’s large enough for activist investors not to want to come in and purchase more.

Luigi: But Kate, we started this episode by basically telling people that the way they invest really ends up damaging their pocketbook, damaging the way they consume. What is our recipe for those investors?

Kate: That is a tough question. I mean, if the problem is then that they are causing their portfolio holdings, the firms that they hold, to act like monopolies, then that’s going to lead directly to higher prices at, let’s say, the pharmacy. It’s going to lead to higher prices in the water that I buy at CVS. And it’s going to lead to higher prices in the airline ticket that I buy to fly to Chicago. But essentially it all evens out, right? You get a higher return on your retirement savings. You have to pay higher prices at the drugstore and for your airline tickets.

Luigi: But Kate, I don’t want to be too philosophical, but it is true that as economists we think that monopolies are bad no matter what. Even if you redistribute money to the right consumers, I think that there is some deadweight loss, as we call it in economics. There are purchases that people would have made and they don’t as a result of higher prices. And this is not a transfer, this is a net loss. So I think it’s not as benign as you would like to portray.

Kate: I know. I’m being a little unfair to the economics profession just because I personally think that inequality is a huge problem right now.

Luigi: What I want to make sure that comes across very clearly is we’re not telling investors not to diversify their portfolio, not to buy index funds. I still think that the right thing to do for an investor, and that’s what I do myself, is to diversify your portfolio and buy index funds. Maybe what we should tell people to do is to be more active in asking those funds to be more accountable. Ask them what they do to avoid this problem. Are they really paying attention, or not? And I think that that’s what would be helpful if we all do a bit more. And I think what makes it problematic from my point of view is that there’s not an easy solution. Because if we take away the ability, for example of mutual funds, to have a voice in corporate governance, we’re actually probably making the problem worse rather than better because we’re going to have a lot of managers that are completely self-interested. That are not motivated and don’t try to maximize profits at all. So I think that it might be that the solution is worse than the problem.

Kate: Part of me wonders whether this wouldn’t just naturally lead to a market solution. Which is that ultimately, let’s say over time these mutual funds end up holding entire swaths of all firms within industries that are publicly traded. And then the firms stop competing against one another. Within the industry they start charging higher prices, the managers get lazy. These companies end up not being run very well. Then this is just an opportunity for private equity firms to come in and to take over some of those lazy companies. So, to take the companies private and to have that particular company start competing more aggressively against the other, lazier, publicly traded companies. And so in this market what will happen is that eventually companies will be taken private. Those companies will outperform. And then the managers of the public companies will have to wake up and they’ll have to start taking more action. And so I think that there is sort of a market solution to this. We don’t necessarily need to step in with regulation.

Luigi: Wow Kate! You sound like more Chicago-style than I am!

Kate: No!

Luigi: I think you’re right, in the long run maybe everything would be solved. In the long run. As Keynes said, in the long run we’re all dead. So we need to be careful of being so cavalier that it would be fixed. But you’re right that there might be a market solution to this problem. My concern is that if I am a private equity firm and I’m in a market in which everybody else colludes, my first reaction is to collude as well. And it’s going to be very hard for me to be the only guy fighting against everybody else.

Kate: Yeah, and I’m going to undermine my own argument because I don’t want to seem overly pro-market. But a problem with this is that eventually that could lead to more privatization, fewer firms being publicly traded. And the people who invest in private equity, the types of people who have their money in private equity firms, are very different from the types of people who have their money in 401(k)s. And so it’s a different set of people who would be benefiting from competition and I think that the returns might ultimately go to richer people, and that might aggravate the inequality problem. So we don’t want that outcome to ultimately happen, which means that we might need some more regulation to prevent that state of the world from coming about. Which as Luigi said, it’s hard to devise regulation that would prevent this issue of common ownership leading to monopolistic-type behavior without at the same time leading firms to act in a way that’s not beneficial to shareholders.

So, one of the regulations that does exist is that there was some antitrust regulation from the 1970s. There’s this thing called the Hart-Scott-Rodino Act, and as part of that firms have to file information with antitrust authorities if they buy a bunch of stock. It used to be $50 million in stock, now it’s like $65 million. But if you claim that you’re a passive institutional investor, you’re only buying that stock for investment purposes, not for actually controlling the corporation, then you get a waiver and you don’t have to file with the antitrust authorities. What I think is kind of ironic is that the antitrust authorities have been super lax when it comes to institutional investors like Vanguard and BlackRock, whereas there was this one strange instance where a hedge fund came around and they bought a really tiny fraction of Yahoo, and they didn’t file with the regulators, and then they got in trouble.

Luigi: Yeah, but as you know, very often regulation is used to protect against newcomers to the industry rather than to actually pursue the benefit of regulation. But I’m a big fan of Justice Brandeis’ position that sunlight is the best disinfectant and the streetlight the best policeman. So I think that you’re absolutely right that enforcing the Scott-Rodino Act is good. I’m not ready to jump the gun on some sort of intervention, but it’s something that we need to watch out for and we need to know more. And I think this is what good economic research is about. To point out problems that we did not even know existed.

Kate: Yeah, Luigi, on this podcast I think you’ve gotten me to say twice that hedge funds are the good guys, and once to say that the market just regulates itself. So, somehow you’ve managed to convince me to turn all of my beliefs on their head!

The new tax reform bill includes a dramatic reduction in the U.S. corporate tax rate. Is this a hand-out to the rich or a necessary measure to spur the economy? Luigi and Kate debate the pros and cons and break down the law’s impact on pass-through businesses.

A special thanks to Clemens Sialm and Jim Albertus for their expert advice on this episode.

 

Policy Links:

– Corporate tax rates in the OECD http://stats.oecd.org/index.aspx?DataSetCode=TABLE_II1.

– Memo from CEA: https://www.whitehouse.gov/sites/whitehouse.gov/files/documents/Tax%20Reform%20and%20Wages.pdf

– Study of corporate inversions:     https://www.cbo.gov/publication/53093

– Congressional Research Service study on possible corporate tax reforms: https://fas.org/sgp/crs/misc/R42726.pdf

 

Relevant academic papers:

– Albertus, James, Does Foreign Tax Arbitrage Promote Innovation? (December 2017). SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2691064

– Foley, C. Fritz, Jay Hartzell, Sheridan Titman, and Garry Twite. “Why Do Firms Hold So Much Cash? A Tax-Based Explanation.” Journal of Financial Economics 86, no. 3 (December 2007).

– Faulkender, Michael W. and Hankins, Kristine Watson and Petersen, Mitchell A., Understanding Precautionary Cash at Home and Abroad (September 2017). NBER Working Paper No. w23799.  https://ssrn.com/abstract=3035145

– Djankov, Simeon, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Schleifer. 2010. The effect of corporate taxes on investment and entrepreneurship. American Economic Journal:Macroeconomics 2(3): 31-64. doi:10.1257/mac.2.3.31

– Petersen, Mitchell A. and Faulkender, Michael W., Investment and Capital Constraints: Repatriations Under the American Jobs Creation Act (April 29, 2012). SSRN: https://ssrn.com/abstract=1364207

Kate: Hi, I’m Kate Waldock, a professor at Georgetown University.

Luigi: And I’m Luigi Zingales, a professor 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.

Donald Trump: I’m giving the largest tax cuts in the history of this country.

Speaker 4: Everyone else has cut their corporate taxes dramatically in the world, and we haven’t.

Speaker 5: The tax cut is longer than the Bible, and not quite as inspirational.

Speaker 6: Big, wealthy corporations count far more than kids.

Speaker 7: This is our opportunity to make tax reform a reality, and deliver the most transformational tax cuts in a generation.

Speaker 8: The big winners are clearly corporations.

Kate: On today’s episode we’re going to talk about the recent tax reform. In particular, the reduction of corporate tax rates from 35 percent to closer to 20 percent. You’ve probably been hearing a ton of fiery rhetoric from both sides of the aisle about how this is just a handout to the rich. Or this is going to solve all of our economic problems and lead to 6 percent growth.

It’s all over the place, but we want to cut through all of that and focus on the economic issues here, in particular the economic issues surrounding corporate tax rates and international competition. So, Luigi, do you think that this is really a handout to the rich, or it’s going to solve all of our economic problems?

Luigi: Let me start actually with a story. In 2014 a group of economists of different persuasions were invited to the White House. I was lucky enough to be one of those.

After being in very pleasant conversation, President Obama said, “You know, I invited you here to have ideas. What are you proposing?” And Kevin Hassett, who is now the head of the Council of Economic Advisers, stepped up and said, “I think that we should cut the tax rates of corporations.” The reaction of President Obama was not, “This is a handout to the rich. It’s a terrible idea.” He said, “Oh, I know we need to cut the corporate tax rate. But, in order to make this effective and important, it needs to be a large tax cut. Where do I get the money to do so?” Then we had a conversation on how he could get the money. But, the important thing here is even President Obama recognized that a reduction of the corporate tax rate was due. And the question was not if, it was only how.

Kate: I am super jealous that you got to hang out with Obama and a bunch of economists and just shoot the shit on how to generally solve our economic problems. But, before we launch into further discussion about this, I just wanted to insert the quick disclaimer that this recent tax reform act is really huge. It covers all manner of sins.

It covers the mortgage interest deduction, and it covers state and local tax deductions, and it covers individual income taxes. But, we’re here specifically to talk about the business element of it. In particular, how corporate tax rates have changed. But, also what goes on with pass-throughs.

Luigi: Absolutely. Let’s start actually by having a pretty important conversation, which is why do we have corporate taxes to begin with?

Kate: Corporations are subject to what economists call double taxation. So, if you’re a corporation and you earn some profits, then after certain deductions you have to pay taxes on those profits. Then, if the owners of that corporation want to then receive that cash afterwards, they need to pay an additional tax. Either through capital gains or through dividends on what’s dispersed to them in cash.

So, there’s sort of this two-layer process. First, you’re taxed at the corporate level. And then you’re taxed on the cash that’s given back to you as a shareholder. So, Luigi, why should we even have these corporate taxes?

Luigi: It’s actually kind of a theoretical puzzle why we have an additional layer of taxes on corporations. There are three main explanations. One interpretation is we want to avoid that people will postpone paying taxes forever. So, if I am an owner of a corporation I can divert my income into a corporation, and if this corporation is not taxed, I can postpone paying my personal income tax for many years with clear advantages because paying a tax later is better than paying today.

The second idea is you want to tax rents. You want to tax not the normal return to capital, but the return to some form of monopoly.

The third interpretation, which is one I tend to espouse, is historically there was an easier way to collect taxes. Whether we like it or not, governments need to collect taxes, and they always prefer an easier way rather than a more complicated way. In the old days, tracing down individuals was very difficult. And just assessing a tax at the level of corporation, especially when it’s a big corporation, is relatively easy.

Kate: There’s this excerpt that I want to read from the Council of Economic Advisers, this report they came out with on taxes back in October. They start with a summary. And the first sentence of the summary is, “Wage growth in America has stagnated. Over the past eight years ...” So, that’s sort of a direct dig on Obama, saying that this is his fault for stagnation.

The first sentence of the second paragraph is, “The deteriorating relationship between wages of American workers and US corporate profits reflects the state of international tax competition.” So, they’re saying this is an international issue.

And then the first sentence of the introduction is, “An extensive literature on corporate tax policy documents that reducing the corporate tax rate results in increased capital formation and economic output.”

So, there’s these three different ideas that they are glomming together. In particular, there’s two separate ones that I think we should talk about.

One is that, we need to reduce taxes because we just can’t compete with other countries versus we need to reduce taxes because that boosts economic output. We need to recognize that those are two distinct ideas. I agree with the idea that we’re facing international tax competition. I’m not so sure what I think about the supply side argument that cutting taxes always boosts output.

Luigi: I don’t want to sound like a Trump defender, but I don’t think that what you read is so crazy. In the sense that, it is true that higher taxes lead to low investments. Imagine that I need to decide whether to create a plant in Michigan, or on the other side of the border in Canada. If I create this plant in Michigan, I end up paying 39 percent: 35 at the federal level, plus some other stuff at the Michigan level. Thirty-nine percent of my profits in taxes.

If I go to Canada, which is not exactly sort of a tax haven, I end up paying only 27 percent in taxes. If you, Kate, want to start a business, and you’re in doubt, and you know, they speak English on both sides, they basically have similar laws—we’re not going to an underdeveloped country where we cannot get what we get in the United States—at the end of the day, everything is similar except in one place you pay 39 percent, in the other 27. Which one do you choose?

Kate: I’m a goddamn proud American citizen, so I would stay over here.

Luigi: I’m glad that you have this sense of patriotism. I guess not everybody has the same sense of patriotism They might decide to go on the other side of the border.

Kate: Actually, I think that that sense of patriotism is important to this argument here because if enough people do think there’s a premium to staying in the United States, either through a sense of patriotism or, just because they just think that US workers are better trained, or because there is some benefit to being in the US for whatever reason, maybe it has to do with education, then we don’t need to worry as much about cutting taxes because we don’t actually face as much international competition.

Luigi: I think you have an image of the 1950s where the United States was so ahead of everybody else, that setting a plant anywhere else was basically going to no man’s land. First of all, the interesting thing is even if the United States has a higher statutory tax rate than Canada, it actually raises less taxes from corporations than Canada. Only 2.3 percent of GDP in the United States and 3.1 percent in Canada. How is that possible?

The answer is because in spite of having a high statutory tax rate there are so many loopholes that de facto you end up raising much less taxes. That’s what I would like to change. What I was hoping this reform would change.

Kate: But, now I feel like you’re contradicting yourself. If companies aren’t actually paying the statutory tax rate of what used to be 35 percent, then we shouldn’t care as much. I mean, going back to your Canadian example, if Canadian legislatures are actually making their corporations pay 27 percent, whereas in the US it’s higher but our corporations have ways of dodging it, then it shouldn’t matter.

Luigi: Actually, it does matter a lot because there are two things. Number one, only the connected and the big companies with big lawyers can exploit the system. So, you’re making it difficult for a new guy who starts a company to actually start a company. But, if you’re an established company with all your connections, etc., you end up paying much less, number one.

Number two, this is a huge subsidy for lobbyists, lawyers, and last time I checked, these are not really productive activities. These are just sort of what we call in economics “rent-seeking activities.” You spend resources to increase your share of the pie, but you’re not increasing the size of the pie for everybody.

Kate: I agree with what you’re saying, but I think that this current tax reform act makes things even worse for small businesses relative to large businesses. So, here, I think it’s important that we get into the rules about pass-throughs. I think that this word has been thrown around a lot in the past couple weeks. But, I’d like to just try and explain this as simply as possible.

So, we’ve been talking about the corporate tax rate. This applies to corporations. Corporations are just one sort of company. There’s a lot of different companies out there. So, if you’re walking down the street wherever you live, chances are if you’re looking left and right and you’re seeing restaurants, if you’re seeing dentist’s offices, if you’re seeing law offices, none of those are corporations, they’re probably LLC’s, some of them are probably sole proprietorships. There’s various different types of businesses that you can form, and only corporations are subject to this corporate tax cut.

Everything else is called a pass-through. So, what a pass-through means is any profits that the business makes, those profits ... No matter how they’re distributed back to who owns the business. So, let’s say you both own and manage your business. So, you’re paying yourself a salary like the manager, or if you’re paying yourself dividends as the owner, it doesn’t matter. Any profits that go back to you, they’re taxed at your personal income tax rate. Not a corporate tax rate, even though they’re coming from a business. So, this income that you’re earning from your own smaller business is called pass-through income.

Now, note that pass-through businesses don’t have this double-taxation problem. Income from a pass-through business is only taxed once at the individual level. Even so, corporations would have been getting this big tax cut, while smaller businesses or smaller business forms would have gotten nothing. So, to help pass-throughs, the tax plan cuts the pass-through rate. But, it does this in a really convoluted way.

So, only 20 percent of your income is eligible for these lower rates, in the form of a deduction. And for businesses in the service sector, which by the way is most small businesses, you’re only eligible for the deduction if your income is on the pretty low end. And for non-service businesses, the deduction is tied to your payroll.

So, overall, I think that it favors some industries over others. And also, many small businesses won’t be eligible for this deduction at all.

Luigi: Kate, I completely agree with you that having these favored industries is terrible because the moment you start picking and choosing the winner, the favored one and the unfavored one, then you generate incentives for people to try to become the favored one. So, a lot of money, effort is spent in distorting the tax system, rather than fixing. I was hoping that this tax reform was a possibility and opportunity to actually make the tax code simpler. And more fair.

To lower the tax rate, but increase the tax base. It does go in part in that direction. For example, you cannot deduct all the interest expenses from your bill. Before you’re treating profits and interest payment as two different things. We know in finance that they shouldn’t be taxed in a different way. By eliminating this distortion, and increasing the base, the tax reform goes a bit in that direction.

Kate: Also, another way that people can exploit the system is that individuals who used to be compensated as employees can establish their own pass-through businesses now and call themselves consultants. And still do essentially the same job, but now, potentially, take advantage of this pass-through deduction. There are apparently some safeguards put in place to prevent this.

But, a bunch of tax professionals got together and published this report that was basically like, “No, there’s still loopholes.”

Luigi: I agree. I’m not trying to defend the Trump tax reform. What I’m trying to highlight is the motivations behind this reform were not as crazy as they appear. The idea of decreasing the corporate tax rate to make more attractive doing business in the United States I don’t think is a bad idea.

I think that decreasing the rates, and increasing the base, the taxable base, is actually an excellent idea. And making this more homogenous and less differentiated across sectors, I grant you that they didn’t, but I think that that is a great idea.

Unfortunately, the implementation was far away from the principle. I think that you’re living in a world in which companies have a choice on where to locate. If you don’t treat them nicely, they don’t locate here.

Kate: I just want to touch on one thing you said, that it’s increasing the taxable base. So, I want to clarify that. Do you mean that because they eliminated certain deductions like interest deductions, or state and local taxes, that there will be a larger subset of businesses that now have to pay taxes in the first place?

Luigi: It’s not a large set of businesses that pay taxes. But, every business will pay taxes on a larger base because they cannot exclude from the taxation this item or this other item. But, at the lower rate. As economists, we know that what matters is the marginal tax rate. What you pay on the last dollar, because if you make an investment decision, you don’t look at how much you pay on average, because you’re going to keep paying that whether you make that investment or not. You look at how much you pay on the last dollar that you invest, or the last dollar that you produce.

That’s the reason why, as economists, we tend to like reforms that lower the rates and increase the base because they have the potential to raise the same amount of money with lower tax rates, and by the way, lower expenses for lawyers.

Kate: I think this is going to create a lot more work for lawyers. I think we should talk a little bit about another element of this, something that seems particularly sneaky and potentially harmful for future accountability, which is that a large component of this tax cut has to do with repatriation of profits that have been sitting abroad for a long time.

That just seems to me like it’s inconsistent with the message of past and potentially future administrations that you need to respect what tax rates are. If you have earned profits abroad, and if you want those profits to be distributed back to the US owners of a corporation, then you need to repatriate it and pay a higher tax. In particular, you need to pay the difference between the US corporate tax rate and wherever those profits were made in a foreign country.

What companies have been doing is just holding that money offshore, waiting for tax rates to go down. Or waiting for some sort of tax holiday, and that’s exactly what they got. I mean, they were rewarded for their bad behavior.

Luigi: I agree with this, but part of the problem is not only that there was this differential taxation, but as sort of Kate said that in 2004 George W. Bush passed the American Jobs Creation Act. Basically, it was a tax holiday to bring that money back. Once you pass the tax holiday once, then corporations are rational. They expect another tax holiday.

Kate: What did he say about fool me once?

Luigi: Yes. So, they understood. And as a result, the accumulation of cash grew to $2.7 trillion. Unfortunately, the problem was already done by the Bush administration. I think that this reform is better than what Bush did because had they done another tax holiday, it would have been a disaster.

So, what they’re doing is they’re trying to homogenize the tax rates so that in the future the incentives to accumulate sort of cash abroad go down.

Kate: It seems to me like there’s a much simpler solution to this, which is that you have to pay your taxes when you make the money. In the US, if you are a regular person earning income you have to pay those taxes every year. It’s not like April comes around and you’re like, I’m just going to shift these taxes into the future just because I feel like it because the income tax rate may go down in the future.

Corporations abroad, when they earn money abroad there’s no limit on how long they can just park it abroad. To be fair, I mean, there’s a reason for that. That’s because they may use that cash abroad to reinvest in their foreign subsidiaries. But, there’s got to be a period of time in which they can’t just keep holding onto it in the hopes that it can be repatriated.

I think that, instead, an easy solution is just to put a two- or three-year clock on how long you can keep those profits abroad before it has to be repatriated or reinvested. You can’t just hold onto it for forever.

Luigi: Again, you don’t realize that corporations have a choice of where to locate. And most countries don’t use this worldwide definition of income. They use only the territorial definition of income.

So, in 2006 at some point Pfizer was considering transforming itself into an Irish company. Buying an Irish subsidiary. That’s called corporate inversion. And corporate inversions are going up precisely because corporations see the advantage of being located somewhere else.

So, if you want all the major multi-nationals to be located in Ireland rather than the United States go ahead. I think that introducing a rule like that is sort of the perfect rule to lose all the major corporations to Ireland.

Kate: Yeah, but we can also take separate measures to try and prevent corporate tax inversions, which is what we’ve been trying to do. I think that we could go even further and say, that if you start out as a US multi-national, and you invert to essentially become a foreign company, and pay lower tax rates abroad, that means you can no longer do business here in the United States.

Luigi: Great. You’re going to make Facebook and Pfizer, etc., not able to do business in the United States.

Kate: If those are the rules, and we enforce them, they’re not going to invert.

Luigi: Look, you can certainly use, if you want, the brute force of the government to keep people in.

Kate: Yes.

Luigi: I prefer to have people attracted here rather than constrained here. I think that having lower tax rates, but with a bigger base, is one way to do it. The second way to do it, which is relatively easy, is at the end of the day what matters is the overall tax burden that you pay. Or the overall tax that you raise. If you reduce the corporate tax rate, but you increase the tax at the personal level on dividend incomes and capital gains, you’re going to by and large recover many of the corporate taxes you lose at the corporate tax level.

I’m not trying to say we need to transfer money to the rich here. There are plenty of ways at which we can avoid that, but still make America a better place to do business in.

Kate: The problem is that everything is going down. It’s not just corporate tax rates and favored pass-through rates that are going down. It’s also estate taxes, and a number of other taxes that benefit the rich.

Luigi: I agree. I think that reducing estate taxes is a problem, especially these days. I think that the perception that this is a handout to the rich is not just a perception. I think that because it lacks the other components, it is a big handout to the rich. But, what I would like to ... our listeners to understand, is that we’re not here to throw away the baby with the bathwater. We want to separate.

And as economists, we just say, look there are some aspects that are reasonable. In fact, probably necessary. And other aspects that are not only not necessary, but I think going the opposite direction of what should take place.

Unfortunately, this tax reform is a combination of the two.

Kate: If it were up to me, I’m not entirely ruling out the idea that cutting corporate taxes by a little bit could be OK. I mean, I understand that we face stiff foreign competition. I understand that we want to keep jobs here in the US. But, I think that the right thing to do is to move it incrementally, not by like 15 percent all at once. Also, to try and use the stick a little bit more. I don’t see what’s wrong with being more punitive to companies that try and dodge taxes.

I think that should be the first step, combined with maybe a very small decrease in corporate tax rates. But, there’s plenty more that we can do in enforcing not necessarily fraud, but tax-avoidance strategies.

Luigi: The United States are a major player. So, they should not compete with Ireland. They should not try to reach the Irish tax rates. But, we are in a competitive world. And you might want to discuss whether you want to change this at the global level, but good luck, because before the United Nations will decide this will be before your grandchildren are dead. But, I think it is important for the United States to understand that as you said, they should go gradual. I think that maybe this tax reform has been too aggressive in cutting corporate tax rates.

Kate: I don’t know why you’re so pessimistic about the prospect of international coordination on tax reform. I mean, yes, there is a premium to locating in the United States. It’s not like the corporate tax rate in the US is ever going to go to zero. But, you could imagine a world in which there is all of a sudden this fierce race to the bottom. Where a bunch of countries are competing with each other, just to keep cutting their corporate tax rates to attract more investment, and more jobs. This seems to me like a really dangerous negative spiral. And we should be coordinating on this issue the same way that we should be coordinating on environmental issues.

Luigi: We should definitely consider that. But, we are in a world in which we are competing on taxes. And my lack of faith in coordination derives from the European experience. In the European Union, allegedly, they have a way to coordinate at the European level. In spite of that, Ireland is playing the deviant with just a 12.5 percent tax rate.

Even within a union, or an alleged union, you can’t get this done. Imagine across countries that have no institution in common except maybe the United Nations.

Kate: Actually, this raises a good point, this kind of reminds me of Switzerland back in the ’70s and ’80s, when the Swiss bank account was a way for rich people to essentially just hide their money. That eventually ticked off a lot of US authorities, so we started trying to ask them whether they would share information with the IRS about who had bank accounts in Switzerland.

Of course, they didn’t want to do that because they wanted to protect their precious secretive Swiss bank account status. So, the way that we eventually got Switzerland to change the rules and start reporting these accounts to the IRS was to be mean. Whatever banks were doing this, we stopped letting them operate here. We started imposing these harsh penalties to coming over to the US.

We could do the same thing with Irish companies that are operating in the US.

Luigi: First of all, much of that effort led to the movement of the money laundering industry from Switzerland to Singapore.

Kate: Then we should be doing it to Singapore too.

Luigi: What I’m saying is it’s not easy. I agree with you. Especially, I’m much more in favor of doing that against the money laundering industry than I am against the tax component. But, I think in a short period, we’re not going to change dramatically this. So, the right strategy for the United States, as you said, is two parts.

One is cut the rates, but not too much. And two, use a little bit more of the stick, rather than the carrot. But, from here to say that we should not do anything on the corporate tax rate front I think is too much.

Kate: Maybe a small decrease could be in order. I would have much preferred to have seen a decrease from like 35 percent to like 32 percent. Not much below that.

Luigi: I think a reduction from 35 percent to 32.5 is not going to accomplish anything. It’s going to reduce some revenues without really making doing business in America more attractive. I think that if you do, you have to do it in a significant way. By the way, this was also what Obama said. He said, “I know I’m not going to stop corporate tax inversions with a small reduction. I need to have a big reduction, where do I get the money for the big reduction?” I think that’s still a problem. One other thing I don’t like of this particular tax reform is that it creates a big hole in the budget. It will add to the debt. At a time when this is not necessary, and not desirable.

Kate: So, Luigi, when are you going to lunch with Trump next?

Luigi: He did not invite me. I’m not sure he ever will.

Not long ago Facebook CEO Mark Zuckerberg hinted at a run for political office. Luigi and Kate debate whether a President Zuckerberg would give the social media giant a dangerous monopoly. Should government regulators do something to limit its power?

On the role of Facebook in the distribution of news:

– http://www.journalism.org/2016/05/26/news-use-across-social-media-platforms-2016/

 

Market Power in Data:

– Graef, Inge, Market Definition and Market Power in Data: The Case of Online Platforms (September 8, 2015). World Competition: Law and Economics Review, Vol. 38, No. 4 (2015), p. 473-506. https://ssrn.com/abstract=2657732

 

Possible solutions:

– Sokol, D. Daniel and Comerford, Roisin E., Does Antitrust Have a Role to Play in Regulating Big Data? (January 27, 2016). Cambridge Handbook of Antitrust, Intellectual Property and High Tech, Roger D. Blair & D. Daniel Sokol editors, Cambridge University Press, Forthcoming. – https://ssrn.com/abstract=2723693https://www.nytimes.com/2017/06/30/opinion/social-data-google-facebook-europe.html?_r=0

– This idea is discussed in this online symposium

http://www.aei.org/publication/washington-vs-big-tech-should-you-own-all-your-social-network-data-an-aeideas-online-symposium/

 

Other relevant news on the topic:

https://www.nytimes.com/2015/12/02/technology/mark-zuckerberg-facebook-charity.html

– https://www.wsj.com/articles/the-new-copycats-how-facebook-squashes-competition-from-startups-1502293444?mg=prod/accounts-wsj

– https://www.wsj.com/articles/facebooks-onavo-gives-social-media-firm-inside-peek-at-rivals-users-1502622003

Kate: Hello, I’m Kate Waldock of Georgetown University.

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

Kate: This is the pilot episode of Capitalisn’t.

Luigi: You mean capitalism?

Kate: No, Capitalisn’t, as in what capitalism is and capitalism isn’t.

Luigi: Basically what works in the current market system and what doesn’t.

Kate: We are two academic economists. I know just one of those would be boring enough, together they sound unbearable, but we’re here to prove you wrong.

Luigi: Because we’re very passionate about public policy, and we do believe that economics can be really useful in coming up with new proposals and new perspectives.

Kate: On this podcast we’re going to explore the problems of capitalism, but we’re here to fix it, not destroy it. We’re more critical of capitalism than the Left and more supportive of true capitalism than the Right.

Luigi: And what is better to begin with than talking about the potential presidential run of Mark Zuckerberg, the CEO of everyone’s favorite social media platform, Facebook?

Kate: Actually my favorite social media platform is Instagram.

Luigi: Actually my favorite is WhatsApp. Doesn’t matter. Facebook owns them all.

Kate: Yeah, Facebook owns all of them.

Speaker 3: New clues that Facebook’s chief, Mark Zuckerberg, could be eyeing another office, maybe the presidency.

Speaker 4: It was just dinner, but it could be Mark Zuckerberg’s first course in politics.

Speaker 5: If he left the company he would lose his majority control, except if he was leaving to serve in government.

Speaker 6: I doubt if he would run, but if he did I would vote for him because I trust him.

Kate: All right, so let’s say that Mark Zuckerberg does decide to run for president in 2020. What’s the big deal? I mean, after all, Mark Zuckerberg seems like a nice guy. He’s giving away all his money, or so he says, to charity over the course of his lifetime, and also this isn’t an economic issue. It’s a political issue.

Luigi: You mean you’re not worried? This is like super important because this guy has an enormous amount of economic power thanks to the control of Facebook, all the social media, all the data, and now he might become the President of the United States with all the power that presidency gives to you. You put them together, this guy becomes too powerful.

Kate: Yeah, but he’s powerful because he was a good businessman. I mean, some people think that he just got lucky, but based on his net worth, why is that such a big deal?

Luigi: I don’t think it’s a problem necessarily that the businessman becomes president, even if the last record was not great, but I grew up in Italy and Berlusconi was a media, and still is, a media mogul, and all of the sudden decided to run for office. Of course, his TVs were broadcasting how great he was, and he controlled at the time half of the markets of TV in Italy and became Prime Minister. Becoming Prime Minister, he got control over the other half of the TV that was state owned, so at some point he controlled the entire TV market in Italy. This is the problem of putting together sort of the power that comes from business, the power that comes from government, and becomes absolute power. As you know, absolute power corrupts absolutely.

Kate: All right, so as a disclaimer I have a connection to Facebook. Back in the day I was friends with Eduardo, who was one of the original Facebook founders, Eduardo Saverin that is. He has since exiled himself to Singapore, and I haven’t seen him since, but we were friends.

Luigi: And as a disclaimer, I don’t like Facebook because my children did not befriend me in Facebook and I cannot see what they’re doing.

Kate: Yeah, it’s because it’s weird to be friends with your dad. I’m not friends with my dad.

Luigi: But I’m a nice dad.

Kate: All right, one of the reasons that it’s hard to pinpoint the role of Facebook as a monopolist or a duopolist is that traditionally for monopoly it produces some sort of good, and consumers purchase that good, and there’s a price. For Facebook it’s less clear what’s going on there. First of all, it collects information from people, and using all that aggregated information it sells advertisements to anybody, to anyone who wants to advertise online as long as they pay a price. There’s two different ways that the monopoly is being obfuscated here, being covered up here. First of all, as a consumer of Facebook—right—if you have a Facebook page, it feels like you’re not paying anything. It feels like you get to post pictures for free, and you get to have friends for free, but you are paying something. I mean the value of your private information is, in itself, a currency. You’re not paying for Facebook with dollars, but you are paying with information about yourself, which a lot of people would want by the way.

On the other end of the spectrum, Facebook is charging digital advertisers to be able to reach an audience on Facebook, and they may be charging monopoly prices on that side, but because it’s not obvious as a consumer, because we like having access to Facebook for free, I don’t think that it gets as much attention, particularly, from antitrust regulators.

Luigi: You’re absolutely right. In fact, I had the fortune to interview Judge Richard Posner, who was one of the luminaries of US antitrust, at a conference that the Stigler Center organized, and he was talking about Google, not about Facebook, but he was saying that he loves Google, that Google offers its service for free, at least as a consumer, that’s exactly the point you are making, and he doesn’t see any problem of antitrust with Google.

Richard Posner: I spend a lot of time Googling, so I don’t want to hear criticisms of Google, my principal source of knowledge. That’s why I say I’m, I might just be out of it, but I’m very comfortable with the modern American giant companies. I mean, maybe there are lurking serious antitrust problems, but they don’t come to my court.

Luigi: But there is a reason why they don’t come to your court, you know.

Richard Posner: Well, Google gives access to two billion websites, and that seems to me to swamp the concern about that they’re, you know, a serious problem.

Kate: I think it’s important that we talk about the word monopoly. I’m going to try and define it here. A monopoly is a producer of a good. In fact, it’s the major producer of that good, and for whatever reason, it’s difficult for other firms to come in and start producing that same good. That’s what we call barriers to entry. Therefore, competition against that main producer is limited, and that’s what we call market power.

Imagine a world in which there’s no Android, and there’s no Samsung Galaxy, and there’s no LG, and in this world if you want to buy an ... sorry, if you want to buy a smart phone, you basically have to buy an iPhone. There aren’t that many other options. In that case, Apple would be a monopoly in the market for smartphones.

Luigi: So that would be like Microsoft was in the mid-’90s with operating systems for computers. They were, by and large, the only operating system people had on PCs.

Kate: Yeah. I’m sorry, I don’t remember the mid-’90s.

Luigi: I know, that’s the reason why I mentioned, but what’s interesting is what happened to Microsoft when they had this dominant market share? They actually got indicted for violation of the antitrust laws in the United States, and they had to fight these allegations for a long time, and eventually they were convicted for abusing their position. Most people don’t know, but today we have Google and Facebook as different from Microsoft because of that antitrust suit. Because what Microsoft was doing at the time was using its monopolist position on operating systems to expand in more and more markets. So you probably don’t even know that before Excel there was a thing called Lotus 1-2-3, and you don’t know that before-

Kate: What?

Luigi: Yeah. The first spreadsheet was called Lotus 1-2-3, and it was an independent company, and it was completely wiped out by the fact that Microsoft incorporated a copycat of Lotus 1-2-3 into its Office suite, and as a result, Lotus was gone. Before Word existed a company called WordPerfect. We’ve seen this before. What Facebook is doing by buying Instagram, by sort of copying other products that come into market is exactly what Microsoft was doing 20 years ago.

Kate: OK, I just want to outline all the potential reasons that a monopoly might be bad. OK?

Luigi: OK.

Kate: So first of all, pricing. Monopoly pricing. I’m going to go back to my iPhone example. If you’re the only company selling phones in a market ... I don’t know how much you would be willing to pay for a phone, but let’s say the average person is willing to pay $800 for a phone, which is, I think, pretty fair, given how much iPhones cost. Let’s say it costs this producer, Apple, $200 to make a phone. So if Apple has a monopoly in a market, it can decide to price its iPhones at $800, even though it only costs it really $200 to make. Whereas if there were a ton of phone producers in a market, competition, or at least the way economic theory goes, is that competition amongst those producers would lower the price of the phone until it was basically the bare minimum that it cost to make.

Luigi: You don’t need to go to phones. Think about drugs. In the United States, many drugs are monopolies because of the patent, and they sell at an outrageous price. Many, many times the production cost, and that is the rent that the monopolies extract.

Kate: And-

Luigi: But to be fair, economists, I don’t necessarily agree with this, but economists say that this rent is just a transfer. It is a transfer between consumers, from consumers to producers, and if you don’t see any problem with that ... There is no inefficiency involved in that transfer. Now, you might think this is bad for income inequality, but not necessarily for economic efficiency.

Kate: Yeah, so this is actually something that confuses me a bit about ... I don’t want to put a name on this school of thought, but the school of thought that thinks that the monopolies aren’t actually that bad. Right? They recognize that high prices, monopoly prices are not in and of themselves a problem, and that’s something that Scalia said in a Supreme Court ruling where he was talking about why monopolies are not problematic. But if you’re acknowledging that a company is charging monopoly prices, doesn’t it also follow that there is under-consumption? Those two things go hand-in-hand, and so-

Luigi: Yes, it does, but it is case by case. You can argue that in some sort of markets that loss is small, and there are some benefits of monopoly. The way people sell the monopoly is that because you have some extra profits you’re going to do more investment, and so long-term the efficiency’s going to be higher. John Hicks, a British economist who won the Nobel Prize many, many years ago, said that the biggest privilege of a monopoly is a quiet life. So it’s a quiet life for the producers. It’s a quiet life for the workers. There’s not the pressure to innovate and improve. That’s the reason why I said that the antitrust suit against Microsoft was really instrumental for Google and Facebook to arise, because otherwise we’d be in the hands of Bing and not of Google search.

Kate: I think if you’re a true monopoly and you have a lot of power in a market, then you can shirk your social responsibilities. So if you’re a monopolist, and everyone wants that one good that you’re producing, you can kind of treat your workers very poorly. You can pollute. And it’s hard for people to really criticize you in any way. It’s hard for people to have any say because they need your product.

Luigi: But Facebook is not just a monopoly. It is a particular monopoly in what is now called the digital platform business. The digital platform is a different concept because it naturally leads to a concentration of the business in one or a few sources. This is not unique to Facebook. We see that Google is very similar. We see all the digital platforms with that characteristic. It is what we economists call natural externalities.

Kate: So you’re saying that these naturally arise because if you use a particular sort of email client, then you want your friends and everyone else in your network to be using the same email client, and so this builds, and it builds, and all of the sudden everyone is using Gmail.

Luigi: Absolutely, and very often it’s not even guaranteed that the platform that comes out as the winner is the best. It simply is what everybody else is using.

Kate: Yeah, and so I think in some respect, this is particularly relevant for a social network. Right? It’s a social network. You want your friends to be on it. There’s no point in sharing your photographs and in posting what you’re saying if none of your friends are on it, and so a social network will naturally kind of snowball into something that has everybody on it. But at the same time, social networks are trendy. It used to be the case that Myspace was really popular, and there were social networks before that.

Luigi: I think that you are right that there is the possibility of switches, but this possibility is much easier in early phases. That’s the Myspace versus Facebook analysis, but also it is easier if there are the conditions that make it possible, and here there are two things that make it difficult. Number one, there is not the data portability, or the portability of the social graph, from one network to the other. Suppose that you come up with a better social network, and I want to join it. I would like to carry with me the social graph of my friends. If I were able to do it, I’m more likely to join because, as you said, all my friends would be notified that I moved to your social network and will receive a reminder that I am in the new social network. But if I cannot do that, then I’m stuck with Facebook, and today the ownership of the data of the social graph belongs to Facebook, and they are fighting very aggressively to keep it, and one of my ideas is we should actually give data to the people, ownership of the social graph to the people.

Kate: Yeah, so this is related to that, but not necessarily about the social graph, is this question of how important is information to Facebook and to other potential competitors? I think it’s worth mentioning something that happened, or has come out in the news relatively recently, which is that there was this company called Houseparty. It was sort of a video chat group app, and it was starting to gain some traction, but Facebook had acquired a company called Onavo, which was an Israeli company. They acquired it a few years ago. And Onavo, because of the way that it provided network services, can essentially spy on everything that you are doing on your phone.

If you have Onavo installed for some purpose, that company can see how much time you’re spending on Snapchat, how much time you’re spending on Facebook, exactly what you’re viewing. Prior to that, only the actual phone providers could have this information. Facebook purchased Onavo, and they’ve been using the data that they’ve gotten from Onavo to essentially crush their competition before the competition even becomes big. They have these special, built-in, proprietary metrics using Onavo data so that they can identity potential competitors or just purchase them outright.

Luigi: You see, that’s exactly Microsoft 1998 all over again. The incumbent with a huge market share abuses the power they have from the market share to crush the competition, and that is what is the biggest problem.

Kate: I would push back on that a little bit because the issue with Microsoft was that they were bundling products together, which is explicitly outlawed according to the Clayton Act. Microsoft had all of these computers, and the computer would come with Microsoft software on it. So it was the fact that when you purchased a Microsoft computer that you already got the Microsoft software, which if you didn’t want that, you’d have to actually go out to a computer store and purchase that other software. It was that tying together of products that made it problematic. Here it’s less clear. I mean, Facebook certainly isn’t bundling. Right? That’s not the crime that it’s committing. In some sense you could say that it’s like corporate espionage because they’re stealing Houseparty’s data-

Luigi: But forget the way they obtained this stuff. That is for the police to investigate, but let’s look from an economic point of view. From an economic point of view what they are doing is they are sort of smashing the competition by basically using their unique market power to leverage their network and trying to prevent new entry. That’s exactly what a monopoly does in a way that is very negative, and they give-

Kate: I don’t think Facebook used their unique market power, though. Let’s say Facebook were like a $2 billion company. Let’s say they only had 20 percent of the market share in social networks. They could’ve still bought Onavo. They still could’ve used their data. It was nothing about Facebook being a monopoly that made this problematic.

Luigi: No, but the way in which they are able to crush, what’s the name, Officeparty-

Kate: Houseparty.

Luigi: Houseparty, sorry. The way they are able to crush Houseparty is because all of the sudden they’re going to start to offer, within their Facebook suite or whatever, Houseparty as a feature for free. Exactly like Microsoft did. And how do they make money? They make money with the data and with the advertising. If you are an advertiser, do you want to give advertising to the Houseparty that has very few customers, or you want to give it to somebody that has a lot of customers? That’s exactly why they leverage their existing market share to conquer markets that are contiguous, and the market for Houseparty is slightly different than the market for Facebook, but they’re gaining that, and in the same way in which they got Instagram. Part of it is Instagram could have become a competitor to Facebook and-

Kate: Oh, they were definitely competitors. That’s why they purchased it for what, a billion dollars?

Luigi: Yeah, and so they bought it out. And where was the antitrust when they bought it out? This could have been stopped by the antitrust, but the antitrust was asleep.

Kate: OK, but if you were a federal regulator, what would have been your argument for preventing that acquisition to take place? What, that Facebook is really popular, all of my friends are on it, so therefore it shouldn’t be fair, I mean you need-

Luigi: Wait a second, the antitrust is not a popularity game. The antitrust is say-

Kate: No, I’m saying like a social network is a popularity game, and a social network’s value is all in it’s popularity.

Luigi: I understand, but if I say that Facebook has 90 percent market share in-

Kate: of what?

Luigi: Of the social network, and then they are going to-

Kate: But that’s meaningless. I mean, how can you define a market if it’s not charging any money for its social network?

Luigi: They are charging money. It’s called your data. You pay in giving away your data for free, and that’s a pretty important thing because that data, number one is worth a fortune, number two is worth more the more you have it because you can use it in a more strategic way, and that is what gives this sort of self-enforcing power of Facebook that becomes more and more powerful.

Kate: OK, but I think that this is an important distinction to make. Up until now, I mean not even now, but traditionally antitrust law has had to do with the fraction of the market, the existing market where transactions are taking place that a company has. You’re talking about the assets that a company has. You’re saying that in terms of the data assets that exist in the world, Facebook owns let’s say like 90 percent of those assets, and that’s not traditionally the way that antitrust is defined.

Luigi: Actually-

Kate: Are you saying that we should rewrite antitrust rules?

Luigi: No. We should just reinterpret the antitrust rules. The antitrust rules were created in 1890, the first one, when politicians and even economists did not understand very well the difference between what is a monopoly and distortion of monopoly. They were created because they thought that excessive market power was bad. Excessive concentration of power was bad. Excessive dimension, bigness, was bad, and they created the law for this. Then over the years, we reinterpreted those laws as saying that you should care about consumer welfare, but that’s a reinterpretation. The law, the 1890 Sherman Act, does not speak the language of economics because it’d not been developed at the time yet.

Kate: OK-

Luigi: ... and actually, to be honest, it was the Chicago School, so-

Kate: Yeah, I haven’t wanted to say that.

Luigi: The Chicago School, in the ’70s, we interpret this by saying we should interpret not in terms of market share. We should interpret of consumer surplus, which I think was, to be honest, reasonable at the time because at the time people had become obsessed with market share to the point that you couldn’t even gain 20 percent of market share. That was considered excessive monopoly. I think that the application of the original stuff in the 1960s went too far. The reaction was reasonable. The reaction has gone too far, especially in light of new phenomena like digital platforms like Facebook.

Kate: I think that you’re being too generous to the original drafters of the Sherman Act. The actual text says, basically, every contract in restraint of trade or commerce among the states is illegal. I mean that’s just too vague. We need better antitrust law that explicitly defines what a market is, and whether information, as an asset, counts as having a dominant market share.

Luigi: I think that buying Instagram by Facebook is a form of restraint of competition. I think you should read ... What you just read is so clear, you don’t need any new law. You just need somebody who’s willing to apply it.

Kate: Right, but the problem with that argument is that then you’re going to get people on the other side saying, “Oh, well if you construe the law this way, then anything can be considered a restraint of trade or competition, and therefore we need to interpret the law as conservatively as possible.” I think that we should rewrite our antitrust laws to make them more specific so that there’s no question.

Luigi: I’m not against rewriting the law, but it’s not going to happen anytime soon. Let me break it to you. And what I think is we need something fast. In particular, God forbid, Zuckerberg becomes president. Can you imagine? Now he’s going to rewrite the law, and you know what that will look like.

Kate: Look, I agree with you that Facebook owns too much information, and I agree with you that it can leverage that information in a way that squelches pretty much any potential competitor no matter how small, and I agree with you that data privacy is an important topic, but it’s not clear to me that the way that the law is written means that Facebook is a monopoly that’s abusing its market power, and that’s what I have a problem with. It’s the fact that the text of the statutes is too vague, and it allows people to get away with these things.

Luigi: I’m not a lawyer and I’m willing to concede that you might be right here. I think that it is so clear cut from an economic point of view that the law should understand that, and if it doesn’t, I’m happy to change the law, but I think that what is important is actually to go after Facebook not only because it controls a lot of data ... Google does too, and by the way Google is another problem that we’re going to talk-

Kate: Yeah, we’re not talking about that.

Luigi: ... maybe a different podcast-

Kate: Yeah.

Luigi: ... but in addition-

Kate: Google, we’re coming after you. Don’t worry.

Luigi: In addition to that, they are also the channel of transmission of a large set of the news that people read. I think that, to me, is even more scary than the monopoly itself, because you can argue that Amazon has a huge monopoly on online blah-blah, but at least so far they don’t control news. It might control books, but they don’t control news. So I think that Facebook does represent a problem, and it represents even a bigger problem if Mark Zuckerberg runs for office.

Kate: Yeah, you touched on a point that actually makes me sort of sad, which is that if we had impending regulation that was about to revise the antitrust, that was about to make antitrusts tougher on media companies, or was about to make it so that people actually owned their own data, or made it so that people could import their data over, if those types of regulation were on the horizon and Mark Zuckerberg announced his presidency, then I would be like, “Oh, well he’s obviously going to veto them as president.” But the sad thing is that they’re not even on the horizon. In some sense it doesn’t feel like Mark Zuckerberg running for president would even change much, and I think that that’s the biggest problem.

Luigi: OK, so maybe you should start a petition and say sort of-

Kate: Great, we’re starting a petition.

Luigi: And the petition should be [explicit]?

Kate: That’s your title, not mine. This podcast may contain explicit content.

Luigi: You cut that out.

Kate: He’s not cutting it out.

Luigi and Kate deliberate over the topics that will be discussed on Capitalisn’t — they range from market power to Italian history.