In order to combat the coronavirus, Congress has passed a $2 trillion-dollar stimulus bill. It targets individuals, small business and large corporations. But, from an economic point of view, who are the real winners and losers in this bill. On this episode, Kate and Luigi analyze the CARES Act. Is it enough money to stabilize our tanking economy, does it target the right people, and does it accomplish the right objectives?

One of the prominent economic debates to emerge during the coronavirus outbreak has been whether to continue with shelter in place measures that are hurting the economy but, hopefully, slowing the virus' spread. On this episode, Luigi does a cost-benefit analysis that shows why it could be better to keep the economy closed, and debates his proposal with Russ Roberts, host of the popular EconTalk podcast.

If you had to name the most famous living economist, it would be hard to come up with anyone other than Paul Krugman. On this episode, Kate and Luigi talk with Krugman about his new book "Arguing with Zombies: Economics, Politics, and the Fight for a Better Future", why he thinks America's economy has failed the middle class, and how we can create a better economic future for our children.

On this episode, Kate and Luigi give an economist view of the coronavirus outbreak. How should we think about the economic trade-offs of interventionist quarantine measures, could this virus change the way we work, should you or should you not be buying up stocks? They tackle these questions and more.

Companies like Uber, Lyft, and Doordash have brought the term "gig economy" into our lexicon. But what is the gig economy really? When you start digging into the data, you find it's a lot harder to define than you think. On this episode, Kate and Luigi investigate the pros, cons and myths of the gig economy.

Are the economists of the 60s and 70s to blame for our current state of affairs? That's the argument Binyamin Appelbaum makes in his book "The Economists' Hour". On this episode, Kate and Luigi debate the history of economists, the problems with economics today, and what changes could lead to a better economic future.

Emmanuel Saez is probably one of the most controversial economists around these days. Recently, he's garnered significant attention for being one of the architects of Elizabeth Warren's wealth tax proposal. On this episode, Luigi and Kate dig into tax policy, the wealth tax and why Saez's work is so controversial.

As the Democratic primary is ramping up for the Iowa caucuses, everyone is talking about how much money the candidates have spent. And they're asking whether billionaires like Tom Steyer and Mike Bloomberg should be able to use their wealth to buy their way into the race or, even buy the presidency? On this episode, Kate and Luigi breakdown the economics of money in politics.

Kate: We’re in the throes of the Democratic primary, and everyone’s talking about how much money is in politics.

Speaker 2: 2019 was a year of dramatic changes and new trends in campaign finance.

Kate: What’s interesting is that I don’t actually see that many political ads. Or, at least I used to not see that many political ads. And so, this idea that there’s all this money in politics didn’t really resonate with me until around November, when Bloomberg jumped into the race, and all of a sudden, the ads for shoes and hair stuff and makeup that I used to see all got replaced by ads for Mike Bloomberg. And I was like, “Oh, OK, now I understand what a billionaire can really do if he wants to make a dent.”

Speaker 3: In the race for the White House, it’s the billionaire candidates who are overwhelmingly spending the most on political ads. Tom Steyer and Michael Bloomberg are leading the way—

Luigi: Generally, I don’t watch ads for shoes. And, as I said, I don’t get even the ones for Bloomberg. I feel I may live in a bubble, because I don’t watch TV. I only use Twitter. And Twitter has banned political ads. In fact, you know that when we were trying to promote our podcast on Twitter, it was blocked for a day or two because it was considered a political ad. So, they’re very strict.

Kate: Yeah. We explicitly try not to be overly political. Which is a little bit ironic.

Luigi: Yeah. But that suggests that Twitter has a very, very tight system, and it seems to be screening out every political ad. And, as a result, I’m isolated from the Bloomberg campaign.

Kate: That’s actually sort of a nice existence. I’m kind of jealous.

Luigi: But you don’t know what the latest kinds of shoes are. So, you’re missing out, I would imagine.

Kate: Yeah. That’s true.

Luigi: The entry of Bloomberg in the political campaign is really changing the game, at least from a financial point of view. It’s putting so much money into the game, we’re starting to wonder, can you buy your way into the presidency?

Kate: From Georgetown University, this is Kate Waldock.

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

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

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

Actually, we’re talking about politics today, we’re talking about how capitalism can impact politics. And we’re talking about the big, big question of money in politics. So, the cost of a presidential race is overall north of $2 billion. If you add the cost of all the congressional and Senate races, they are another $4 billion. So, the total cost of an election in a year like 2016 is north of $6 billion. That seems like an enormous amount of money, doesn’t it?

Kate: Yeah, that’s a lot of billions.

Luigi: However, I think it’s useful to put it in context, because it’s true that this is a lot of money. But last year, AT&T spent $5.4 billion on ads.

Kate: Wow.

Luigi: So, do you think it is more important what cell phone you use or what president you’re going to elect?

Kate: Probably both. But maybe the president.

Luigi: I like your preferences. They’re really well aligned.

Kate: As a relatively young person, when I think about money in politics, the first thing that comes to mind is Citizens United. Citizens United, as you’ve probably heard, was a Supreme Court case that came down in 2010. And it extended the right of free speech under the First Amendment to corporations.

Now, I just assumed that the problem with Citizens United is that it made corporations people under the law. That’s not exactly what happened. Before Citizens, there was the McCain-Feingold Act, which made it illegal for corporations to make independent expenditures for electioneering communications.

And that’s basically spending money on ads on TV or on the radio. What Citizens United did was that it struck down this limitation on corporate spending on electioneering communications. Now, is that really the same thing as making corporations people? I argue that this idea is not really consistent with a real problem of citizens. So, imagine two scenarios, one in which Johnson & Johnson wants to donate a million dollars to, I don’t know, some political candidate. Luigi, give me a candidate.

Luigi: Donald Trump.

Kate: OK. So, let’s say Johnson & Johnson wants to donate a million dollars to Trump. And let’s say, alternatively, that Johnson & Johnson wants to directly pay for ads that tell people to vote for Trump. In the first case, there are other laws from the Federal Election Commission that say that corporations can’t contribute directly to candidates. And Citizens didn’t change that.

And, in the second case, Johnson & Johnson airing ads directly for Trump, corporations are extremely wary about attaching their names to specific candidates or specific political ideologies, because there are always consumers that have differing views on the political spectrum. And so, they don’t necessarily want to alienate those consumers. And so, when it comes to directly airing ads, I don’t think that Citizens had a huge impact on the way that corporations spend money.

Luigi: Yes, you’re right. In fact, Walt Disney always said Mickey Mouse is not a Democrat, he is not a Republican, Mickey Mouse is just American. And so, they don’t want to be identified with one side or the other. They certainly want to be identified with, “We want to extend the trademark of Mickey Mouse as long as possible. And we’ll give money to any candidate who support this position.” But they don’t want to distinguish between Republican and Democrat.

Kate: So, the impact of Citizens United was not necessarily to suddenly flip the switch and allow corporations to be people. But it did have a profound effect on super PACs, not only super PACs, but these other groups that are maybe even more concerning, dark money groups. The reason that it made it harder for them to regulate is because Citizens fundamentally changed the definition of corruption.

So, this is an idea that’s been championed by the dean of Yale Law School, Heather Gerken. And she argues that the most important line of Citizens is actually that ingratiation and access are not corruption. Before Citizens, the Supreme Court, as well as other lower courts, had slowly been expanding the definition of corruption. And that came to an abrupt end with Citizens.

Luigi: And they can raise as much money as they want to put out as many ads as they want in favor of their candidates, as long as they don’t coordinate explicitly with a candidate. Now, many super PACs tend to be located on the floors above and below the headquarters of the very campaign they support. So, the idea that there is no coordination is really a figment of the imagination. And here the Federal Election Commission that is supposed to actually regulate and enforce these rules is completely asleep. I think that, if I may summarize a bit brutally what you’re saying, the bottom line is we’re still screwed, in a sense that anything is possible in fundraising—

Kate: No, we’re more screwed.

Luigi: —And the money’s flowing in large quantities. But I want to start with a provocative statement: I don’t think that there is necessarily too much money into politics. Democracy is expensive. Companies spend $5 billion to try to make you decide whether to use one cell phone versus the other. I’m not so sure whether spending $6 billion to choose who runs you is such a terrible way to spend money. Imagine the kind of mistakes you can make, and no reference to any all the current elected people, but imagine the kind of mistakes that people can make as a president, as a head of the House, as Speaker of the House, you can have a dramatic impact on the performance of the US economy.

Saying that we spend $6 billion every four years to make sure that things are run properly, it doesn’t strike me as a terrible number. What I’m more concerned about is that this doesn’t seem to be well spent, at least if you look a bit at the outcome. And, second, it seems also that it produces a lot of distortions in who runs for office and so on and so forth.

Kate: I think that that’s true. But there should also be a level playing field in terms of which side is spending more or less money than the other influencing elections. And also, which side is subject to more or less disclosure. If we made a law that said, “Democrats don’t have to disclose any of their political contributions, but Republicans do,” I think everyone would agree that that would be unfair and absurd. And yet we have loopholes in our political disclosure law that effectively allow that to be true. In our current environment, the biggest loophole has to do with these dark money pools.

If you register as a certain type of nonprofit, what’s called a social welfare organization or a trade association, and as long as you claim that your primary purpose isn’t solely electioneering communication, then you can essentially spend as much as you want. And they also don’t need to disclose who they’re raising money from or what exactly they’re spending it on. There are now these huge dark money pools. They are spending many, many millions, if not billions, on our elections, and they’re unduly influenced by conservatives. So, in effect, it is one party that’s exploiting rules more than another. And I think that that’s unfair.

Luigi: So, on disclosure, you cannot find somebody who agrees with you more than me. I’m always in favor of disclosure, that sunlight is the best disinfectant, as Louis Brandeis used to say. So, I am 100 percent with you on that.

Now, you seem to be a bit biased in this description, because recently we learned that, you know who uses a nonprofit institution to fund his campaign, nothing short of Bernie Sanders with Our Revolution—

Kate: Hold on.

Luigi: —a non-for-profit political organization that funds—

Kate: I don’t think that he . . . He does not support those contributions. I think that they exist outside of his control. And there’s nothing he can legally do to shut them down. But I don’t think that he has endorsed them.

Luigi: I’m sure that Hillary Clinton said the same about the PAC that she was not controlling, and I think that that’s part of the problem.

But let’s look a bit at the economic literature, because many years ago, a very eccentric economist called Gordon Tullock had this idea that actually there is too little money in politics. So, the idea is, consider a lottery, it must be that the prize of the lottery must be no bigger than the price of buying all the tickets. Why? Because if you buy all the tickets, you’re sure to win the lottery, right?

So, think about an election as a lottery, and think about the money as lottery tickets. The total price of all the lottery tickets is the cost of an election cycle. So, we just said that this is roughly on the order of $6 billion. Now, what is the prize? Imagine that you are Bloomberg, you spend $6 billion dollars, and not only do you get elected president, but you elect all your buddies in Congress and all your buddies in the Senate.

Luigi: So, you do, like, an enchilada, you control the entire federal government, let’s say for two years, because after two years you have to run a new congressional election. We know that the federal budget is roughly $4.4 trillion a year. But a lot of it is nondiscretionary. So, let’s say that you play around just with discretionary stuff, it’s still $1.3 trillion. Over two years, there is $2.6 trillion you can play around with, completely at your own discretion, because remember, you own the government. OK?

Kate: OK.

Luigi: So, you’re paying $6 billion to get ahold of $2.6 trillion. That’s a phenomenal investment. Now, you might say, “Oh, wait a minute. Even if you are a very kleptocratic precedent, you cannot steal $2.6 trillion.” But let’s say that you get 20 percent. You still get $520 billion over two years for an investment of $6 billion. This seems like a phenomenal investment. And the question is, why don’t more people invest in this activity?

Kate: I don’t think people have been able to see my eyes rolling throughout that little empirical, or I guess theoretical, exercise. But you can’t assume that the election cycle is a lottery, right? The election cycle might be random in the sense that we don’t really know who’s going to win, but it’s not a lottery in the sense that you can’t just, as a billionaire, spend the total amount of money that’s in the system and then be guaranteed to win. I think Bloomberg is a good example of that. He’s already spent how much?

Luigi: I think we’re going to test this, this particular election, to see whether that’s the case. But I agree with you. But let’s assume for a second that if you outspend everybody else by some margin, you win. OK? I think that that’s—

Kate: I just don’t think that’s an assumption that you can make. And, if anything, Donald Trump eventually did start spending money. But his meteoric rise within the Republican Party was not a result of him spending much money at all initially.

Luigi: That’s absolutely true. So, people don’t vote because they’ve been advertised to, they vote for him because they love him.

Kate: I hate to admit it, but yeah. I think that initially there was an element of truth to that. I think that the issue is that you can’t ever distill an election down to something like a simple lottery. The way that money is spent and the way that people are influenced by money is very complex. And you can easily overspend and turn people off.

Luigi: So, two things. Number one, I think that the power of the argument of Gordon Tullock is shown in the fact you are here now defending that actually money does not matter so much for politics. I thought that was your whole concern at the beginning of the podcast, and now you already turned around and said, “Actually, ideology matters. People are much more deep than that.” So, I think that Gordon Tullock has already won once. OK? Then the second—

Kate: No, no, no, no. Hold on. I think that you’re putting words in my mouth, because saying that whether you can reduce an election down to a simple lottery and arguing against that is not the same as saying that money doesn’t influence politics. I’m just saying that money influences politics in a complicated way. And so, therefore, it’s never going to be a straight arbitrage opportunity.

Luigi: That’s absolutely true. But in a sense, you are saying, and I agree with you, and I think it is actually good, that money’s not everything. We’re going to put this to a test with Bloomberg’s candidacy. But I think that we saw last electoral cycle, as you said, Jeb Bush started with much more money than Donald Trump, and he ended up nowhere. So, the great thing about elections is that money cannot buy them all. However, the point that Gordon Tullock was making, and which is still valid to some extent, is that we understand why there is so much pressure to escalate the stakes, because the stakes are so high.

If you can control—and here I talk only about money, I’ve not talked about things that are much more important than money, like your freedom, the right to abortion, the right to gay marriage, all this stuff has not even factored into the calculation. The stakes are incredibly high. And the incentives to put more money into this game are very large. And I think, actually, that’s the reason why I’m in favor of some form of limitation in campaign financing, because that can escalate to an arms race to no benefit.

Gordon Tullock himself showed that, while in principle, there should be no possibility that the cost of the lottery is less than the prize that you seek, it’s very possibly the other way around. These people outspend each other in order to win for the same reason why, in the United States, there is a salary cap in basketball, for example. There should be a limit to campaign financing, because why is there a salary cap in basketball? Because you don’t want one guy to hire all the best players and it’s no fun watching the games, right? Because if one team has all the best players and wins all the time, end of the story. So, you want the two—

Kate: And I would argue that it’s never fun, but that’s just me.

Luigi: It depends on which game you watch. But you want more balance, as you want more balance in the political system. So, I’m very much in favor of some limitations in campaign expenditures. But that’s something that I don’t think that even my grandchildren will see in America, because with the current constitutional point of view, I don’t think that I don’t have any hope of that.

Kate: Well, there are limits on how much hard money you can contribute to campaigns, right? If I want to directly give money to Joe Biden or Donald Trump even, or if a corporation wants to give money directly to Joe Biden or Donald Trump, there are severe limits on how much they can do that. And that’s because of campaign finance reform. However, those hard limits have spawned this entire complicated, convoluted system of all these different conduits that are constantly evolving, right? It used to be 527s and then they turned into super PACs, and now they’ve turned into dark pools, and 501(c)4s. And I just can’t keep track.

I don’t think anyone can keep track of what the conduits are. And what this has done is that now we have limits on direct spending by campaigns, but there are no limits on indirect spending outside of the campaign on political ads. And we haven’t been able to successfully rein them in. And so, this creates a weird dual system in which the actual candidate, him- or herself, can’t have too much influence on what these indirect forms of spending do. You argue that they do, and I agree with you to some extent, but at least the law says that the campaigns are not supposed to be coordinating with these independent organizations. But then all the power is taken away from the candidates and put into hands of billionaire donors, who have political views and who are operating on behalf of candidates, but really in their own way. And so, yes, we should have campaign-finance reform, but we shouldn’t necessarily have campaign-finance reform that applies only to the candidates, but not to anyone else who wants to spend on campaigns.

Luigi: I agree. But I think you said limits to direct spending, I think it is a limit to direct contributions. Because in the United States there are limits to contributions, but there are not limits to spending. And this is an important distinction.

Kate: Yes.

Luigi: Because if you are Bloomberg, you don’t get any contribution. And, as a result, you have no limit in spending. And I think that what we should . . . The problem of campaign expenditures is twofold. One is the corruption that can come from receiving the donation. But the other is the unequal balance that you start with. So, if you are Bloomberg, Bloomberg might be a great president, but he starts at an enormous advantage vis-a-vis all the other candidates because he has so much money. And we don’t necessarily want a country where the president is elected based on how much money he has to spend and not on the quality he has to run the country. And so, I’m also in favor of limits on expenditures so that people actually are on equal footing, or more equal footing. I don’t think that you want complete equality everywhere, but I think that the imbalance we have today is worrisome to me.

Kate: I think that that’s a great proposal. And to the extent that you can, I think that those expenditure limits should apply not only to the direct candidates, but also any “independent” organizations that are spending on their behalf.

Luigi: Yeah. Especially close to the election, where it says, “If you want to campaign for legalizing marijuana outside of the election period, that’s perfectly fine.” But if you are campaigning for a candidate or for a person near the election, it has the potential risk of being very distortive. One other thing I learned is not only the amount of money that is spent, but also the amount of money that could be spent. So, we focus all the time on presidential elections because they attract the attention of everybody. But I think that actually the presidential elections are fairly fair, in the sense that they get so much visibility that it is much more difficult to pull tricks.

But if I am a congressman or congresswoman in the middle of the country, I don’t get to raise an enormous amount of money, but I live in fear that all of a sudden some super PAC will a drop a million dollars to my opponent in the last two weeks of the election and take away my seat in the last two weeks. And because there are not very many people that can drop that kind of money in the last two weeks, I have to be very careful of antagonizing some vested interest, because those vested interests are the ones that can actually get me out of my job at the last minute. And the perverse beauty of this system is that there is no trace left. Nobody spends any money. It’s just a threat of spending that kind of money that fast that makes me behave differently as a congressman.

Kate: Yeah. I think you’re right about the threat point. An interesting loophole that super PACs exploit that has to do with timing relative to the elections is that super PACs are supposed to disclose more as the election ramps up. But if you only spend money within the few days before the election, then you don’t have to disclose who your sponsors are until after the election. There’s this proximity loophole. And so, super PACs can and do exploit that, so that they don’t actually have to reveal who’s giving them the money.

Luigi: So, our producer told us that his wife is very concerned about money in politics. However, she decided not to donate to her favorite candidate, because she thinks that at the end of the day nothing will change, that her $100 will not make a difference. Our producer was very upset, because he thinks that this is an irrational way to behave. And we’re trying to convince him that his wife actually is very rational in the sense of being individually rational. She does what is optimal from her point of view, which is, whether I donate $100 or do not donate $100, nothing will change. But I will end up adding $100 more to actually make a nice birthday present for our producer.

So, she is super rational from the individual point of view. Of course, collectively, that’s the wrong decision. But that’s part of the problem with campaign financing. If I am a very wealthy donor, I know that my million dollars will have an impact, and I’m willing to make that donation. Even if we keep things in proportion and you donate the same fraction of your wealth that that wealthy donor donates, you are not willing to do it, because of what we economists called the free-rider problem and now we’re going to call Matt’s wife’s problem.

Kate: Exactly. And an interesting part of this election is seeing how all of these frictions, these economic frictions, play out. I think that Bernie Sanders has done a really good job of doing away with that free-rider problem for his campaign. Because, first of all, he has made it very clear that he doesn’t want to accept donations from billionaires, and so that makes the individual donors feel like they do have more individual influence, even if it’s with a relatively small gift, because they’re not up against a billionaire who has a gift that’s 1,000, 2,000 times bigger.

But on top of that, I think what Bernie has done successfully is that he’s made donations to his campaign less about the dollar influence on his electability and more about this signal of what it means just to have a large number of donors. I think that in November he announced that he had something like four million individual donors, and we know now from the early January stats that he has raised a huge sum of money. And so, he’s made the donations less about the dollar value and more about the signaling effect. And I think that that has ironically been incredibly successful in terms of raising a large dollar value.

Luigi: Yeah. I think it’s extremely good marketing techniques. We should tell AT&T to hire Bernie Sanders as a marketing guy. One of the consequences that people often don’t see, but I think is very important, of this huge influx of money into politics, particularly in the form of large donations, is the radicalization of the political scenario. If I want to raise money in small quantities from a large set of people, I need to, number one, stay very far away from the contributions of the large companies, and two, really cater to the extreme left or, on the other side, to the extreme right of the political spectrum, where people are more excited and more willing to contribute in small quantities.

The moment I decide to be more moderate, then I have a choice. I can tilt a bit more to the business side and get the donations of Facebook, or Google, and Goldman Sachs. Or I can be a little bit more anti-big-business, and then—unless I’m super radical, and then I play the Bernie Sanders game—I don’t get any money. So that creates, in my view, a hole in the political spectrum, where either you are a centrist, and you are completely in the pocket of business, or you are a super radical like Bernie Sanders, and you are not in the pocket of business, but you’re not necessarily very moderate in your proposals.

Kate: To be fair, I think that some of the other Democratic candidates, even though they have accepted money from billionaires just based on their policies, I don’t think that they’re all in the pocket of big business.

Luigi: Actually, Warren is struggling in this, because that’s my view of why Warren is radicalizing. Because once she cannot get that money, then she had better be like Sanders to the extreme. It’s very hard to be more moderate. Part of some of her proposals that made her lose votes, et cetera, is exactly for that game.

Kate: That’s a very interesting political theory.

Luigi: Yeah. It’s not a problem, in my view, just in the United States of America, it’s also a problem in all Latin America. If you are a centrist, you are basically pro-USA, and you get the support of all the big businesses who are pro-USA. You cannot be just slightly critical of USA and not be a radical, because you don’t get the money that comes with the critics, or with lack of critics. And you’re going to get the support of the extreme radicals. So, at the moment you are not completely pro-big-business, the next day you are Chávez. There’s very little in between.

Kate: I agree with your political theory. I would just make one modification, which is that it’s not necessarily the threat of big business and corporations themselves. I do think that they spend a lot of money on politics. But I think they do it in a more balanced way than most people think. I think it’s actually the billionaires who, for the most part, not all of them, but for the most part, are pro-big-business. And they’re the ones who the political candidates really have to worry about.

Luigi: Yeah. But generally, billionaires tend to have big businesses. Not all big businesses are billionaires, but certainly, in order to be a billionaire, you have to have a big business.

Kate: Exactly. I agree.

Luigi: So, Kate, what do you think, is this capital-is or capitalisn’t?

Kate: Campaign-finance reform, if it worked, would be a capital-is. I think that the way the things have played out have shown that it is a serious capitalisn’t, that has had not only effects that we didn’t expect, but effects that run contrary to the spirit of campaign-finance reform. Which is essentially empowering billionaires, the already very wealthy, and making it harder to observe all of this activity. What about you, Luigi?

Luigi: Actually, Bo Rothstein, a Swedish political scientist, said that in a market economy, you have to have everything for sale except the government itself. And I think that that’s a very deep insight that we want to maintain. We want to have everything for sale except all the offices of the government. And I fear that in the United States, those are for sale, too.

On this podcast we mostly talk about what isn’t working in American capitalism. But, on this episode, we're taking a break to look at how capitalism can go wrong in other countries, specifically...Russia. And we’re going to do that with a very special guest, Putin's so-called number one enemy, Bill Browder.

Luigi: In our podcast, we mostly talk about what isn’t working in American capitalism. Today, we’re going to take a break to look at how much worse capitalism can go wrong in other countries, particularly Russia. We’re going to do that with a very, very special guest, Bill Browder.

Kate: Fun fact about Bill Browder is that he’s the grandson of the head of the American Communist Party, and he ran against Roosevelt in 1936. And also, now, he has an international warrant issued against him.

Luigi: Yes. By Putin. You’re very knowledgeable. I don’t know whether of American history or Communist history, but at any rate, you’re very knowledgeable.

Kate: I also just happened to read biographies, Luigi.

Luigi: I see. At any rate, we’re very excited to have Bill here, and this is Luigi Zingales from 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.

Kate: So, Bill, welcome to the show.

Bill Browder: Great to be here.

Kate: Now, tell us more about your instrumental role in changing Russian corporate governance in the early 2000s.

Bill Browder: When I showed up to Russia, all the stocks in the stock market were dirt cheap to the comparable Western values. So, for example, Gazprom, which is the largest gas company in the world, traded at a 99.7 percent discount per barrel of hydrocarbon reserves to companies like BP and Exxon. And the reason that it was trading at such a big discount was that everybody thought that every last cubic meter of gas and gas reserves had been stolen out of Gazprom.

One of the things which we did was a stealing analysis of Gazprom to figure out how much was stolen, and people often think of Russia as being a very un-transparent, opaque place, and it is in certain respects, but Russia is also a country with incredible bureaucracy, and all the bureaucrats collect information on everything, and all those bureaucrats were effectively making that information available. We took that information and we analyzed it, and we figured out, instead of 99.7 percent of assets being stolen, we discovered that only about 9 percent of the assets had been stolen.

Now 9 percent of the assets was like the size of Kuwait in terms of oil reserves, which is enormous, but perception was so different than reality, where the world thought everything was being stolen. And we figured out that almost everything wasn’t being stolen, and we figured the best way of trying to inform the world and correct the situation at the same time was to expose how they went about doing that stealing.

We took our analysis and we put together a dossier, and we broke it into seven chapters, and we shared the first chapter with The Wall Street Journaland the second chapter with the Financial Timesand the third one with the Washington Post. And by them writing the stories about the stealing, it created a public scandal, and they then had parliamentary hearings and more stories got written. And then, the management tried to defend themselves, and they actually hired an American accounting firm, PricewaterhouseCoopers, to write a report to say that it was actually good that these assets had been stripped off the balance sheet, and more stories.

And in the end, it created such a public scandal that Putin stepped in and fired the CEO who was doing all the stealing and replaced him with a new guy whose job it was not to steal assets. He could steal other things, just not assets, and then, the day after the new guy came on, the share price went up 138 percent.

Luigi: I know it sounds funny now, but in the early 2000s, the rumor was that you are an ally of Putin. Everybody would say, “If this guy is serious and he’s as effective as you describe, why is he still alive?” And that’s the reason why there was this rumor that he was an ally of Putin. So, what’s the story?

Bill Browder: Well, everybody in Russia was saying to themselves, “There’s absolutely no way that some guy from the South Side of Chicago would show up to Russia and do this on his own volition,” and they thought, “OK, if he’s not doing it on his own volition, who is he doing it for?” And then they looked at the fact pattern of the story, and they said, “Well, look, here’s this guy. He did all this stuff and then all of a sudden Putin steps in and fires the guy. Ah, maybe it’s Putin. This is a Putin project. I mean, how clever of Putin to—”

So, instead of doing some KGB operation, he gets some guy from the South Side of Chicago to do it. And from my perspective, I didn’t want to disabuse anyone of that thought, because if they thought it was a Putin project, they weren’t going to kill me. And so, I didn’t tell anyone it wasn’t a Putin project and let them think what they wanted to think. Now, of course, my subsequent years have proven that I’m not a guy of Putin, but I certainly wasn’t going to disabuse anyone of that notion at the time.

Kate: Sure. So, what went wrong in what you call the subsequent years? What was the turning point in your relationship with Putin?

Bill Browder: Well, so, I was doing this naming and shaming, not just at Gazprom. I did it at the national electricity company, at the national savings bank of Russia, at several oil companies, and for a while it worked, and it worked because Putin basically had the same problem I had. You had these oligarchs stealing power from him, and these were the same oligarchs who were stealing money from me. And so, it was going well for a while, and every time I would publicize a scandal involving one of his enemies, he would come down like a ton of bricks on his enemies, and it all worked well.

The trouble was that Vladimir Putin wasn’t doing this because he wanted to clean up Russia. He was doing this because he wanted to destroy the oligarchs, and he finally had his moment in October of 2003. In October of 2003, he arrested the richest oligarch in Russia, a man named Mikhail Khodorkovsky. He was the owner of an oil company called Yukos. He arrested him off his private jet that landed in Siberia.

He was brought back to Moscow. He was put on trial, and in Russia, when you go on trial, you sit in a cage. And they allowed the television cameras to film Mikhail Khodorkovsky, the richest man in Russia, sitting in a cage.

Now, imagine you’re the 17th-richest person in Russia, and you see a guy far better, far richer, far more powerful than you sitting in a cage. What’s your natural reaction? You don’t want to sit in that cage yourself. And so, in June of 2004, after Khodorkovsky was found guilty and sentenced to 10 years in prison, these other oligarchs went to Putin one by one and said, “Vladimir, what do we have to do so we don’t sit in a cage?” And Putin said, “It’s real simple. Fifty percent.”

And this is not 50 percent for the Russian government or 50 percent for the presidential administration of Russia. This was 50 percent for Vladimir Putin. At that moment in time, he became the richest man in the world. And I was carrying on with all of my naming and shaming campaigns, but I wasn’t naming and shaming his enemies anymore. I was naming and shaming his own personal financial interests. And in November of 2005, as I was flying back into the country, I was stopped at the border. I was detained for 15 hours, and then I was deported and declared a threat to national security.

Kate: Yikes.

Luigi: So, this story is quite shocking, but it’s also exemplary, from the euphoria of the late ’90s. Now we are in the fear of the 2010s. This period we’re celebrating the 30th anniversary of the fall of the Berlin Wall, and when that happened, there was a lot of inspiration, a lot of hope that we’re going to build a democracy in Eastern Europe, but particularly in Russia.

So, in your view, what mistakes did we make as Western nations to cause what we see is now developing in Russia?

Bill Browder: Well, I would argue that most of the problem of what happened in Russia has nothing to do with the West. It has to do with the decisions that were made in Russia. Though in the West, we had a little bit to do with some of those decisions, but the original sin and the thing that has created this whole problem was the decision which was made by the Russian government, with the support of a team of economists from Harvard, to do what they called mass privatization.

The theory was, in order to go from communism to capitalism, Russia wanted to create capitalists, and the way in which they wanted to create capitalists was to give everybody all the state property for free. While that may sound good in theory, in practice what happened was they gave all the state property away, but they didn’t give it away to the people of Russia. They gave it away to 22 oligarchs, and those 22 oligarchs then lived like kings in ways that nobody could even imagine.

There were yachts and planes and villas all over the world and money was burning up. They were having champagne wars in the South of France, $500 a bottle, and at the same time the average Russian, and every Russian, pretty much, was living in destitute poverty. And so, by creating these oligarchs, they created a base of anger, which was palpable, and that base of anger eventually was the base of anger that brought Putin to power.

Putin was brought into power to “restore order,” to strip the oligarchs of their power, to bring the power back to the state. But instead of Putin doing that, Putin just took the whole concept, and instead of having 22 oligarchs, he created a state where he was the oligarch, and everyone else continued to live in destitute poverty. But instead of running it as sort of a chaotic criminal state, which was how it was run under Yeltsin, Putin centralized all the power, and it became a criminal state where he was the crime boss, and in fact, that made things immensely worse for the average Russian.

Kate: But I thought the original impetus for the privatization program was this idea that markets lead to efficiency, they’re better at determining prices and wages than, say, a centralized government, and that laissez-faire is actually good for an economy. So, how did this then lead to this oligarch system so quickly?

Bill Browder: Well, all those things sound good when we’re discussing them inside the University of Chicago or Georgetown University—

Kate: Oh, burn.

Bill Browder: These are all great concepts, but the way I would describe it is, it was kind of like building a house, a beautiful house. It all looked really good from the outside, and the mass privatization, and everyone owning things, and efficiency, and so on.

But the problem with this house was when they built it, they forgot to put in the plumbing and electricity. And in this case, the plumbing and electricity were rule of law and property rights. And so Russia did all this without having a proper system to adjudicate conflicts, to enforce the law, to make sure that people were entitled to what they agreed to, and so on and so forth. And so, as a result, it became the law of the jungle, and you had these 22 individuals, some of whom who were ready to kill in order to become rich, and the people that they killed quit wouldn’t stand in their way and everyone else was afraid of being killed, and so you ended up in a situation where courts didn’t work, the police didn’t work, governments didn’t regulate.

And so, in theory, all this could have worked if they had done it in the proper stages. And the proper stages would have been, first, to create an independent court system; second, create a regulatory framework and regulators that were honest and ready to regulate; and, third, have some kind of culture of independent property. But they didn’t do any of that, and so they just let a free-for-all happen, and the free-for-all without rules ended up in a situation where policemen were working for the oligarchs, arresting their enemies. Nurses had to prostitute themselves to support their families. Art museums were selling art off the walls to keep the place heated. Professors were driving around as taxi drivers. And that was the Russia that was created by these 22 oligarchs and by this system of chaos.

Luigi: Let me disagree on these lightly here. It’s not that they didn’t think about creating the rule of law. They hired Bernie Black, at the time he was at Columbia, to write the Russian court as actually, almost verbatim, the Delaware court. So, the law on the book was as beautiful as it can get.

There was a little detail that they forgot, that the structure of ownership impacts enforcement. It’s only in a more equal society that you can have a real rule of law. When you have somebody extremely rich, it’s very difficult to have independent courts. In the United States in the 1910s and ’20s, we invented regulation, in part because the courts were completely bought and paid for, or influenced by, the rich oligarchs of the United States.

Bill Browder: You’re absolutely right. I mean, if you look at the law books, they don’t look bad. But it’s the enforcement of the laws that’s a real disaster. I think the real problem comes down to the courts, and it comes down to the fact that the judges weren’t independent, and judges felt at risk. And maybe there was no way that this could have ever worked in reality, because nothing worked as it was intended to work, that everything was corrupt.

Whatever the reason, by giving it all away, you ended up in a situation where a few people got very rich and everyone else was poor, and when you have the type of disparity of wealth that you have in Russia, that creates a toxic formula.

Kate: Yeah, I would add another addendum to that as well. They seem to have gotten the disclosure part pretty wrong, or at least there weren’t enough practices in place to force companies to disclose who the beneficial or the majority shareholders were.

My understanding is that in the ’90s there was some effort to catch up with corporate governance rules, to let minority shareholders overrule votes that they didn’t like. For example, if the majority shareholders got dividends that the minority shareholders didn’t approve of, they would be able to sue. But the burden of proof was on them to show that this happened, and if there was no disclosure about who the majority shareholders were, then they didn’t know who they were suing. And this whole issue of the opaqueness of ownership seems to be what really held up a lot of the enforcement issues.

Bill Browder: Well, we were exactly in those situations, where the majority shareholder was squeezing out and doing terrible things to the minority shareholders, but we always knew who the majority shareholders were. The issue was, and we went to court many, many times, and we always lost in court, because the court would always rule in favor of the person who was paying the bribe, and we didn’t pay the bribes.

Luigi: At this point, what can we do as a Western nation to minimize this cancer?

Bill Browder: Well, the first thing I would say is that as Westerners, we shouldn’t be investing in Russian companies. It’s not investible. The lack of information, the lack of transparency, the lack of property rights, make it a situation where normal financial analysis of companies doesn’t apply, because it doesn’t matter whether these companies grow, or shrink, or the markets are good or bad. If you have no idea if you’re going to get the economic benefits of the company because it’s going to be stolen from you, you shouldn’t have anything to do with it, and so I would say, first and foremost, we shouldn’t invest.

And particularly, public pension funds and college endowments, and people with responsibilities like that should absolutely not invest. And, ultimately, if there is no capital flowing to these companies, at some point they either have to say they don’t need the capital, or if they need the capital, then they have to improve. But with the current situation, where capital to some extent still flows, there’s no incentive for them in any way to fix these problems.

Luigi: One other thing that I take from the Russian story is, to some extent, how dangerous it is to have the wrong economic theories applied to policymaking. When the Western economists went to Russia to try to fix it, I think they had the best intentions, but they were driven by a view that institutions are given, and then the only thing you have to do is fix the incentives for managers to work hard. And so, if you concentrate more ownership, then you have more incentives and the company will be more valuable, and completely missing the macroeconomic impact of what an ownership structure creates from the point of view of institutional enforcement, political decisions, and so on and so forth.

By ignoring that, they contributed to the deterioration of the situation. In Russia, of course, it is not the only reason, but I think that if they had had a broader view of the institutions, I think that maybe we would not be in this situation today.

Bill Browder: Well, I think you’re giving way too much credit to your academic peers in this whole thing. I mean, the Russians used this as a fig leaf for their own intentions. It was a cooked-up plot from the very beginning with a bunch of guys who wanted to steal the assets of the state, and it’s great to have a little veneer of endorsement from famous academics who come in and write some laws and talk about some theories, et cetera, but at the end of the day, we can neither be blamed for it nor take responsibility for it.

This was the Russians’ fault. They created this mess for themselves. They did nothing at any step of the way to try to fix this mess, and while they might have used some of these theories as justification, it’s their fault. It’s the fault of Vladimir Putin, and it’s the fault of people around him, that they benefit so much from this thing, that the last thing they want to do is create any kind of normalcy which would allow the system to work.

Kate: OK. So far, we’ve talked about the Russian oligarchs, but do you see any similarities in the United States?

Bill Browder: The difference between the United States and Russia is that in the United States you have rich people, and then you have different people who have political power, and it’s pretty much one or the other. I mean, I guess Mayor Bloomberg has just announced his candidacy, and so he would be both. I’ve never believed that Donald Trump was worth $10 billion or even $2 billion. I think that he’s just a showman, and so not really an oligarch. But in Russia, you can’t have political power without wealth and you can’t have wealth without political power, and that’s the big difference.

In America, we’re seeing a lot of challenges to the system right now, but the institutions, the individuals are still, for the most part, not greater than the institutions. And a rich person who tries to overcome the institutions generally finds the institutions are stronger here, and that’s what makes America, so far, a strong, functioning place where the system works.

Luigi: I feel you’ve lived a bit too long abroad, because I think America is drifting in that situation. Part of the reason why Mayor Bloomberg decided to run is because many of the billionaires are afraid of Elizabeth Warren. They started looking at the proposal of the wealth tax, and they’re saying how much it costs me, and I don’t think it’s past them to say, we need to do something to stop her.

Bill Browder: Well, that might be a reason. I could also imagine that Bloomberg might be running to say that if Elizabeth Warren was the nominee, she would lose to Trump. The main selling proposition that the Republican Party continues to have is that we don’t want to be a socialist country, and so, I mean, we could argue there’s a . . . the moment you get into politics, every argument is a good argument, and there’s no way to disprove one versus the other. But I think that, of course, people also look after their own interests, but America tends to be a country or always has been a country of aspirational people, of people saying, “If I succeed in business, I don’t want someone to take it away from me, even if I’m poor, and so I’ll vote for the guy who is a good business president.” And so, I think that there’s a lot of different ways to skin this cat, but I don’t think that the oligarchy is as powerful here by any means as they are in a place like Russia.

Luigi: Of course, it’s not as powerful. I don’t want to go to that extreme, but I think that we’re drifting slowly in a bad direction. When your grandfather was running for president against Roosevelt, there was another guy who tried to run for president but was shot. It was Huey Long. He looked very much like Donald Trump on the left, it was very much like Donald Trump. In part he was getting his support by saying, we want to tax the rich people. We want to go after Standard Oil. We want to redistribute wealth, and he was very popular. It’s not past me that he was not killed by accident.

So, I think that when there is extreme inequality, I think the temptation of redistribution through the democratic process is present, and if you are on the rich side, what do you do? You’re going to try to capture the process so that this doesn’t happen, and then it becomes a vicious circle in which you need to defend yourself as a rich person by controlling power, but that defense creates more resentment that will lead to more temptation to expropriation, and you don’t get out of that very easily.

Bill Browder: Well, I mean this is exactly what’s happened in many Latin American countries, where they go from hardcore corrupt capitalism to socialism, and back and forth, and populism, and ending up having crisis after crisis after crisis.

And why did fascism happen in Europe in the 1930s? It was because there was a huge economic crisis, which led to hyperinflation, and so on and so forth, which led to the Nazi Party and various other terrible things.

And one could argue that the reason why we have a lot of populism in the world right now is because of the global financial crisis in 2008 and the fact that a lot of people ended up being economically worse off, and disparity of wealth, and so on and so forth.

And surely, if you have a system where all rich people are going to benefit and a big part of the population gets worse off, and you live in a democratic country, then the pendulum’s going to swing the other way. And perhaps that’s why Elizabeth Warren is popular right now, but I don’t believe that American oligarchs have that much influence over the process. I think they do to a certain extent, but this still is a democracy here.

Kate: I think I have a slightly more cynical view, which is that American oligarchs or billionaires have just figured out a way to run the system from behind the scenes, making it seem like they don’t run the system. I think the Koch brothers are a good example of this, so just because they’re not as prevalent or as obvious political figures as they might be in other countries, I don’t think that’s a sign that they’re not running things.

Bill Browder: Yeah, but George Soros and Tom Steyer and various others are on the other side of this thing. I mean, it’s people with money arguing all sorts of different things from different corners. I think that it’s easy to create conspiracies and to talk about these evil people behind the scenes, but this is a very robust place.

Kate: Right. I think that that supports my point, though, which is that, OK, there might be people on different sides of the political spectrum running things, but they’re still running things. I mean, maybe what’s better about the system here is that our oligarchs are more . . . they have more diverse opinions, and so they’re not all working in unison to entrench themselves.

Bill Browder: There’s a fractious democracy among oligarchs here.

Kate: Yeah, maybe that’s how our system works.

Luigi: Yeah, but I think that much of the disagreement is on abortion rights or gay rights, so things that don’t have a huge amount of economic impact. When it comes to the particular exemption of the carried interest in private equity, this is not something that excites people, but it’s still there on the books and has been there for 20 years, and that favors just one particular group of people. I think that when it comes to economic interests, I think that there is pretty much a consensus on certain things.

Bill Browder: Well, I mean, it’s kind of irrational why private-equity fund managers would pay much lower taxes than average wage earners, and that’s something that probably would get ironed out in some administration at some point in the future.

Just to give you an example, I’ve been living in London for 30 years, and they had a special rule called the non-domiciled rule, and the non-domiciled rule said that if you’re a foreigner and you live in the country, you don’t have to pay the same tax as regular British people pay. And the Conservative government basically took a chopping block to the non-domiciled rule, just because it seemed to be unfair by the average person. It wasn’t the Labor government, it was the Conservative government that did that, and so the carried-interest rule could easily be gotten rid of by a Republican administration in the right circumstances. I don’t think that it’s as corrupt and as terrible as what a person who’s not benefiting from the carried-interest rule might think.

Luigi: I think this is the difference between the British democracy and the American democracy, the fact that this rule has not been changed for, what, 25 years under Republican and Democratic administrations. The fact that many times it was promised to be removed, including by Donald Trump, but then when they run the country, they don’t do it.

Bill Browder: Well, I think what you’re describing is the quicksand and molasses of the legislative process. I mean, I’ve been through the legislative process to get the Magnitsky Law passed between 2010 and 2012, and this was probably one of the easiest things to argue, of all things, which is, should we or should we not allow Russian torturers and murderers coming into America? And this is one where very few people were arguing against it. But even with that, it still took us two years and a lot of fumbling, and it was only because the planets lined up perfectly that we were able to get the law passed.

Luigi: Yeah. I’d like to talk about that, in particular, I’d like to talk about how you succeeded in passing this, because I know that you’re very effective. I saw you in action in Russia. You’re very effective, but you have a relatively small operation, and you succeeded in passing a form of the Magnitsky Act in many countries in the world. How many?

Bill Browder: Six countries so far.

Luigi: Wow.

Kate: That’s impressive.

Bill Browder: We got the Magnitsky Act in Canada . . . first in the United States and then in Canada, Great Britain, Estonia, Latvia, and Lithuania.

Kate: Can you tell us a little about the origins of this act and what you’ve been doing in order to get it passed?

Bill Browder: So, the Magnitsky Act is named after my Russian lawyer, Sergei Magnitsky. Sergei Magnitsky was murdered in Russian police custody in November of 2009 after uncovering a massive government corruption scheme, in which government officials stole $230 million of taxes that my firm paid to the Russian government from the Russian government. He exposed it, he was arrested, and he was tortured for 358 days and he was killed. And I’ve made it my life’s work for the last 10 years to go after the people who killed him and make sure they face justice.

I tried originally to get justice in Russia, but Vladimir Putin circled the wagons and exonerated every person involved, gave a bunch of them state honors and promotions, and so I had to look outside of Russia where I could get justice. I said to myself, the people who killed him, killed him for $230 million, and they don’t keep that money in Russia, they keep it in the West.

I went to Washington after Sergei was murdered, and I told the story of Sergei and what they did to him to a Democratic senator from Maryland named Benjamin Carden and a Republican senator from Arizona, John McCain, and I said, “Can we freeze their assets and ban their visas?” And they said, “Yes, we can,” and that became known as the Magnitsky Act.

At first, it started out just as a piece of legislation for Sergei Magnitsky, but as soon as it was launched, other victims started coming forward from Russia and saying, “My God, you found the Achilles heel of the Putin regime. This is what they care about, their money abroad. Can you possibly sanction the people who killed my husband, my brother, my sister, my aunt?” And they added 65 words to the law, which would sanction all Russian human-rights abusers. And in a world where everybody disagrees on everything, and we’ve just talked about how impossible it is to get stuff done in Washington, there wasn’t a pro-Russian-torturer and murderer lobby in Washington.

Luigi: But tell us precisely why they’re so effective against these oligarchs.

Bill Browder: Well, this is what makes it so interesting, is that the Magnitsky Act has been globalized. It doesn’t just apply to Russians anymore. It applies to Chinese, and Venezuelans, and anywhere people are doing bad stuff, and so if you’re one of these bad people doing bad things, and the United States government wants to sanction you, and they’ve sanctioned now, I think, 150 people, you get put on something called the OFAC sanctions list.

When you get put on the OFAC sanctions list, every bank in the world subscribes to a database which has all the sanctions list people. And the moment that you get added to the sanctions list, every bank in the world closes your account. Why do they close your account? It doesn’t even matter if it’s an American bank or a Chilean bank or a Dubai bank or a Korean bank, the moment that you get put on a sanctions list, that bank doesn’t want to be in trouble with the US Treasury, and they get in big trouble.

If they do business for somebody on the sanctions list, they get fined by the Treasury three times the amount of business. And so, let’s say that you have $1 million in a bank account in Europe, and you’re a sanctioned individual, and your bank moves that money to another bank account. Let’s say it’s going from a Swiss bank to a Russian bank. If the Treasury finds out, they fine the bank $3 million, and what does the bank make off that wire transfer? $150. And so, the moment you’re on the sanctions list, you become a financial non-person in the world, a financial leper, a financial pariah, and you can’t do business anywhere, and it ruins the business of any person on the sanctions list, and so everybody hates it more than anything.

Kate: What about banks like in the Seychelles or the Cayman Islands or Panama? Aren’t there ways for them to shield your assets without having to report to the US government?

Bill Browder: No. It doesn’t matter where the bank is. Every bank of the world, in order to be a bank, has to transact in US dollars. And so, if you’re a bank in the Seychelles, and let’s say that you’ve moved $1 billion to a bank from the Seychelles to the BVI on behalf of a sanctioned individual, and the US Treasury finds out about that, which they will find out about, because all wire transfers in dollars go through the US Fedwire system for a second, and so there’s a record of it. When they find out about it, they’re going to charge the Seychelles bank $3 billion.

And then the Seychelles bank, in theory, could say, “Well, we’re in the Seychelles. You have no jurisdiction over us. We’re not going to pay the $3 billion,” and then the US government says, “OK, fair enough. You’re now banned from using US dollars,” and all of a sudden, that bank in the Seychelles is not a bank anymore, because there’s no such thing as a bank that can’t move dollars, and that’s why nobody wants to defy the US Treasury.

Kate: Pretty cool.

Bill Browder: It’s devastating. This is the new technology for going after bad guys, and you can’t imagine . . . and it’s not just the people who are sanctioned, it’s actually much better for the people aren’t sanctioned. There are 150 people, roughly, who are sanctioned right now on either the global or Russian Magnitsky list, but the number of people who are absolutely living in terror right now about possibly being sanctioned is in the tens of thousands. The worst people on the planet are all absolutely terrified that they’re going to get caught and sanctioned by the US government, and some of these people may say to themselves, “I’m not sure if Putin is going to last that long, and do I want to be a financial non-person for the rest of my life to do Putin’s bidding for the next three years or next five years,” or whatever they handicap his political survival at, and some people may say, “You know what, I’m just going to call in sick that day when I’m asked to go and torture that guy.”

Luigi: So, why do we not sanction Putin? He’s the richest man on Earth. So, why is he not on the Magnitsky list?

Bill Browder: Well, I’ll tell you something. Vladimir Putin is absolutely terrified that one day he will be on the Magnitsky list, and he’s also terrified because Putin doesn’t hold his own wealth. His wealth is not held by him. He has trustees or other oligarchs who hold his wealth for him, and there’s open season to sanction them. And so Putin, who is a guy who has so little respect for human life, who values money more than anything, and all of a sudden, his offshore fortune is put at risk. One way or the other, he’s affected by this, and he made it his single largest foreign-policy priority to repeal the Magnitsky Act because of his absolute fear of what could happen to his money.

Luigi: So, is there lobbying in the United States to repeal it?

Bill Browder: There’s intense lobbying. If you remember, there was a famous meeting in which a Russian lawyer named Natalia Veselnitskaya went to Trump Tower on June 9, 2016, and she went to meet with Donald Trump, Jr., Jared Kushner, and Paul Manafort, and she went with a specific request on behalf of Vladimir Putin to repeal the Magnitsky Act. They’ve spent millions of dollars on anti-Magnitsky campaigning in Washington.

They even had the one Putin-loving member of Congress. He’s no longer there. His name is Dana Rohrabacher. He was a Republican Congressman from Orange County who tried to take Sergei Magnitsky’s name off of the global Magnitsky Act, and was doing various things to try to disrupt and persuade people to repeal the Magnitsky Act. It’s really unrepealable, and it’s not going to happen.

Kate: It was nice to meet you, Bill.

Bill Browder: Nice to meet you, too. Good talking to you.

Kate: Thanks for being on the show.

Bill Browder: It’s all very interesting and different than what I normally do. So, it’s good, because there’s been a lot of podcasts where I say the same thing over and over again.

Luigi: I know, I know. We try to be a little bit different.

Does Silicon Valley have a capitalism problem or does capitalism have a Silicon Valley problem? On this episode, Kate and Luigi sit down with Mike Isaac, New York Times technology reporter and author of "Super Pumped: The Battle For Uber " to find out if these tech startups have a toxic corporate culture issue.

Luigi: There was a time when being an investment banker was cool. Then came the financial crisis, and investment bankers started to hide at cocktail parties pretending to be tech guys.

Kate: And then came the Cambridge Analytica scandal, and tech guys started to hide at cocktail parties pretending to work for startups.

Luigi: Then came a time when working in a Silicon Valley startup, like Uber, was cool. Then, 2017 came, and Uber was accused of every possible crime, from intellectual theft to promoting a sexist culture. From paying bribes in foreign countries to knowingly buying defective cars for its drivers.

Uber employees started to hide at cocktail parties, pretended to work for, what is the next cool thing, Kate? You certainly know.

Kate: I actually don’t know if I know. Here’s what I do know. I have a bunch of friends who are former Facebook employees. Some of them work in medical technology companies or, I guess, in healthcare startups, but that’s not OK, because they can manipulate prices, jack them up and hurt consumers, and so they hide. And then one of them actually works for the DNC doing tech stuff, but that’s not OK, because maybe the DNC is manipulating the election. And so, I think that the best example I have is somebody who went to go work for corporate social responsibility at Goldman Sachs, and his job is considered the best of all.

Luigi: So, maybe it’s full circle. Now, we have the socially responsible investment bankers that are returning to be cool.

Kate: Yeah.

Luigi: And I wonder how long it will take until the new cool thing becomes synonymous with greed, corruption, and failure.

Kate: Exactly.

Luigi: Is this just a Silicon Valley problem, or is it a capitalism problem?

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

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

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

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

Kate: So, to reflect on this question of whether corporate culture in Silicon Valley is a Silicon Valley problem or a capitalism problem, we have an exceptional guest, Mike Isaac, technology reporter at the New York Timesand author of the recent book Super Pumped: The Battle for Uber, filled with details about everything that went wrong at Uber. Welcome to the show, Mike.

Mike Isaac: Yeah. Thank you for having me. The last two months, I guess, have been pretty crazy. It’s been nonstop talking about a bunch of different cultural issues with Uber and how this company was operated, so I’m kind of interested and curious as to what you guys want to talk about with me. I thought you guys usually like to talk about capitalism and not the cultural effects of it, but let’s see what we can get into.

Luigi: Yeah, you’re right. It used to be the case that economists did not want to talk about culture at all. When I did my PhD at MIT, at the turn of the ’80s, the word culture never entered my classrooms.

Kate: That wasn’t really the case with me, actually, I’m sure most of our listeners are familiar with Luigi’s name, but I have been hearing about Luigi ever since I was, I think, a sophomore in college, when I took cultural economics, and half of the papers on the syllabus were written by the one and only Luigi Zingales.

Mike Isaac: Oh, wow.

Kate: So, Luigi, how have you brought about a resurgence of cultural economics?

Luigi: If you come from a different country, you cannot fail to see how cultural explanations are important, especially in a country like Italy, where this culture goes back millennia and affects everything you do.

For our listeners, the simplest form of culture that we can import into economics is simply a set of beliefs and values shared by a group and transmitted to the new members of the group via education or socialization.

Whether this is true in a country, it is even more true in a company, where you can actually select people based on those values, and Netflix, Amazon, a lot of companies are spending a huge amount of time making sure that you fit with their culture and, of course, in motivating you with large rewards.

Kate: So, Mike, if we accept Luigi’s definition, how would you describe Uber’s culture in this context?

Mike Isaac: Oh, wow. One of my favorite things to talk about, not just in the lens of Uber, but in the way a lot of Silicon Valley companies operate, is this idea that the founders of companies should be sort of worshiped in a cult-like way, right? And a lot of that started with the Zuckerbergs and the Larry Pages of the Valley, right? And so, I think with Uber especially, Travis Kalanick, the main subject of the book or the founder of the company, is the main figure through which all the culture sort of stems from.

Luigi: If you have to distill what that culture was about, in the positive and the negative, what would be the essence of Uber’s culture?

Mike Isaac: I mean, that is again from Travis, it’s just sort of dominate and crush all competition, right?

Speaker 4: It has reportedly been cutthroat in its quest to expand, ordering rides anonymously, for instance, from archrival Lyft, only to cancel them. It employs contractors to lure drivers away from the competition.

Mike Isaac: It kind of didn’t matter what the secondary effects were after that, whether it was systematic sexual harassment of women inside of the company.

Speaker 5: A former engineer is going public with what she says is a frequent problem inside Uber, sexual harassment and sexism. She describes the company as an organization in chaos.

Mike Isaac: Some real dangerous sort of behavior in countries around the world. The leadership didn’t really pay attention to any of the bad behavior inside.

Speaker 6: What we see over and over again, when Uber gets in these PR messes, they never fire anyone responsible. Now, what message does that send if you’re at the company? I get rewarded for taking more risks that frequently involve putting women’s lives in danger.

Mike Isaac: And it was just sort of this idea that growth at all costs was the best, and that’s what they had to care about.

Kate: It sort of sounds like an ask for forgiveness, not permission, type of culture, but don’t even ask for forgiveness. Just look away if anyone comes close to catching you.

Mike Isaac: Well, that was the thing, the forgiveness was just sort of their valuation going up. Maybe we recklessly entered a bunch of new markets, but we’re also worth $20 billion now, or this next month, we’re worth $30 billion or whatever. Their proof was the business plan and the valuation continuing to go up for investors, and Travis didn’t feel like he had to apologize at all.

Luigi: To what extent is this lack of etiquette? To what extent is this doing business in a different way? We know that younger startups tend to be less formal in every dimension, but some of the stuff you say, like trying to crush competition at all costs, being ruthless, looking over the numbers, doesn’t seem so unique to Silicon Valley, certainly not unique to Uber? You are a technology reporter, so you can speak more broadly about other tech companies. Is this an Uber problem, or is it a general problem?

Mike Isaac: Well, this is the thing I debate with a lot of folks in the Valley, too. I think the main ethos is to destroy or at least uproot incumbents. And the idea of disruption for the sake of disruption or for finding a better way is generally celebrated, right? And so, I think the idea for a lot of founders is, you’re not going to disrupt incumbent companies without bending or maybe breaking the rules in a lot of ways.

Some would argue that maybe Uber was sort of following the blueprint that a lot of these companies had already done. Airbnb is probably a prime example. It just sort of burst into real estate and home sharing without any sort of worry about a regulatory framework, and then they created one behind it. I think it’s more about being willing to push or break rules than other companies in other industries, and that the end often justifies the means, and usually that is in a rich IPO or a rich valuation.

Luigi: Let’s remind ourselves that Milton Friedman said that you should maximize shareholder value as long as you follow the rules of the game, which was, in particular, fair and open competition. And when I read Mike’s book, and when I see that there was a surveillance system to get around regulation, that doesn’t seem to me really respecting the Friedman rule, even though there is so much criticism about the Friedman rule, but they are past that and they’re even much worse than that.

Mike Isaac: You know what’s really funny, too, is that one of the main points that one of the biggest shareholders, Bill Gurley, who runs Benchmark, one of the things he said in the letters that they made public and in these lawsuits that they would go back and forth against with Travis is Friedman’s basic point, which is the fiduciary duty of us is to maximize shareholder value.

And that was their defense of removing the CEO at that point. And I don’t know. I think Travis would have probably argued . . . When we were reporting this stuff out and when it was happening in real time, their legal point was there’s no laws around this to begin with. There was no ride sharing framework. It didn’t have laws to ban it, therefore, what we’re doing was not illegal, which is an interesting interpretation of the law, but I think that was his pushback.

Luigi: The other point that I’m worried about is you correctly pointed out that Gurley was concerned about maximizing shareholder value, but he was not equally concerned about following the rules, and in fact, he probably said, “Oh, I didn't know what was going on inside Uber.” But at the end of the day there’s also a lot of willful ignorance, because he doesn’t know, he’s not responsible. Uber pays a fine. In the end, he is rich with his investment.

So, what is the lesson you’re taking from this? Do more of it, right? It would be hard to take any other lesson from this than you break any law you can, and if you are successful, eventually things will patch up.

Mike Isaac: I mean, Travis is a billionaire multiple times over right now. He just sold a bunch of stock in the lockup expiration. He’s got a new company now that he’s working on, that’s, like, virtual kitchens, which is actually very interesting. You guys should look into that, but it's . . . And he’s not been ousted out of polite society in the Valley. He was at the Met Gala the other day. It’s just very much ... There is no real social cost to the way things have gone down.

Luigi: Because if you're a billionaire, but you cannot go to the Met Gala, that’s a problem.

Mike Isaac: That’s when you know you’ve gone too far.

Luigi: Speaking like a true New Yorker, not as a true Silicon Valley guy. As a true New Yorker.

Kate: You’re betraying your roots.

Mike Isaac: I totally agree with the idea that folks join companies and those companies sort of create those values and people fit into what works, but I also think one of the things that is kind of a revisionist form of history for a lot of these companies is creating what they think their values are supposed to be probably after they’ve gotten to scale.

One of the things that I think about in terms of Facebook or Airbnb, another Vice reporter uncovered this scam where dozens of their listings were total scam houses, and their CEO was basically saying, “Look, we’re going to vet every single house on the platform now. This is how we take this very seriously,” but the whole point of getting to scale is the idea that you’re not going to vet any of these things.

You just want as many listings on the platform as possible up front. I think people have to internalize that thinking from the beginning, from when you’re small, and then come back later and then create a more firm set of rules. I agree that the internal culture develops over time, but I also wonder if they just kind of try to rewrite their own history a lot of times, once they’ve gotten to a point of being the one in power.

Kate: Yeah, I think that’s a good point. That’s something I’ve wondered about a lot. Maybe that in the very early stages there’s actually a lot of uniformity across these startups and that it’s just sort of a regular place to work, and it’s only when they really start to explode and break onto the new scene that they try and rebrand themselves as what they think will be sexy.

Mike Isaac: Right.

Luigi: But we have to recognize also that the right culture for a startup is different than the right culture for a more established organization, that things need to change. The right culture for an innovative firm is different than the right culture for a nuclear plant, because in a nuclear plant, safety is number one. You don’t need to be very innovative, but you have to put safety number one.

Safety’s important everywhere, but if you run Netflix, it is less of a concern, and you can afford to make some mistakes. That’s what is difficult, is that you need to have a culture that is appropriate to your business and appropriate to the phase of development you are in.

And I think that that’s a big part of what is happening here, is that many of these firms start very informal with a lot of the natural mistakes that informality brings with it. And once they develop, they need to change. And if they don’t, and they don’t change fast enough, they are scolded, in a sense.

My reading of your book and the story of Uber is a company that did not change fast enough, because it grew so fast. It’s one of the fastest-growing companies, probably in the history of humankind, and it’s not surprising that they got caught a bit off guard.

Mike Isaac: I do think this scale of internet businesses, too. Fundamentally, a lot of these businesses are able to grow so much faster than probably many before, especially probably software businesses. Facebook grew to encompass two-and-a-half billion people in the span of the last 15 years, but most of its hyper-growth was much earlier than that. Uber, in particular, was interesting, because one of Travis Kalanick’s big things was that he never wanted to feel like a big company and actually resisted a lot of the probably normalized corporate processes that you would create once you get to scale.

When you have 15,000 employees, you probably need to create a functioning HR department so they can handle crazy complaints, and I think that’s probably a mistake of a CEO who is inexperienced or doesn’t want to accept what it means to become a big company. My favorite example now is just looking at WeWork and how that whole thing is playing out, too, because it’s like Uber on steroids, basically. But I agree. I think scale, and this is probably more dangerous for internet businesses that go through periods of hyper-growth really quickly.

Kate: There’s this whole shareholder versus stakeholder debate. You have equity holders who own the company and just kind of want to make money for the company at any expense. And then you’ve got the rest of the society. And so, as a manager, being aligned with shareholders, sometimes you can do best by everyone, for everyone, by actually creating new value and innovating and creating good products, maybe more efficiently than other competitors.

But then there’s also a billion different ways in which you can create value for your shareholders that aren’t good for society. For example, flouting regulations. For example, hurting workers or ignoring antitrust concerns. And I think that you touched on a lot of that in your book through a bunch of different anecdotes that highlight the point that there are good ways of making money and there are bad ways of making money. And I think that the corporate culture is important in all of this, because it helps send a message to your employees, “Here are the directions that we’re going to go in, in order to create value.”

And so, if you’re sending a message to everyone, like, just break things and don’t apologize, then that’ll have an impact in the sense that your employees will start moving in that direction of trying to flout regulation. Whereas if you create a different culture that’s just really, we really value PhDs and we really value big thinkers, and we want to give you a lot of freedom, so we’re going to create a happy environment and let you just do whatever you want, then that tells people that they might want to focus more on innovation and creativity.

Mike Isaac: I’m very curious as to what the Uber diaspora of folks who came up at Uber and had that mentality that you’re talking about and now go and leave, they’ve vested their shares, they’ve sold after the lockup that just occurred, and they go and start their own new things.

And there’s a number of little micro-VC funds that are popping up that are being led by these guys, and I’m curious what those companies look like and if they have similar value sets. Uber, of today, is trying to rebrand and say, one of their big cultural points from Dara Khosrowshahi is, we do the right thing, period. They’re basically cleaning up the baggage that came with Kalanick and everything in the past. But I think your point is right, what does that look like and how is that going to look over the next few years? I think there’s a real tension, too, like what some workers want versus how they were taught to act for the past 10 to 15 years.

Luigi: Don’t you think that the real problem here were the venture capitalists, because they are the adults in the room? Those are the people who bring the real money, that know how things get done, who basically hire the talented and brilliant CEO to get the startup off the ground, but they should be the ones that think about putting up the guardrails when this is necessary.

And here, and in general, at least from the literature, we know that traditionally, venture capitalists would ensure having enough control so that the CEO will not become too powerful, and here they fail big time. They fail at the beginning by giving too much control to Travis, but also, he accumulated extra control over time, and they were aiding and abetting up to the last moment.

Mike Isaac: No, that’s exactly right. The VCs were happy to let Travis amass as much power as he wanted, as long as the valuation went up and they weren’t making too many negative headlines. And then you really saw a sort of crisis internally among the board members, among some of the board members and among most of the LPs.

There’s a scene in my book where Bill Gurley was getting calls from his LPs every day saying, “Our investment’s going to go to zero. What are you doing about this?” And so, it’s hard to praise the board members and VCs too much when . . . It’s hard to imagine they were pearl-clutching later on in the game when they had allowed sort of this behavior to go on for years when it was under the radar.

And now what they would say is, “Look, we didn’t know the extent of how bad it was,” or there’s probably a level of rule-breaking or defiance that they have to live with, because that’s just what you invest in. That’s the type of people you invest in, but I don’t know. I’m thinking that mostly they were forced or compelled to intervene when the real danger was their investment being lost later in the end.

Kate: One thing that I found interesting was that, based on the reading of the academic literature in finance, there’s this idea that venture-capital firms and private-equity firms, when they come in, even at an early stage, they take a lot of control and they make a lot of decisions for the firm, especially in areas where they have expertise but the CEOs don't have expertise.

And I thought you characterized it in a slightly different way, which is that the VCs are pretty cautious about taking too much control, because they want to have access to the highest-growth startups, and they don’t want later CEOs and founders to get turned off by the amount of control that they took away from other CEOs.

And so, I wonder, how much of this is really just Uber? How much of it is the way that Silicon Valley corporate culture has changed over time? It was a little unclear to me.

Mike Isaac: Yeah, totally. I think this is really specific to tech in the past . . . probably around the Facebook, Google rise. And so, I would attribute it a lot to the Zuckerbergs and Pages of the world who did not want to go public. The whole point of going public was taking a lot of that out of their hands. They made popular, I wouldn’t say created, but made popular this share structure that over time, as sources of funding became more abundant in the Valley, and you could go to a zillion different family offices or VC firms or whatever, where everyone wanted to be seen as founder-friendly, one source put it to me, like you had to play the game that was on the field. And that game meant giving up more control to the founders over time.

And so, I don't think it’s necessarily that private-equity firms or VC should take immediate control of the reins, because there’s probably a number of examples where good companies have been totally screwed up by that once they come in.

And there are just as many founders who would argue that that’s the case. But in a spectrum of, let’s say, Zuckerberg before 2016 or 2017 was a positive version of complete founder control. And Travis is probably the negative version of that. I think there’s a whole lot of room in the middle to play around there. And so, I wanted to show the lengths to which this super-controlling founder can also be a negative influence, if that makes sense.

Luigi: You said that a lot of former founders were complaining about being kicked out by the venture capitalists. I’m sure that all of them complain, because all of them think that they were great, of course. But looking from a more, if you want, academic perspective, we know that companies need to change, and we know that some people are very good at changing, but they are rare. I think that it’s rare to find a case of a very good founder who’s also a very good manager of a mature company, like Jeff Bezos comes to mind. But they’re one in a million, probably.

And I think that there is a need, if you want to grow, to change the culture of the company, and with it changing the CEO. And in order for this to take place, you need to have the rules, the corporate governance in place. And I think that you described correctly that now the game has changed, that the entrepreneurs are these heroes that have all the bargaining power, and the venture capitalists are desperately trying to find what is the next new, new thing. And, as a result, they stop putting in place the rules of the game that allows them to change when things go out of hand.

And, in particular, the thing I’m very adamantly against are all these super voting powers that Travis had, that Facebook introduced, that Google introduced, that give a disproportionate amount of power to a very few individuals. And I think concentration of power is bad at every level. It is bad in the political realm, but it’s also bad in the economic realm, because people get crazy, especially when they get rich, and you need a mechanism to constrain this craziness, and the VCs of today, they’ve given up on that.

Mike Isaac: I thought Uber was going to be an apex of that. I guess it was probably a naive thought just because, again, let’s go back to WeWork. SoftBank has had to pay Adam Neumann a billion dollars to leave the company because he was so terrible of a CEO. That’s probably the worst—

Luigi: I want that, too, to get a billion for being terrible. That’s a pretty good reward system.

Mike Isaac: Destroying it, right? And I would imagine, or I guess I would hope, that that pendulum is going to swing the other way. But the other dynamic here, and this is specific to the Valley, but SoftBank is coming in with this Vision Fund with $100 billion and is investing crazy amounts of money to get into the startups out there.

If you’re a VC who wants to get into any round, and SoftBank is also putting $100 million or $1 billion into it, it just changes what the game is. A lot of the complaining I hear now is from VCs saying SoftBank is screwing this whole thing up for them. I don’t know what the power dynamic is going to be, but I think it’s going to be even further messed up because of the Vision Fund coming into the Valley.

Luigi: This art of always blaming the foreigners.

Kate: I think there’s also an interesting corollary to be made with a different side of the financing spectrum, which is on the debt side. When it comes to traditional bank lending, what we usually think about is that you have a bank that has a relationship with a firm, and when they want to lend to the firm, they put in these covenants into loan contracts that say, look, the CEOs and the equity holders can’t do certain things that will disenfranchise the creditors or allow the equity holders to run away with a ton of value.

But when you have fierce competition on the lending side and not that many investments to make, then you have this gradual erosion of the covenants and controls in place that allow the bank lenders to have any influence. And so now we’re in this period where people are saying it’s extremely covenant-light, that all the control is in the hands of the managers, and it sounds like this sort of dynamic is playing out kind of across the whole capital spectrum.

Luigi: You both seem to blame competition in the capital market for these things gone wild. I would like to blame lack of competition in the product market. Mike correctly said that the world changed since Facebook and Google took over, and those are the examples of two companies that became very successful by achieving a monopoly in their own segment of the market.

And there are a lot of negative things in that. Number one is that when the price is a monopoly, then you’re ready to do anything to reach that, because the alternative is to be nothing. It's not like, “Oh, I can be second or third place and still make good money.” It is whether I become a superstar multibillionaire or I basically crash my company. And when the choice is between these two things, I think more people are willing to do things that they’re not supposed to do.

The second is that to create this critical mass of customers, then you do need a bit of this personality cult of the CEO. And then it’s very hard to get rid of him or her, most of the time it’s him, because he was crucial to the creation of this big mass. In trying to pursue these lottery tickets, these are basically lottery tickets to hold a monopoly. And in order to pursue that, the capital market is buying anything. If you buy lottery tickets, you aren’t particularly careful in which one you buy, because you can’t tell the difference. And it seems that that’s what VCs are doing this day.

Mike Isaac: I mean, that’s definitely an investment strategy. I think that people make fun of VCs like they just go and have a very luxurious life, but I think it’s actually pretty hard to be a good VC. A lot of the time the investment strategy is kind of just spreading the money pretty evenly, and most of your investments are going to fail. The whole name of the game is your one grand slam makes up for every one of your big misses or whatever.

The other sort of funny dynamic that is, again, post-Facebook and Google is that now companies are being created just to flip to Facebook and Google. Because the game is sort of already lost . . . If you’re trying to operate in a digital advertising world, that’s gone, right?

You can’t compete against . . . and I work for a newspaper, which has basically ceded that market to Facebook and Google. A lot of these companies, their entire business plan is, well, if we’re an ad tech startup, we’re definitely going to probably get bought by one of these two companies. Or, if we’re some consumer product that can tell a plausible-sounding monetization story, we don’t really need to worry about it, because Facebook or Google will probably buy us even if we fail or whatever.

Those are the other sort of things that regulators are looking at right now. I mean, if those aren’t signs of a total monopoly on consumer internet products or at least ad-supported products, then I don’t really know what is.

Kate: OK. This has all gotten pretty depressing. Mike, do you think that there are any good examples of positive corporate culture that’s going . . . where CEOs are going out of their way to make positive changes?

Mike Isaac: So, I’ve been thinking about this a lot, because I don’t like always ending on a down note. And one of the positive things that I’ve been doing on this book tour is talking to a bunch of young startup people, basically a lot of young founders and entrepreneurs who want to build the next company.

First of all, there’s a bunch of whiplash around tech going from great to awful, very quickly in a very short amount of time. So, they’re all confused, but they also harbor some feelings of resentment or disgust around certain companies. If you work at Facebook, it’s not as cool as it was a few years ago. Or maybe young technologists think that’s like—

Luigi: You hide at a cocktail party.

Mike Isaac: Right, exactly. That’s exactly it. You don’t want to put your Facebook shirt on at the cocktail party. That’s exactly it. And so, when I go to these channels—

Luigi: Which is not like hiding from the gala.

Mike Isaac: Slightly lower stakes, oh my God. But they’re asking questions like, “How do I create a good culture? How do I create a company? I want the company that I make to not treat women like objects or very poorly from the very beginning or at every level.” Or, “How do I make sure that we act ethically?” or, “How do I have our ranks represent the kind of company and the kind of products that we want to build early on?”

I think there’s hope in that, in that they’re thinking about these things now, especially because it’s come to such a crescendo in the press and in the way we think about tech companies now. And the other thing I would point out is that there’s a real sort of rise in tech workers to recognize that they have collective power. Unions have been a thing for a very long time, but now these sort of quasi-unions are starting to be created inside of these companies and they’re recognizing that the CEOs have to answer to us in some ways. Not in every way, but they’re pushing back a little bit more in ways that I’d never seen before.

Luigi: At Harvard Business School they created a pledge for students to pledge how they will behave in the future. Maybe Silicon Valley should create a pledge that entrepreneurs choose whether to pledge or not of, I follow the rules, I don’t try to kill my competitors, I do X, Y, and Z. And VCs, if they are serious VCs and they are concerned about their impact, only finance the one who make the pledge. And if you violate that pledge, then you are expelled from the community. I think that that is a private solution to this problem. Since you are a journalist, you should launch this initiative in Silicon Valley.

Mike Isaac: Gosh, I would be very curious who would be excited to sign this and who would not be excited to sign this. But it would be funny. And I do think there’s an informal way of looking at companies now to see who’s above board and who's not.

And it’s interesting to see which investors won’t . . . like, not everyone invested in Juul out in San Francisco. They were still seen as a vice company, and you’ll pay a social tax if you invest in that. So, some of the blue-chip firms would not invest in that, even though the valuation had skyrocketed. I don’t know if there’s ever going to be a formal pledge, but there’s certainly some maybe unspoken code right now that everyone is kind of grappling with.

Kate: I don’t know, Luigi, for someone who’s often very cynical about how markets work, I feel like a pledge just seems like a little bit fanciful of a solution.

Luigi: So, now you are the negative. I’m trying to be positive and to have an effective way to change things. I think a pledge that might actually help VCs discriminate is useful. I think it is worth trying.

Kate: Then it’s not so much the pledge as much as VCs or maybe the government’s willingness to sanction companies that act poorly. You don’t need a pledge to do that. I mean, we already have plenty of examples of companies acting poorly and no sanctioning, no repercussions.

So, Mike, what we often do on the show to wrap things up is to figure out whether the topic was a capital-is or a capitalisn’t, to tie things to our name. Just in general, Silicon Valley culture, do you think that's a capital-is or a capitalisn’t?

Mike Isaac: Oh, man, I’m going to guess it’s probably a capitalisn’t. Yeah, that would be my experience so far.

Luigi: So, what about you, Kate? Do you agree?

Kate: Look, I have sort of a different answer, which maybe could launch a whole new discussion, and this is also a somewhat unpopular opinion, but I just look around me, and I don't think a lot has changed in the past 10 years.

If I just even look around my apartment, I'm in New York right now, and walking around the streets. My laptop is the same laptop that was there 10 years ago. The phone is basically just a tiny bit bigger than the phone that was there 10 years ago. Google Maps existed 10 years ago. All this stuff that I use has been around for the past decade.

And so, if this whole—

Luigi: Not Uber.

Kate: Yeah, Uber is a big change, and I agree that there are some improvements that have been made along the margin. But to me, that was a disruption of local rules and regulations rather than really a new technological innovation.

And so, in terms of whether or not Silicon Valley culture is really bringing about huge improvements to everyday living, I think the answer is kind of no. And so, to then compare that to these horror stories that you hear about discrimination and harassment and the cutthroat work environment, it just doesn’t seem to me like it could possibly be a capital-is.

What about you, Luigi? What are your thoughts?

Luigi: I think that clearly some of the aspects we analyzed today are capitalisn’t, but I think that there is a more positive culture. I think that what I read about Netflix or Amazon in this respect seems to me a positive innovation culture that brings disruption, that is not very coddling, but it does contribute to improving productivity and the economy in general. So, I would not like to throw everything away with the bathwater.

You don't need us to tell you there's something very wrong with the American healthcare system. The real question is: what can we actually do to fix it? Could Democratic candidates Elizabeth Warren and Bernie Sanders be right that Medicare for all would be better? Would a single-payer system fix all the frictions in the industry? On this episode, Kate and Luigi delve into the economics and capitalism of the healthcare debate.

Kate: You don’t need us to tell you that the US has a problem with its health-care system.

Speaker 2: Why does American medicine cost so much, and if we’re going to pay so much for it, why don’t we get better results?

Speaker 3: We have got a huge competitive disadvantage in American businesses, far more important than any tax change in terms of our health-care costs.

Luigi: And the dysfunction of the US health-care system has taken center stage in the Democratic primary, becoming, for many, the central issue of the election.

Bernie Sanders: Every family in America would receive comprehensive coverage as we move to a publicly funded program.

Elizabeth Warren: Health care is a basic human right, and I will fight for basic human rights.

Luigi: Everyone who has ever had to go to a hospital in the United States has felt the fear of getting stuck with an outrageous bill that your insurance won’t cover. Or, even worse, you don’t have insurance at all.

Kate: Have you ever gotten an outrageous bill, Luigi?

Luigi: Yes, actually, I remember when I was a graduate student, my wife had a tubal pregnancy, and we rushed to the hospital to get surgery, and after that I started to receive bills. There was one, there was a second, there was a third, and I never wanted to sum it all up, because it was too sort of shocking, but it was a lot of money, especially at the time, and especially given my finances at the time, it was a lot of money.

Kate: In terms of the actual numbers, here’s another way of thinking about how expensive things are in the United States. The U.S. spends about 17 percent of its GDP on health care, and that’s pretty high compared to most other rich countries. For example, in France, that number is 11 percent, and in Turkey it’s only 4 percent.

Luigi: On today’s episode, we’re going to take the Capitalisn’t view on health care in the United States. What’s the problem? Where does it come from? And, most importantly, how can we fix it?

This is Luigi Zingales from 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.

The current system is not working. And if there is a thing that doesn’t seem to work that well, it is actually health outcomes. If you compare the United States to other countries, you are shocked by how poorly the United States does. Life expectancy is almost 83 years in Japan, 81 in Italy, and only 78 in the United States. Now, you might attribute that to the fact that in the United States people eat too many candies, and they eat butter and not good olive oil, and they don’t drink the good red wine, and they shoot each other. But I think that . . .

Kate: Sounds like you really have Italy in mind as the basis of comparison.

Luigi: No, Japan. But if you look at deaths that should not occur in the presence of timely and effective medical care, in France, you have roughly 50 of these preventable deaths per 100,000. In Italy, 65. In the United States, 103. And even in infant mortality, the United States doesn’t do that well, 6.2 per thousand versus 3.3 for France, 5.5 for Italy and 5.8 for Cuba. So, we are below Cuba in infant mortality.

Let me leave you with one last scary statistic. The top 1 percent in the income distribution have a life expectancy 15 years longer than the bottom 1 percent.

Kate: Now, what’s so puzzling about health care in the United States is that its approach to health care is radically different than other countries in the rest of the developed world. In fact, it’s the only rich country that doesn’t have universal health care. Universal health care itself is a hard concept to define, but it refers broadly to some form of government action that’s aimed at making sure all citizens have access to health care that meets a minimum standard.

Luigi: No country has a pure health-care market or a free health-care market, it is always impacted by the government in one way or another. Now, the question is, why is the United States doing so much worse than all the other developed countries?

Without scaring our listeners too much, I think that the problem is fairly simple. It is difficult to have a completely voluntary insurance system, because young people who are unlikely to have health problems prefer not to insure themselves, and sick people want to insure themselves a lot, so you don’t obtain a good sharing of risk if you don’t force people to get insurance. This is all the debate that we had about the mandate.

Speaker 4: Top Republicans like Finance Chairman Orrin Hatch now have woven a repeal of the individual mandate or the requirement to buy insurance into the Senate tax-cut bill.

Speaker 5: By eliminating the individual mandate, 13 million people, mostly healthy, are expected to choose to go without insurance, driving up premiums by at least 10 percent for Obamacare customers who don’t get government subsidies.

Luigi: Many people feel that it’s very coercive to have a government mandate to have health insurance, but the reality is that the only way not to have a government mandate is to be very strict and let people die, if they get sick and they don’t have health insurance. Now, nobody’s willing to do that. This ex post problem makes it very difficult to have a system work without a mandate.

Kate: I think this question was well answered by two health-care economists, Garber and Skinner. This is from a paper that was 10 years old, but I think that its main lessons still apply today. I’m going to quote from this paper. They say that “the fundamental cause of health-care costs is a combination of high prices for inputs, poorly restrained incentives for overutilization, and a tendency to adopt expensive medical innovations rapidly even when evidence of effectiveness is weak or absent.”

Luigi: Translated, that means that people with health-care insurance tend to consume too much health care and are probably paying too much for what they’re getting. That adds up. And not only that, but there are perverse incentives in even the administration of health care, because there’s very intense lobbying to use more procedures, more drugs, even when these precision drugs are not necessarily demonstrated to be superior.

Just to give you a sense, during the last decade, half a billion dollars was spent in lobbying every year by the health-care industry. In addition, during the 2018 election cycle, members of the industry gave roughly $225 million to federal candidates in outside money groups and parties. This is not to mention the problem of revolving doors. There are 267 former aides who worked for four congressional committees in reforming health care. They now work in the health-care industry.

But the most insidious way, in my view, in which this lobbying takes place is in sponsoring research that, surprise, surprise, finds that the product is extremely useful and needs to be adopted. For example, there’s now a medical recommendation that after a C-section women should be treated with blood thinners to prevent fatal blood clots. Many doctors claim that there’s not really any evidence to support that such widespread blood-thinner use really improves health-care outcomes. Now, what is disturbing is that the recommendation was developed and espoused by a group of prominent physicians called the National Partnership for Maternal Safety, whose parent organization receives funding from makers of blood thinners, also known as anticoagulants.

Kate: Marketing of drugs in the United States is another area that I consider also insidious. Luigi, you quoted the statistic that about half a billion dollars is spent on health-care lobbying per year. Well, that number is on the order of about $4 billion when it comes to the money that’s spent on the marketing of pharmaceuticals as well as medical devices by their manufacturers.

And what’s also disturbing, or more disturbing, is that, whereas in other countries—as well as the United States before the ’90s—marketing is OK, but it’s usually done to professionals, to doctors and health-care service providers, who have a good sense of what drugs are useful and what drugs aren’t, or which drugs are effective and which drugs aren’t. But now, in the United States, a huge amount of money is spent on direct-to-consumer marketing.

Speaker 6: Abilify . . .

Speaker 7: Crestor . . .

Speaker 8: Cymbalta . . .

Speaker 9: With Advair . . .

Speaker 10: Common side effects are dizziness, sleepiness, weight gain, and swelling of hands, legs, and feet.

Speaker 11: Serious, sometimes fatal events such as infections, lymphoma, or other types of cancer have happened.

Speaker 12: So I can join the fun at my family barbecue.

Kate: This started in the ’90s, and by 2002, 81 percent of consumers reported having seen a direct drug advertisement. Just anecdotally, whenever I talk to my friends who moved to the US from other countries, one of the things that shocks them the most is how many drug commercials they see when they’re watching TV as opposed to where they come from, where it’s almost unheard of.

Luigi: Plus, they tend to all be drugs for elderly people, both because elderly people need more drugs, but also because they are the only ones left watching TV, so I think that . . .

Kate: Are you sure those just aren’t the ones that are marketed to you, Luigi? Maybe those are just the ads that you’re seeing.

Luigi: No, it’s any TV. You go from CNN to whatever TV program I watch. I only watch news on TV.

Kate: Maybe that’s why.

Luigi: You get bombarded by medicines for old people. Now, you might say that I belong to that category, but that’s a different story.

Kate: Now, there are a bunch of economic issues that also arise in terms of the relationship between insurance companies and pharmaceutical providers. If you are an individual and you’re trying to bargain over the price of a drug, chances are you have no bargaining power whatsoever. But the more concentrated the insurance market becomes, and I guess the ultimate form of concentration is what we call single payer, where there’s just one government that’s negotiating with drug providers, the more power the insurance companies have to negotiate over the prices of those drugs.

Economists call this monopsony power. Usually we think about monopsonies in the context of companies having control over wages, but in this case, monopsony can be a good thing for consumers, because it means that whoever’s providing them with insurance is negotiating with drug providers so that they get drugs or health-care services at the lowest cost.

Luigi: Actually, you said it can be good for consumers. It definitely could be good for government finances. Whether it’s good for consumers or not depends on your view of how much of that surplus is necessary to provide the research and development and how much is not. Because if you were able to extract 100 percent of the surplus out of the pharmaceutical industry—hard to imagine these days, but imagine you could—maybe they would stop investing and buy stock. If you stop investing, you will not get the improvement in medicines that we observe today.

We know, for example, that the price of insulin in Canada is one-third of the price of insulin in the United States. The reason is that the Canadian health-care service has bargained hard and reduced the price of insulin. So, at the very minimum, we can ask ourselves why, as Americans, we want to subsidize research and development for the rest of the world. And, if you think about it, with subsidizing research and development for Africa, we say that’s fine, because they’re poor and maybe it’s our duty to do so, but subsidizing R&D for Canada or Japan or Germany, that seems to be a bit crazy.

Kate: Yeah. And Luigi, you mentioned extracting surplus, and it also takes place directly whenever drug manufacturers or health-care service providers interact with consumers who don’t have insurance. So, if you’ve been in the sticky situation of not having insurance and having to go to the doctor or the hospital, you’ve probably been stuck with a crazy bill, I mean, on the order of tens of thousands of dollars. And sometimes you look at that bill and you’re like, wait, why is the bill for me higher than the total amount that would have been paid from myself as well as the health-insurance provider if I had health insurance? And this goes back to the idea that health-insurance companies have monopsony power, and so they’re able to bargain over the prices of the services that are provided, but individuals don’t, which is why individuals without insurance are, in some sort of perverse, contradictory way, stuck with an even higher total bill.

And what happens is that they usually don’t end up paying that full amount, right? So, if you don’t have insurance and you get a $100,000 bill, chances are you’re not going to have to pay that full $100,000. There are ways that you can negotiate with the hospital or the doctor. But what that effectively is, is a way for service providers to price discriminate against individuals who don’t have any health insurance. They can extract the full surplus from these individuals. And so, they start with the highest price possible, and then they cut that down to the maximum amount that each person can pay.

One last thing has to do with taxes. There are perverse incentives that are created by the tax system as well. This might not necessarily lead to higher costs, but it does lead to a higher administrative burden. As Luigi mentioned in the beginning of the show, when he had to go to the doctor for his wife’s early pregnancy, he got hit with bill after bill after bill from different types of doctors.

And this is because, for very highly paid individuals, physicians and specialists included, the tax code incentivizes them to be independent contractors rather than hospital employees. So, of the best-paid doctors that you might come across in your lifetime, chances are they will all be individual independent contractors, sort of like they run their own little consulting businesses and provide consulting services to the hospital. This creates this administrative mess and makes things pretty stressful and complicated for the consumer, because you don’t really know how much you’re going to be charged, because you’re working with 12 different entities rather than one hospital.

Luigi: The bottom line is that the health-care market is filled with frictions and market failures and problems.

Kate: So, what can we do about this, to borrow from Bernie Sanders, huge quagmire of a situation?

Bernie Sanders: 500,000 Americans are going bankrupt. You know why they’re going bankrupt? Because they suffered a terrible disease, cancer or heart disease.

Kate: At least as of the time of this recording, there are a ton of Democratic candidates still in the running. Most far left, I would say, are Sanders and Warren. They’re pretty much on the same page when it comes to health care.

Bernie Sanders: Every study done shows that Medicare for All is the most cost-effective approach to providing health care to every man, woman, and child in this country. I wrote the damn bill, if I may say so.

Kate: They both believe in universal health care under a single, government-payer system.

Elizabeth Warren: There are a lot of politicians who say, oh, it’s just not possible. We just can’t do it. We have a lot of political reasons for this. What they’re really telling you is they just won’t fight for it.

Kate: And they want to do away, for the most part, with any opportunity for private health-insurance providers, because they think that that will distort the transition into a single-payer system. Now, assuming that that doesn’t get passed, they do support a public option, which means that if you can’t afford health care or if you don’t have insurance, then you should be able to buy into a state exchange that would normally only be available for low-income people. And on the price side, both Warren and Sanders support the idea that the government should produce generic drugs.

Luigi: On the one hand, Sanders and Warren want to obtain the benefits of a single-payer system, where everybody is covered and where you have the maximum amount of risk pooling. In order for this to take place, you need to ban not necessarily every form of private insurance, but certainly any form of basic private insurance. So, you might go to a country like France, where you can have private insurance, but its private insurance is for the stuff on top, not for the basic coverage. This move will generate a lot of turmoil, because on the one hand, you will have a lot of people who get deprived of the existing health-care system they have, which many people are happy with, and they will all be put in the same pool of insured, so treated in the same way.

The second big issue is, of course, how to pay for this. And the third is, how much does this impact the supply of health care? Because, if you simply subsidize everybody or provide insurance to everybody, but you don’t do anything to the supply, then the cost will skyrocket. And so, what you need to do is also do some intervention in the supply.

Now, the idea of producing generic drugs is a little bit in that direction. But let’s remind the listeners that in the United States, the number of doctors is fixed by law. The number of seats in medical schools is fixed by law. So, the supply of doctors does not respond to the market. At the very minimum, if you expand demand, you have to expand supply at the same time. Otherwise, we know from economics 101, what you would observe is a huge surge in medical doctor prices. And we know by international comparison, the doctors are already much better paid in the United States than in other countries.

Kate: So, I personally am a fan of this proposal. I think that it hurts rich people. Certainly, the top 1 percent, maybe more than that, maybe let’s say the top 10 percent, and that’s because they don’t have or they won’t have the option for private insurance.

Now, I have been on Romneycare. For a little while, I lived in Massachusetts and didn’t have any health insurance, and so I relied on the state-provided universal health insurance within Massachusetts, sometimes fondly termed Romneycare. And the few times that I had to see the doctor, I thought that the experience was completely satisfactory. You know, the waiting rooms were sort of dingy, and the lines were longer than when I had nice school-provided insurance. But for the most part, I was pretty thrilled by how efficiently it worked. I know that that’s just an anecdote, but it’s not like people are going to be waiting in lines around the corner and being deprived of key resources just because this goes to a system that would take care of everybody.

Luigi: But sorry, Romneycare was a public option. It was not Medicare for All, and it’s not that you eliminate the possibility of private insurance.

Kate: Oh, sure.

Luigi: Because I think that the controversial point is that one, and in particular it’s controversial, in my view, in the Warren proposal, because she went through how you pay for it. And one way she says she’s going to pay for it is that she’s going to basically take away all the money that your company’s paying for your health care and put it in the pool to finance everybody else.

So, if I am paying less because I have very good care, in the Warren proposal, I find that the next day that I will be still paying less, but I will have the same insurance as everybody else. So, it is a form of, if you want, mild expropriation of the people who currently have chosen to have less compensation and more health care.

Kate: Yeah, to the extent that it is pegged to the current system of paying for health care, then I would call it redistributive rather than expropriation. But sure. People who are opting for better health care now will still be paying similar amounts but would be receiving the public option under this plan.

Luigi: No, but sorry, it is a bit of expropriation, because generally taxation is based on some principle of ability to pay. This is randomly chosen depending on who employs you. So, it’s not necessarily that you are redistributing from the rich to the poor. On average, you’re going to do that, I agree.

But in practice, there is a lot of redistribution that takes place depending on who is your employer and what choices of health care this was done. And I think that that’s a bit crazy and will generate an enormous amount of bad will. I think people are subject to a status-quo bias. If you take away what they have today upfront, this will make their resistance enormous.

Kate: Well, yeah, I think that that’s the reason that the resistance is enormous and that it’s unlikely that this sort of health-care reform will be passed. But I think that it’s worth pointing out that there are a number of countries where this is the status quo already, and they seem to be perfectly fine with it. Countries where there’s an option for private insurance, but not that many people take it up, because the universal public health-care program works quite well. I think it’s just a matter of people in the US transitioning poorly. But that doesn’t mean that the system itself is a bad one.

Luigi: No, no. You need to distinguish between what is the optimal point at the end and how you get there. But how you get there, the transition phase, is not irrelevant. I might say that we shouldn’t have any coal miners in the world, because coal is polluting, but I cannot say F– you to all the coal miners and ignore their pain, because tough luck, it is a transition phase. Or I can say that free trade is better, but we do know that along the way it hurts a lot of people. So, the transition phase is very important and should not be ignored.

Kate: I don’t know, maybe you could argue that in this case the transition phase affects more people, or it would be longer, and so it’s more painful and deserves more consideration. I think the transition phase is important insofar it’s the reason that health-care legislation isn’t being passed, but I still think it’s important to think about the optimal.

Luigi: Yeah. But, for example, I think that the optimal is a system of universal, single-provider health care for the basics and some option of getting additional health insurance for more sophisticated things or better treatment. But I don’t think that going cold turkey from one to the other is a good idea, and there are a lot of other things that need to be done to make this transition, because in other systems you have some major form of rationing to avoid the overpayment of medical services, and you have a lot of restrictions in marketing and lobbying. Now, in the United States, if you do universal health care, with no restrictions, free lobbying and free marketing, you end up with 30 percent of GDP eaten up by health care and quality that is not much better. So, we need to be very careful with the transition.

Kate: I think we’re basically the same page in the sense that, yes, in this ideal world, universal single-payer is the right answer. The point being that if we move to this universal system, that doesn’t solve all the problems in the United States. In particular, it doesn’t bring prices down, to the extent that those prices are linked to administrative burdens or linked to high doctor salaries or linked to lobbying or linked to marketing. All of those things are problems that are particularly severe in the US that won’t be solved with a universal health-care, single-payer provision of insurance.

Luigi: So, how do you think that these can be solved?

Kate: Through a slew of regulations that are aimed at how much health-care companies, number one, can spend on marketing. Direct-to-consumer marketing of drugs should be, for the most part, banned. One of the policies that I support on the Warren and Sanders side is to have federal production of generic drugs. This is something, by the way, that Buttigieg and Biden don’t support.

Luigi: This provision is to fight cases like that of one of the most-hated men in America.

Kate: Shkreli. Yeah.

Speaker 13: You may remember the name Martin Shkreli. He’s the hedge-fund manager who jacked up the price of a lifesaving drug back in 2015.

Speaker 14: One tablet of Daraprim used to cost $13.50. The drug maker recently increased the price to $750.

Luigi: In a market where the buyer is the government or health insurance that has the mandate of the government to provide the service, demand is completely inelastic to prices, and so, there is a strong incentive for a producer to jack up the price to the highest number he can get away with.

Shkreli became infamous only because he did it with gusto, but the pharmaceutical industry does that on a regular basis every year. The idea of at least threatening to enter into production of those drugs might be a useful way to try to reduce prices, but I think that it’s not going to solve the problem generally if the government is not willing to be a tougher bargainer.

Kate: Yeah, I think it’s worth mentioning that there are ridiculous regulations in the United States that prevent Medicare or the federal government from being able to negotiate and bargain with pharmaceutical companies over the price of drugs. And this is something that, across the board, all of the Democratic candidates want to do away with. I think it’s worth pointing out that there are similarities across the candidates on some measures.

Luigi: But I want to point out to the listeners that there is a reason why this legislation was introduced, because at some point, when you expand demand by the government massively, you are in a situation that we call in economics a bilateral monopoly. On the one hand, you have only one buyer. On the other hand, you have only one seller, especially for drugs that are under patent. And so, there’s only one producer, and we in economics have basically nothing to say about what the price is going to be in a bilateral monopoly. We only know that it’s in a range, but this range is huge.

And so, on the one hand, people are concerned that the government is too aggressive, extracting all the surplus, and by extracting all the surplus, it will demotivate pharmaceutical companies from investing in new drugs. On the other hand, the opposite concern is that the government is completely captured and the pharmaceutical industry extracts too much surplus, and as a result, you have a distortion of all types, including the fact that we have a large deficit.

But we need to realize that it does become an issue. As you expand the role of the government, like either the public option or Medicare for All will do, you are going to have this problem again in every sector, including in many cases for doctors, because the government will be the largest purchaser of medical services, the largest employer of doctors, and it will set the price of doctors, and as a result you might have a shortage of people who want to become doctors.

Kate: I don’t think it’s entirely ridiculous, because the situation that you just described, the one where markets break down or economics itself breaks down, right, this bilateral monopoly. That’s created by the government in the first place because of the patent protections that are granted by the government, and so I still think it’s ridiculous for the government to be like, OK, so we’re a big purchaser, that’s not fair, and then there’s only one provider, which we have created by keeping out all other providers. And so, because this doesn’t make sense from an economic perspective, we’re just going to tie our hands and eliminate our ability to bargain. That is just a silly system. It’s basically just giving a direct handout to these companies that are innovating, and yes, innovation is good, but if we want to be incentivizing R&D, we should be doing it in a better way.

Luigi: No, I agree. But you know, as we are going to expand the role of the government, this is going to become a bigger and bigger problem. For example, for doctors, I have witnessed in Italy basically a generation of doctors being expropriated, because all of a sudden, the government decided to lower the prices. And for a while, this was great, because the government was able to buy doctors’ services at a cheap price. And you know, if you have gone through medical school, it is unlikely that all of a sudden you are going to leave the profession and do something else. But fewer and fewer people actively enter medicine. In my generation, very few people became doctors, because the return to being a doctor was very low. And now, in the future, as the older generation is retiring, Italy is facing a problem of doctors, because too few people chose to become a medical professional.

Kate: I think that that’s a fair point. But once again, in the US, the government is intervening, it’s requiring people to have medical licenses in order to be doctors. The number of people who are getting these medical licenses just isn’t keeping pace with the number of people who demand medical services. And so, that’s part of the reason why the salaries for physicians have been going way up. And so, as long as this barrier to entry exists, and the government isn’t explicitly price-fixing, we would expect that there should be some rents to be earned by doctors.

Luigi: And there are. But what I’m saying is, be prepared that if you go into Medicare for All, then you also have to start subsidizing medical school or start to massively import doctors from Cuba, which is a great solution for the United States but is not a great solution for the world. But it is an issue that you need to think about. The system is very complex. There are so many frictions that once you move one part, a lot of other things need to be changed.

Let’s have a discussion about cost. Bernie Sanders has not even tried to provide a cost estimate. Elizabeth Warren has tried, but I think it is a bit put together with a lot of hope. First of all, she decided overnight to double the wealth tax. When we had our episode about a wealth tax, I said the danger of introducing it is that it is going to go up, and it’s not been introduced yet, and the demand has already gone up. So . . .

Kate: And I said that there should be caps, by the way, but caps that are like 10 percent. I agree that we also need to be realistic about this transition period and that costs are a huge component of that. I don’t think that we can just switch to single-payer, universal health care without a private option overnight. Not only is this fantastical from a political perspective, but it would mean that the government would be paying for all of the rents, as you said, that the pharmaceuticals and the health-care service providers are already extracting.

I think that we need an interim period in which there’s a public option for people who don’t already have health insurance, where they can buy into Medicaid programs that are pretty low-price. And in the meantime, the real focus of the government should be bringing these prices down, before we switch over to any single-payer system. So that means, you know, restrictions on marketing. It means limitations on lobbying. It means training more doctors and essentially removing all of the administrative burdens and frictions that give rise to all of these rents that can be expropriated along the way.

Luigi: I will add to your series of proposals that should be implemented along the way a more rigid system of authorization of new procedures, where proving that it is marginally better from a medical point of view is not enough. There should also be a cost-benefit analysis, in the sense that if I am an epsilon better but enormously more expensive, it is not obvious that my medicine or my procedure is better, because you’re not factoring in the cost.

In addition, I would be very aggressive against the cosmetic changes of medicines designed only to charge higher prices. We know that basically there is no difference between Nexium and Prilosec. Those are two medicines for reflux, and Nexium was introduced only because Prilosec was running out of patent protection. Nexium was aggressively marketed to all the doctors and to all the health-care organizations to try to get into the prescriptions and be able to charge higher prices. I think that this practice should be eliminated, because it’s pure dissipative rent-seeking.

Kate: I agree. One final point that I’d like to make is I think one of the hardest issues to address is how to incentivize meaningful innovation in the pharmaceutical industry and the fact that this burden in large part rests on the US right now. That means that US citizens are subsidizing global innovation and health-care services. I’m not an international policymaker, and so this is sort of pie in the sky, but I think that there should be some sort of international coordination when it comes to the funding of scientific research. And I think that the US should send a message that it needs global participation. We can’t just keep bearing this burden on our own, because it’s ruining our politics.

Luigi: But what is interesting is to see how much the debate has changed in nine years, because when Obamacare was under discussion, only the most radical Democrats were supporting the public option. That was actually taken out of the proposal, precisely because there wasn’t really very strong Democratic support. And now, the most conservative Democrats are supporting a public option, and what I understand is the majority, or at least the plurality, of the Democrats are already way past that. And I think that that’s a sign of the discontent that is spreading in America about the health-care system.

A common theme on our podcast is whether shareholders have too much power. But if we were going to redistribute that power, to whom should it go? Two recently proposed rule changes at the SEC would transfer more power to CEOs. But do we really want to empower managers to operate with less checks and balances? This week, Kate and Luigi sit down with SEC Commissioner Rob Jackson to talk through these issues and debate the proposed SEC rules.

Kate: A common theme of Capitalisn’t over the past few weeks has been whether shareholders have too much power. That is, whether corporations end up maximizing shareholder value at the expense of employees, consumers, creditors, and members of the community.

Luigi: One way to address the issue is transferring power away from shareholders to managers, and that doesn’t necessarily empower the other groups. It could end up giving CEOs full reign over the corporate landscape without any checks and balances.

Kate: One of the things I’m always afraid of is that there are rules changing in the background. Rules that might have a serious impact on how markets work, but they don’t get much attention from the public.

Luigi: We may be living through one of those moments now. While there is attention being paid in the media to voter suppression in presidential and Congressional elections, and rightfully so, there is less attention being paid to voter suppression in corporate elections.

The Securities and Exchange Commission, the agency in charge of regulating American corporations, is in the process of changing some of the key rules in corporate voting. And I claim that some of these changes may have more impact than changing the gubernatorial election. The power of Facebook is probably bigger than the power of the state of Arizona. Sorry for the people from Arizona.

Kate: On today’s episode, we’re going to explain how shareholder voting works, and discuss whether the new SEC rules could have unintended consequences.

From Georgetown University, I’m Kate Waldock.

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

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

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

Now, who better to discuss the new SEC rules than an SEC commissioner?

Kate: Today, we are incredibly lucky to be joined by Commissioner Rob Jackson, who’s also a professor of law at NYU Law. Rob, welcome to the show.

Rob Jackson: Thanks so much for having me.

Kate: All right, so let’s get to shareholder voting. The first thing to be clear about is that CEOs in the United States, they have a lot of power. But there are a couple of checks on this power, and one of those checks is through the board of directors. And the other check is through the annual meeting that every public company in the United States has to have, where shareholders can vote on various proposals, some of which are put forward by management and some of which are put forward by the shareholders themselves.

You don’t have to attend the annual meeting to actually vote, because often it’s in expensive places, and you have to pay for your plane tickets and stuff. So, rather than attending the meeting, you can just mail in your vote and vote by what’s called proxy. This used to be done by snail mail, but now it’s for the most part electronic.

On today’s episode, we’re going to focus on shareholder voting. To talk about this, we should go back to a time, let’s say the ’70s, when managers definitely had way too much control. But Rob and I probably don’t remember the ’70s very well. I think, Luigi, you are our best bet. So, can you tell us about the corporate landscape in the ’70s?

Luigi: OK, let’s be clear here. I was a little kid in the ’70s, let’s not exaggerate how old I was. But because I was interested in corporate governance from an early age, a very early age, I can tell you from experience. I think that the so-called shareholder revolution started in the early ’80s. In the 1970s boards were still incredibly large, filled mostly by insiders, and the CEO was extremely powerful. The only attempt to break into the corporate arena was done by political activists that were fighting to stop the Vietnam War. And so, you had some proposals to vote at shareholder meetings regarding banning the production of Agent Orange, or stopping supplying ammunition for the Vietnam War, or stuff like that.

Some of the SEC rules come from a period where shareholders’ proposals were seen as just a way to break the peace and harmony and efficiency of the corporate arena for political purposes that have nothing to do with the company itself.

Rob Jackson: Well, certainly in the 1970s, that was a very consistent theme of concerns that were raised and the SEC rules that were designed to address these considerations. But then, in the 1980s, we had the emergence of the takeover wave and a number of disciplining forces entering the marketplace to try to check the power of CEOs, which was being used at that time to build large corporate empires or for perquisites or salaries that didn’t make sense from investors’ point of view. But activist investors in the ’90s and the early 2000s and even over the last decade have been arriving on the corporate scene, demanding change from CEOs and corporate boards, and in many cases getting it.

So, there has been some success in checking CEOs through the activist investing and shareholder proposal process.

Luigi: But most of this effective intervention takes the form of replacing people on the board or replacing even an entire board by an activist investor. When it comes to proposals to direct corporate policy made by shareholders, most of them don’t receive the endorsement of management, and most of them don’t get approved. In fact, in the last proxy season, 2019, only 14 proposals made by shareholders won support.

One was actually a proposal by a Catholic-affiliated investment service, asking Walgreen to compile a report on the reputational risk stemming from opioid sales. The other was a proposal by a social investing fund asking Travelers to produce a report on its workforce diversity. But things are on the verge of a change. For example, a proposal to force disclosure of lobbying by Walt Disney, made by some investors, reached 39 percent of Disney shareholders. Which, of course, is not a majority, but it is pretty close to a majority. And so, I think that the world is changing, or at least it’s about to change.

Rob Jackson: That’s right. One question you might ask if you were an ordinary shareholder is, “Hey, who decides what actually gets voted on in in a shareholder meeting?” And the answer is that the standard corporate governance proposals are often brought by significant funds, public policy groups, religious orders, institutional investors who want to bring forward corporate-governance reforms.

Now, as I noted in a statement that I issued last week when the SEC changed our rules, it’s also well known that a few individuals actually dominate these annual shareholder meetings. They’re sometimes derisively referred to as shareholder gadflies. In fact, some statistics would say those individuals bring as much as a majority, or even more, of the proposals at any given shareholder meeting.

Kate: Luigi, is there not a story about a gadfly that you might know off the top of your head?

Luigi: Oh, there are a lot of stories about gadflies. In fact, I thought this crazy stuff happened only in Italy, where I saw some of these guys in action. No, it also happens in the United States. The most famous one is actually a woman, Evelyn Davis, who started to make proposals in the late ’50s. Basically, she made a good living by selling a publication that was not particularly valuable, but every corporation was subscribing to for the price of $600. Why? Because that was a way to mollify her, to make sure that she wasn’t raising a controversial issue at the shareholders meeting.

So, with a thousand subscriptions from a thousand corporations, she was making $600,000 a year. That was not a bad salary, especially back then, just to make proposals as a threat point and cash in on the side.

Kate: Yeah. So, who are the types of people that would use these sorts of information sources? Going back to the individual voting issue, voting can be hard. It can be hard as a shareholder to know what’s even on the ballot or what’s going on behind the scenes of the company, or which way you should vote, if you even do want to vote. And oftentimes, as a shareholder, you just have too many different companies that you’re invested in. For example, I don’t have that much money in the stock market, but I have a little bit through my retirement account, which is managed by, I think, Vanguard. But I don’t even know what stocks I hold, let alone vote those shares myself.

There were a couple laws that are relevant to this. One in 1988, which was enforced by the Department of Labor. They declared that it was part of the fiduciary duty of managers of plan assets to actually vote the proxies of their investors. And then there was another rule in 2003, an SEC rule, that extended a similar duty to mutual funds as well as other types of retirement plans. And so now, the way that it works is, if you have your money invested in a mutual fund or in some sort of retirement fund, you’re not going to vote those shares yourself, you’re going to have the fund vote them for you.

Now, the fund doesn’t want to get in trouble for voting the wrong way, and they also need to have information about how to vote. And so, they typically refer to pieces of information, newsletters, like the ones that Luigi mentioned earlier, and in general, proxy advisory services to make these decisions for them.

Rob Jackson: That’s right. And these proxy advisory services have played an increasingly important role in helping shareholders cast their votes. And the marketplace is dominated by two large firms, ISS and Glass Lewis, who are sometimes estimated to have as much as 97 percent of the proxy advice market.

One of the things that’s been challenging for me is to watch the debate in Washington unfold about these advisors, because there is really no target of corporate and executive disdain as intense as the proxy advisory firms. It is impossible to escape a cocktail party in Washington or New York without having somebody angrily talk about the role of Glass Lewis and ISS.

And I guess my reaction is to think that the more information investors have about how to cast their votes, the better, especially, Kate, because we live in the world you described. A world where the ordinary investor is diversified, has few incentives to invest in corporate governance or oversight or to pay attention to corporate management, and therefore, the more advice we can give otherwise rationally apathetic shareholders to participate in corporate governance, the better.

Luigi: Can you tell us about the new rules that the SEC has proposed? And, by the way, there are 60 days to object to those rules, so people have time to submit some objections. How are those rules going to change the way in which the market for proxy advisory works?

Rob Jackson: Well, Luigi, you are right. There are 60 days to comment, and I urge all of the listeners and both of you to come forward with new data on this.

Kate: Wait, sorry. Can I interrupt really quickly? If people comment really negatively, does that mean that the rules won’t pass?

Rob Jackson: Not necessarily, but we are required by law to read and review and think through every comment. And I can promise you, even when I disagree with my colleagues, we try very hard to engage with the evidence we get from the marketplace.

Luigi’s question was, how will this affect ISS and Glass Lewis? And the answer is clear. What the SEC rule does is impose a tax on antimanagement advice. If ISS or Glass Lewis wants to recommend in favor of management, nothing changes. Under the new rules, more or less they can proceed in the same fashion. But if they want to recommend against the CEO, if they want to make a recommendation that management does not agree with, then they must do the following. They must check with management before they provide this advice to investors. They then must take feedback from management. And by the way, if management doesn’t like the proposal, trust me, they’ll have feedback.

Then they have to send the advice to their clients but have to include, in many cases, a link to management’s view in their final advice. And, by the way, they must do all of this with the threat of federal securities liability if the management doesn’t like their methodology, their approach, the data that they used, et cetera. And we all know that the threat of serious federal litigation obviously tilts the scales and the kind of decisions folks make. So, the answer is, what the SEC’s proposal will do if it’s adopted is simply move advice toward management, because it will tax antimanagement advice from proxy advisors.

Kate: I’m not a lawyer, but this seems to me like if you had a regular court case, and you have a plaintiff and a defendant, and a new rule is passed that the plaintiffs have to submit everything they know and everything they’re going to argue to the court, and the defendants get a chance to see all of that, but that the defendants don’t have to do the same sorts of actions. Do you think that that’s a fair analogy?

Rob Jackson: Yeah, I think it is. Or another way to think about it is, suppose we were looking at . . . Do you use the website Yelp?

Kate: Yes, of course.

Rob Jackson: Yeah. So, I like Yelp. It gives you very interesting feedback on the places where you can eat. It’s a little bit like the customer having to check with the restaurant before posting a review to Yelp. Oh, look, we can debate whether or not that would lead to more or less accuracy, but for sure it would lead to reviews that are more favorable to the restaurant’s management. Whether that’d be good or bad for consumers is a separate question.

Here’s what I would say, Kate. I hope the Department of Health and Human Services does not adopt such a rule, because I don’t think it’s the role of those who would protect ordinary consumers to tip the scales in favor of management.

Kate: There is also this other proposed rule change that has to do with the resubmission of shareholder resolutions. Can you explain that, and can you explain what the rule is really about?

Rob Jackson: Sure. So, our second package of rules in this area would take the required vote on a shareholder proposal and increase it if you want to resubmit it in the next year. For example, suppose you would submit a resolution this year and it gains only 4 percent support. The question is, could you resubmit it next year? The answer until this rule was adopted was yes, you could. Going forward, the answer would be no, you could not.

Now, a question you might have about this is, look, Rob, if the proposal only gains 4 percent support, maybe it’s a good idea to get it off the ballot, because it’s obviously not one that investors like. But this makes an assumption. It’s a little bit like a workshop paper that has a weakness. It makes an assumption that we should spell out. The assumption is that the short-run voting results reflect the value of the shareholder proposal, and I don’t know if you noticed, but when Luigi spoke earlier, he pointed out that even proposals that don’t get majority support still can draw very substantial amounts of shareholder support and still be ones that are value-enhancing. Rather than just look at the vote total, I think we should look at the long-run value implications of proposals, and the answer is that the amount of vote results in the first or second vote is not necessarily indicative of whether they’re good proposals. And that’s why I dissented from those rules.

Luigi: But let me play devil’s advocate here for a second, because of course there is a risk of blocking some reproposals. There’s also a cost of having a lot of gadfly proposals repeated year after year without much of a following and without much of an effect. And my fear is that too many of those gadfly proposals actually make it difficult to create the space for serious discussion on the other ones. And my understanding of the new rule is not that it prohibits the representation, it just delays it by a few years. And so, if this is a long-term benefit, the long-term benefit might manifest in the long term.

So, even if I cannot propose it in the next year, in two or three years, I can repropose it. It’s a bit like with a referendum for Scotland’s independence. You propose it, but you don’t want a referendum every year. If the referendum does not win, you want to at least not repropose it for the next X number of years.

Rob Jackson: Luigi, I guess my question to you is, how long should investors have to wait to increase value? Because for me, to the degree we think it’s a value-enhancing proposal, we don’t want to knock it off the ballot. And, by the way, these new rules knock it off the ballot for three years. That’s a substantial amount of time to ask investors to wait. And by the way, Luigi, let me just be clear, my colleagues’ proposal, in my statement, I said this is like swatting a gadfly with a sledgehammer. This would not just exclude the gadfly proposals you’re worried about. No.

Also, we showed, we presented new data in our statement that 40 percent of proxy access proposals that allow investors to put their own candidate on the corporate ballot, those would be thrown off by this new rule. Fifty percent of shareholder proposals that would require CEOs to keep skin in the game, those would be bounced off the ballot.

So, I agree with you, Luigi, that we have to manage and balance the costs and benefits here. But I would propose a rule that would address just the Zingales gadfly problem rather than take valuable corporate governance innovations off the corporate ballot.

Luigi: So, what would be your rule if you were the chairman of the SEC?

Rob Jackson: I would develop a rule specifically targeted at this problem. For example, Luigi, there have been many proposals in this area that would say that a particular kind of shareholder should be limited in the amount of times they can access the ballot in a particular year.

Or, if you prefer, I actually like a private ordering solution. You could give to issuers, to companies, a basis to exclude a proposal on a gadfly exclusion and say, look, we believe that this proposal is not of the serious type that Luigi has described in the podcast. Instead, it is a gadfly proposal, therefore we wish to exclude it from our ballot. And the SEC staff could weigh in on the appropriateness of that, like we do for every other kind of exclusion for shareholder proposals.

So, I think there are lots of very tailored ways to deal with this problem. Unfortunately, my colleagues went so much further as to get very basic corporate governance innovations like proxy access off the ballot at many companies.

Luigi: One thing I don’t understand is why there wasn’t more of a decision to use the size of the support for the proposal as a criterion. Currently, if I understand, you have to have $2,000 worth of stock and to have held it just for a year. So, it’s very low as a threshold. The threshold is going up. Either you have $2,000 for three years, or you have $25,000 for a year or something like that. If I require a larger threshold, as long as I can allow people to coordinate and sign onto this, and I keep actively the holding period shorter, because the holding period is a way to make it more difficult for institutional investors to get involved, why isn’t this a way to penalize the gadflies, but let proposals that have a significant amount of following to be on the ballot?

Rob Jackson: Oh, I think it would, Luigi, these are good ideas. One thing to be clear about from the proposal that was made last week is that it prohibits aggregation of individual stakes so as to cross the particular thresholds. So, it rules out the—

Luigi: It prohibits . . . no, let me stop here. It prohibits the aggregation of different stakes?

Rob Jackson: Absolutely.

Luigi: Why?

Rob Jackson: If I had the answer to that question, my friend, I’d be in the majority, not the dissent. Look, for me, this is what I mean by a swatting a gadfly with a sledgehammer. These are not tailored solutions to the particular economic problems that we are facing, a balancing of costs and benefits. This is just, full stop, making it harder for shareholders to bring proposals and making it easier for CEOs to navigate the annual meeting.

By the way, here’s what’s so frustrating to me. Luigi, I know you know. There’s lots of very good scholarship making promanagement arguments for why we should make it harder for investors to intervene.

I’d love to have that debate with my colleagues. We can have that debate on the podcast right now, but we should come forward and say what we are doing. What we’re saying is we prefer to trust corporate managers and grapple with the agency costs than to allow investors to have a say. If that’s the choice we want to make as a society, we can make it, but we should call it what it is.

Luigi: Yeah, but this looks like the old restriction against gatherings that the monarchs in Europe used to have in order to prevent democracy from spreading.

Rob Jackson: Well, without commenting too much on that, here’s what I’ll say. I think it’s very frustrating for shareholders who have been participating in this process for a long time, because it doesn’t feel like a solution for a particular problem. It just feels like tipping the scales toward management. Look, these are areas with very strong intuitions. People have very strong views, and what I try to do is say, look, the fact is we’ll be taking 40 percent of proxy access off the ballot. We’ll be taking 50 percent of share retention proposals off the ballot.

And whatever you think . . . Maybe you think that’s a good thing. We can have that debate, of course, but let’s just agree that that is what we are doing. We are not solving the gadfly problem. We are going much further than that.

Kate: Let’s talk a little bit about market power. Going back to some stats thrown around earlier, it seems like ISS and Glass Lewis, basically the only two proxy advisory firms that operate in this market, they are an oligopoly. Maybe ISS is even a monopoly or bordering on that. Is this something that we should be worried about? Do we think that this actually affects the prices that they’re charging for the information that they provide? And is there anything that can be done to promote competition in this market?

Rob Jackson: So, yes, we should be concerned about it. And I gave a speech about a year ago where I urged my colleagues at the SEC to take a look back at our statute that empowers us to make rules. That statute requires that we consider the effects on competition of any regulatory step we take. When we make rules in the proxy advisory space, we risk turning a two-firm market into a one-firm market. And part of my argument to my colleagues on the commission and in the corporate community has been, if you don’t like a world where you’re held accountable by two proxy firms, imagine a world where you’re held accountable by a monopolist proxy firm that has the sole power to tell American investors how to vote their shares.

And the truth is, I know you both know the history here very well. It’s been decades and there hasn’t been a tremendous amount of competition in the space. And the reason is very straightforward. It’s just not that profitable of a business. We have seen people attempt to enter over the years, companies have opened and closed shop because they couldn’t make the economics of the business work. It is a very low-margin, not highly profitable business. And that’s why there aren’t more entrants.

And that’s what worries me about adopting new regulations, because if we impose those costs, the incumbents will be able to pay them because they’ve achieved the scale necessary to do it. But it’ll make it very, very, difficult to enter and compete. And that’s why I think the rules that we proposed have made it much less likely that we’re going to have a competitive market in the future and much more likely we’re going to have a monopoly, because it’ll be very, very difficult for both firms to survive with all these regulatory changes.

Luigi: But whether they have absolute power or have some power, I think is a source of concern. Number one is the fact that it is a duopoly, and it’s actually funny, I read the US Chamber of Commerce position paper on the topic, and they are extremely concerned about concentration, and they make arguments that are in favor of regulating monopolies or oligopolies, which they’re not very willing to apply in other areas, but in this area, they seem to be very in favor.

The second is, what is the potential effect of conflict of interest? We know that ISS—actually, at the cocktail parties they call it ISIS—that ISS, what they do, they also serve their services.

So, at the same time they judge and decide how to vote, on the other hand, they advise you how to behave. And, surprise, surprise, if you behave well and you pay well, they also tell you to vote in favor. And while Glass Lewis is more rigorous about that—they don’t have a business on the side—they are owned by the Ontario Teachers’ Pension Plan. So, at least in principle, it could be that they represent some specific interests. Maybe this ownership has an impact on the way they operate.

Now, in a world of competition where we had many of these players, this would not be such a major issue, but when we come down to two, that is a concern.

Rob Jackson: I think that’s absolutely right. It’s a conflicted business, and it should be subject to rigorous disclosure. The ISS already does some disclosure, but look, you guys know that I’m a scholar who’s concerned about CEO compensation and conflicts of interest. I can’t be of the position that CEO conflicts should be disclosed, but ISS conflicts should not. No, no. The consulting model there is highly conflicted, which leads to all kinds of questions about what ISS is being paid for and why. And I think rigorous disclosure of that is absolutely necessary.

And to the degree the rules advance that objective, I’d be happy to support them. Again, what’s frustrating is they go so much further than this, requiring not only disclosure of the conflicts but also asking ISS to run their opinions by management before they can tell their clients what they should do.

Luigi: No, no. That part I agree, 100 percent, that seems to be crazy, but why not propose a structural remedy, which is to break up and give away the consulting business? After all, this was also imposed by Sarbanes-Oxley for the auditors. They were in a similar situation, and they were playing on both sides, and Sarbanes-Oxley put some limit on that.

Rob Jackson: To the degree that we end up with a legal mandate from Congress like Sarbanes-Oxley that allows us to attack this problem—and by the way, Luigi, you could not just break them up, you could have an office that oversees this area—I would be in favor of all of these kinds of things.

Kate: What about a sort of nudge on the part of institutional investors? So, rather than setting up a new office, maybe set up an opt-in system, where if you have your money in a mutual fund or if you have your money in a retirement fund, you have to select a proxy advisory service. This not only makes people aware of the proxy advisory services that exist, but it puts the power in the hands of the actual shareholders. As it is now, like Vanguard, Fidelity, I don’t know, I’m assuming that they use ISS, but I don’t actually know the answer to that question.

I think if people felt more empowered, then this might actually promote healthier competition in this market. And it might also promote competition along the lines of specialized advisory services. You might have some that just focus on issues of the environment or some that just focus on issues of social and civil rights. And also, this seems to me like more of a market solution.

Rob Jackson: There’s a lot that’s appealing about that solution, but a lot that’s complicated about it. Let me say a little bit about that. First, Vanguard, Fidelity, BlackRock, those large firms, they do use proxy advisory services, but they’ve also built their own in-house governance teams that oversee and actually cast the votes. And in the case of Vanguard, there have been recent developments in sending that authority more toward the portfolio managers and giving them more oversight over the way votes are cast.

But the truth is, Kate, they use those services, and if you’re at Vanguard, you pay for some of those services. I don’t disagree that you should know more about the way that they’re used. What would worry me about an opt-in or opt-out system is that as it is, it’s hard to get individual investors to engage in the process of corporate governance. Kate, as we said earlier, you’re not even sure which firms you own, which companies you’re in.

Asking you to weigh in about the optimal source of advice when it comes to voting your shares, that’s a lot to ask of an ordinary investor, but that doesn’t mean I’d be against asking it. I’d want to structure the rule to make sure we draw the right inference from investor decisions.

Kate: I think that that’s fair, but I will just say that I think it requires a lot less information to select a certain category of advisor than it does to actually know what stocks are in your portfolio.

Rob Jackson: Well, that’s very fair. And, Kate, let me point to something else. I gave testimony to the Federal Trade Commission last year where I pointed this out. I don’t think ordinary investors know in general how the institutions they invest with tend to vote their shares. Kate, let me ask you, Vanguard, that’s where you keep your retirement savings, right?

Kate: Mm-hmm.

Rob Jackson: Are they promanagement, antimanagement or down the middle? What’s your sense?

Kate: My sense is that they’re probably promanagement.

Rob Jackson: Right. One thing I would like is for the SEC to play a better role in getting you a quick answer to that question. You could also do polling of ordinary retail investors just to try and get a sense for what their actual preferences are for voting on these things.

One of the things that’s so hard for me about the debate we’re having right now is we’re not talking at the SEC about making sure that the way votes are cast actually reflects the preferences of the underlying ultimate investors.

And the reason I’m for that is because I’m a big believer in and concerned about agency problems. I think we’d be better off asking the people whose money is at stake what they want out of corporate elections. For that reason, I think you’re right that Kate has a good idea. Anything that gets at what ordinary investors really want in the voting process is something I’m for.

Luigi: What is the principle that they try to follow at the SEC? If this is not to try to capture what shareholders want, what is the overarching principle?

Rob Jackson: I have to tell you, one of the criticisms I shared in my statement last week is I don’t know what principle is guiding the proposal that we made. Would it be they generally feel that the last 20 or 30 years have involved a shift from management to shareholders in terms of power, and that somehow the role of the SEC is to reverse that trend? I don’t know why we would be in the business of dictating that outcome.

Even if I granted the premise and, Luigi, I don’t, because the three of us know very well that actually the last 30 years have been pretty good years in terms of managerial power in the United States. The approval of the poison pill, the widespread use of staggered boards, there are many impediments to the exercise of shareholder authority, to say nothing of the standard collective-action problems that investors have suffered for decades. So, I don’t know why we’d be in the business of resetting that balance.

Luigi: Sorry, with what underlying idea do they claim they want to do that? Because I thought that many members of this administration were kind of free market, they didn’t want to interfere with the natural outcome of the market. And here you’re saying they want to interfere, but they want to interfere on the side of management against shareholders.

Rob Jackson: I think that’s a reasonable read of what happened last week. And here’s what I’d say. Free market philosophy . . . I don’t think last week’s proposal represents free-market thinking.

Kate: Right. I don’t understand why this is so confusing. The Trump administration seems to be probusiness and antiregulation, and it seems to be doing just that through this SEC vote. So, sorry, maybe being a little unfair to your colleagues.

Luigi: Are you saying that Trump is probusiness but not promarket?

Rob Jackson: Well, right. I think, Kate, it’s very . . . I understand your reaction, and I’ll leave it to you to make that point. But here’s what I’d say. It’s interesting. It’s not probusiness, it’s promanagement.

Kate: Right.

Rob Jackson: And I think it’s so important to draw that distinction because, look, I have an MBA in finance from Wharton. I learned probusiness. I know what pro-investor actually means. The idea that we would favor corporate management is not probusiness. In fact, it risks extraction of very substantial agency costs. No, no, I would think this is a promanagement move and maybe justifiable as a policy choice. But again, that’s not the debate that we had last week.

Kate: Let’s address, I guess, the elephant in the room, which is, OK, so what if they had called it that? What if they had said, look, we want to support management at the expense of disenfranchising shareholders. We just think that that’s the right decision to make at this point in time. Are there any potential benefits from doing that? Maybe shareholders do have too much power, and I have to say that on recent episodes, that’s been exactly the point that we’ve been discussing. And so, it is in some sense a little hypocritical of Luigi and I to be saying, no, shareholders do need to be the ones with the most power.

Rob Jackson: Well, I’m a big fan of the podcast, and so for sure I understand the reasons to be skeptical of too much shareholder power, but I never took your or Luigi’s argument to be that the answer to this is to hand more power back to CEOs. No. Instead, the consideration is giving more influence to other stakeholders, et cetera. But I think all of us who spend time in the corporate governance scholarship know that for 30 or 40 years, corporate management has been telling us, “Trust us, we’ll deal with long-term problems like environmentalism, environmental issues, social issues, et cetera.”

And I don’t think anybody across the marketplace right now is in a place where we think the solution to our problems either as a society or as a market is to hand more power to management.

Luigi: Yeah. And our discussion of the Business Roundtable statement was exactly in that direction, that we don’t think that we want to hand more power to the CEOs. And the Business Roundtable statement was a huge power grab in that direction.

Kate: I have a devil’s advocate argument to make here, and this is also going against what I said on that earlier episode about stakeholders versus shareholders, but my impression of the way that managers acted in the ’50s, the ’60s, and the ’70s is, yes, maybe they extracted perks, right? Maybe they bought themselves planes and ate fancy dinners on the shareholder’s dime. But another source of alignment that they had was with their employees. I think that especially back in the day when they lived closer to their employees and were members of the communities in which their businesses operated, that there was some sort of social pressure to pay employees maybe higher wages than the market would dictate, or to invest in local charities.

And so, to the extent that you think that maybe labor is disenfranchised today because of the secular demise of labor unions, and if we don’t think that those rights are coming back, then maybe giving managers more power at the expense of shareholders is a backdoor way of giving employees more rights.

Rob Jackson: See, Kate, I feel like you tried so hard to make that argument well.

Kate: I did.

Rob Jackson: I mean, bravo, but I got the sense that by the end you’d run out of gas. And here’s why. The fundamental proposition is if you want to secure the future of the American worker, trust CEOs, and it’s such a ludicrous idea that saying it out loud, it makes it hard to keep a straight face.

I have no doubt that American CEOs understand the crisis we have in the American middle class and want to address it. And I believe that they’re thoughtful, brilliant leaders who want to solve the problem. But the idea that we would solve the balance of power between the American middle class and others in the society by trusting CEOs to make those decisions just doesn’t make much sense. They’re simply not well positioned to understand what the problems are and what mechanisms we might have to solve it.

That’s why I, like you, was skeptical about the Business Roundtable statement and why I’m skeptical that the solution to America’s problems lies in the minds of American CEOs. I can tell you right now, I would be happy . . . you can put me down in favor of, I will happily give American CEOs power to exclude more shareholder proposals from the ballot if they promise me in exchange that they’ll live in the same neighborhood and attend the same church as their workers.

Kate: This is kind of why I was saying I was being the devil’s advocate, because I believe that back then that was an important force in the minds of CEOs, that they had to see their workers every day. They had to be members of their communities. And so, it made sense that they extracted perks or extracted rents away from shareholders and in favor of labor. But I don’t think that that’s the corporate environment in which we live today. And in order for them to be living in the same communities and going to the same churches, oftentimes that means they’d have to move to Myanmar or something.

And so, I don’t see that . . . I agree, Rob, I don’t see it being a very viable way of giving more power to labor.

Luigi: So, Rob, we like to conclude the episode by saying whether the particular topic is an example of good capitalism or capitalisn’t.

Rob Jackson: Oh, I see. OK. Well, I think you’d have to look at our proposal from last week and say capitalisn’t. It’s not a market-driven proposal. It’s a proposal driven by the particular interest of CEOs in having an easier job. For that reason, I have to say the proposal comes down as capitalisn’t. But the great thing about this podcast is I hope many of your listeners will come forward and talk to the SEC about the rules we proposed. It’s just a proposal, and try to persuade me and my colleagues to move in a direction that would be more capital-is.

Kate: Rob Jackson, thanks so much for joining us today.

Luigi: Thank you very much. This was a great ending.

Rob Jackson: Oh, Luigi, this was so much fun. It’s like a workshop. I should come here more often.

Kate: Yeah, you should.

Rob Jackson: In my job now I never get to do this.

Kate: Really?

Rob Jackson: Yeah, no.

Kate: I would think that that’s all you did at your job.

Rob Jackson: We need to talk.

Presidential candidate Elizabeth Warren blames private equity for many of the issues in our economy. She plans to reign it in and regulate it with her new bill the "Stop Wall Street Looting Act". On this episode, Kate and Luigi explain how private equity really works, whether it’s bad or good for society, and they dissect Warren’s proposal to regulate these firms.

Getting into the right college is arguably more important than ever, which has put the justice or injustice of admissions processes in the spotlight. On this episode, Kate and Luigi give a fresh perspective on a recent admissions trial involving Harvard, explain its implications for college admissions in general, and ask whether the way elite universities choose their students is an example of capitalism working or failing.

We're just a few days away from the announcement of the winner or winners of the 2019 Nobel prize in economics. On this episode, Kate and Luigi explain how to win the econ Nobel, why it's important, and they make some predictions about who the winner might be this year.

On this episode, you're going to hear how the sausage gets made in economic research as Kate and Luigi personally investigate whether private equity is to blame for the retail apocalypse.

In the last few weeks, we've seen two examples of seeming corporate self-regulation. One is Walmart's decision to end all handgun ammunition sales, and the other is the four largest automakers going around the Trump administration's less stringent fuel emission standards to cut a private deal with California that is closer to Obama era-emission standards. But there's an important overarching question to these two stories. Should companies really be taking it upon themselves to address issues when the government doesn't do a good job policing? Should these businesses be punished or praised?

Many are praising a recent Business Roundtable announcement that corporations should serve stakeholders as well as shareholders. On the surface, this may seem like a historic reversal of the status quo that has held since Milton Friedman's famous "shareholder primacy" theory was put forward in the 70s. But it's not that simple. On this episode, Kate and Luigi layout the history of this theory, revealing that it's really been around for as long as we've been asking the most fundamental question in business: what is the purpose of a corporation? They explore that question, and interrogate the possible underlying motives behind the Business Roundtable's decision.

Many are praising a recent Business Roundtable announcement that corporations should serve stakeholders as well as shareholders. On the surface, this may seem like a historic reversal of the status quo that has held since Milton Friedman's famous "shareholder primacy" theory was put forward in the 70s. But it's not that simple.

On this episode, Kate and Luigi layout the history of this theory, revealing that it's really been around for as long as we've been asking the most fundamental question in business: what is the purpose of a corporation? They explore that question, and interrogate the possible underlying motives behind the Business Roundtable's decision.

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

Luigi: Are stock buybacks evil? A lot of politicians seem to think so. And not just the usual Sen. Bernie Sanders, but also Chuck Schumer, the senator of Wall Street. They cowrote an op-ed in the New York Times this year, calling for a limit on corporate buybacks.

Speaker 2: The senators say companies should pay their workers better wages and provide better benefits. They plan to introduce legislation requiring corporations to, and here I’m going to quote, “address needs of workers and communities before the interests of wealthy stockholders.”

Kate: On the surface, it’s easy for a lot of people to see the logic here. At a time when wages are low, why should corporations be giving themselves a bonus? But most economists would say that it’s more complicated than you think.

Speaker 4: This is basically legislators saying, “We know better how to deploy corporate capital than the managers in the business.” Now, let’s look to history again. Where has that led people?

Speaker 5: I think we paint with these broad brushes when we tend to have these conversations and you forget about some of what it goes back to.

Luigi: Who has got it right this time?

Kate: 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.

On this episode, we’re going to discuss stock buybacks. What are they? How long have they been around? Do insiders use them to drain profits from companies? And, of course, should we ban them or not?

Kate: Before we get into the controversy about stock buybacks, we should first explain what a stock buyback is.

Actually, we should first explain what a stock is. I know that a lot of people are smart. I know that a lot of people have money invested in the stock market through their 401(k)s or their brokerage accounts. But I think there are still a lot of misconceptions about what a stock is.

I like to give the example of a pinball machine. And the reason I like to talk about this is because one of Warren Buffett’s first investments, when he was a teenager, is that he bought a pinball machine.

Luigi: Do you know The Who song, “Pinball Wizard”?

Kate: Luigi, I think that’s the coolest thing you’ve ever said.

Luigi: I actually saw that movie many, many years ago, Tommy. I’m surprised. This is probably one of the few things we have in common, Kate.

Kate: What? That we listen to The Who?

Luigi: Yeah.

Kate: I think that might be true.

Let’s say that you want to buy a pinball machine and you want to put it in a bar. And let’s say you go in on this with a bunch of friends for $10,000, so you each chip in $1,000. You put it in a dive bar, and eventually the pinball machine starts making money. People put quarters in it, and at some point you can empty the tray of quarters and you’ve got yourself some cash.

You and your friends realize that this is a profitable business. You guys are making a lot of quarters, more than you expected. And at some point, you’re like, “You know, maybe we should use the money that we’ve accumulated and we should actually buy another pinball machine in another bar.”

You don’t want to have to talk about this all the time because you’re busy, you have jobs and stuff. And so you designate somebody to make this decision for you. You designate Joe, because he’s not working right now and he has a lot of time on his hands.

Joe decides—and let’s call him the CEO—to take the money that your pinball machine has accumulated. And rather than distribute it to you guys, who own the pinball machine, he decides to buy another pinball machine in another bar. And everyone collectively now owns these two pinball machines.

The stock is the ownership in a company. A company is a business that makes money. Those quarters in the pinball machine, that’s the cash that the company has generated. And the CEO is Joe, who’s making a decision about how to use that cash and whether you guys collectively should invest in more businesses, more companies, or whether that cash should be paid out to the people who own the company, the shareholders.

Here’s the thing. There are different types of payouts.

One is just you guys get quarters, right? Everyone gets one-tenth of the quarters that have accumulated over time. That would be called a dividend.

Now, another form of companies paying cash out to shareholders is a stock buyback. Let’s say, rather than taking that cash and distributing it evenly to the owners of this pinball machine enterprise, let’s say you repurchase one of the shares.

Pretend that Sally wants to be out of the business. She’s too busy. Well, first of all, you have to come up with the value of the company. You take the cash that you’ve accumulated over time. You pay back Sally her fair share of the company, and so now she’s out. Any future money that that the pinball machines make, the cash per person increases, or the earnings per share in stock-market terms. But you also have less cash accumulated within your firm, right? You had to pay her back. And so now there are less quarters within your company, less cash.

In this sense, in the way that the cash has been distributed, or in the sense that the cash has been distributed out of the company, a stock buyback is sort of similar to a dividend. In fact, in many senses they’re equivalent.

Luigi: One question is, why do you want to return the cash to the shareholders if you can expand your business of pinball machines?

In fact, if it is true that you have a great opportunity to expand and buy a pinball machine in every other bar, then that’s a great way to use your money. But eventually you might be running out of places to put pinball machines. Or a new technology may come along, video games, and you know what? You might not be the best guy to run the video games.

That’s one of the reasons why it’s important to return the money to the shareholders. It’s to let the capital market decide where the money is allocated. Because if I am in the business of pinball, I’m a pinball wizard. The only thing I love is pinball. I will think that the future is pinball, even if the future is video games or virtual reality. If I keep investing in pinball when the world has moved by, I’m wasting money.

More often than not, companies don’t have a good control system to avoid this waste. And the way to return the money to the shareholders is the best way to ensure that money is invested in the most profitable opportunities for shareholders at large.

Kate: If dividends and buybacks are pretty equivalent because they’re just a form of a company taking cash that it’s accumulated, that it no longer has a need for, and paying it out to shareholders, then what is the difference, right? Why would people prefer one or the other?

Really, it comes down to taxes. If a company pays out a dividend, then you have to pay taxes on that immediately, right? You received some cash, you have to pay taxes on that. However, in the case of a stock buyback, some people will sell back their shares to the company, and some people will hold onto their shares. If you continue to hold onto your shares, people would rather pay taxes later rather than taxes now. This is an argument for why share buybacks are preferred to dividends.

Luigi: Actually, it’s even better: pay taxes never. There are loopholes that allow you to completely avoid the capital-gains tax.

For example, if you leave a stock to your descendants or you give it to charity, you never pay capital-gains tax. By adding a huge capital accumulation and then donating your stock to a foundation or leaving it in inheritance for your children, you completely avoid any tax.

But to be honest, we have to recognize that as financial economists, we do not have a very compelling reason for why companies pay dividends and why dividends are so sticky. But de facto, we know that companies don’t like to change dividends very much. Dividend payouts, and especially dividend levels, are very sticky over time, while stock buybacks are extremely flexible. There is another advantage that buybacks have over dividends, and it’s exactly the flexibility.

But the interesting fact is, historically, companies were only paying dividends. The first major burst of buybacks happened in the 1970s, thanks to, of all people, Richard Nixon.

Richard Nixon: The time has come for decisive action, action that will break the vicious circle of spiraling prices and costs. I am today ordering a freeze on all prices and wages throughout the United States for a period of 90 days. In addition, I call upon corporations to extend the wage-price freeze to all dividends.

Luigi: Kate, you’re too young to remember. But Richard Nixon imposed not only wage controls and price controls but also dividend controls. OK? This is to say how far we’ve moved, because a Republican president decided that to fight inflation, you should block everything.

And so, companies say, “Oh, wait a minute. We have a dividend freeze, but we can actually experiment with something else.” Ergo, stock buybacks. And so, they started to do buybacks and they saw that it was working quite well.

In the ‘80s, the phenomenon started to become big and then has been growing ever since to the point now that more money is paid back in aggregate to the shareholders in the form of buybacks than is paid in the form of dividends.

Kate: Exactly. To put some numbers on that, if you’re looking at the S&P 500 in 2018, about $1.2 trillion of cash was returned from stocks to shareholders, and roughly two-thirds of that was in the form of buybacks, whereas one-third was in the form of dividends.

This is basically in line with the buyback-to-dividend proportion that’s been in place for the past 20 years, with the exception of 2009.

Luigi: A lot of politicians are now screaming against buybacks. What they claim, what Chuck Schumer and Bernie Sanders claim, is that the reason why companies don’t invest is because they buy back stock. The reason why they don’t pay higher wages is because they buy back stock. And the reason why America is not growing as fast as it used to is because companies buy back stock. Is there any evidence of that?

Kate: Well, it depends on what you call evidence, right? If you’re just looking at a pure historical correlation, then the period in which wages have become more stagnant has coincided with a period in which stock buybacks have become more popular.

Luigi: It’s also coincided with me getting older, but I don’t think I’m responsible for that.

Kate: Actually, I think you might be responsible for all of the problems in the world’s economy.

Luigi: My age, certainly—

Kate: Exactly, yeah.

Luigi: No, but this was a cheap way to say that sort of correlation is not a proof of causation, especially when we look at the overall time trend, because there are a lot of things that trend together. Pollution is trending together. Should we necessarily make a causal interpretation between the two?

But more seriously, if you look cross-sectionally, there is a correlation between companies investing less and paying more in corporate buybacks. But the direction of causality is most likely to be the opposite, in the sense that if I am in a business without much of a future, I don’t want to keep investing.

Until the development of vaping, companies that were in the business of tobacco did not have a bright future. But they were still making a lot of money selling a product that makes you addicted, so a very good product to sell with very high profit margins. If I am an executive of Phillip Morris in 2000, should I keep investing in selling more cigarettes around the world? Or should I return the money to the shareholders?

Kate: Yeah, I think that we shouldn’t be incentivizing companies to make bad investments, right? We shouldn’t force companies to always keep cash within the company, because eventually that might incentivize them to invest in hole-digging projects or dumb pinball machines or cigarettes that no one’s going to smoke. Actually, you know, let’s just get rid of cigarettes altogether. But anyway, I digress. The point is that we don’t necessarily want to force companies to invest when we know that those investments aren’t good.

The alternative, if companies pay back cash to their shareholders, that can be a good thing, right? It means that the shareholders will use that cash to buy more stuff if they want. Or they’ll use that cash to invest in different companies that are better and growing faster. And that’s what we want in order for capital markets to direct resources to the right places.

Luigi: I think it’s important to understand why politicians push for this ban on buybacks.

Because if I look from the perspective of the existing tobacco workers or the existing tobacco producers, trapping the equity there, trapping the cash inside the tobacco companies, is good because it’s making it more likely that I will keep investing in tobacco and that will inevitably benefit tobacco producers and tobacco workers.

And even if I don’t invest in tobacco, I will probably make other investments that are related to the tobacco business. But I will still provide a career to the existing employees.

It is very much a rent-seeking argument of existing workers that want to protect themselves and protect the existing producers at the expense of innovation and efficiency in society at large.

Kate: What about this argument that, OK, let’s pretend it has nothing to do with innovation and new investment. It’s just that workers should be paid more. Every time a company has enough cash accumulated and it’s ready to pay a dividend or engage in a stock buyback, it should also give all workers a raise.

Luigi: This may actually have a perverse effect, because if I’m forced to pay workers more, that will increase my cost of the workforce and will push me to substitute more with machines.

At the end of the day, forcing me to pay the labor force much more might lead to faster automation and more reduction in the workforce. I’m not so sure that this is exactly what Schumer and Sanders want.

Kate: Look, I agree that wage stagnation is a huge problem in society. And the bargaining power lies too much, increasingly and now excessively, in the hands of capital rather than labor. And we’ve seen that because of the secular decline in union participation.

To me, the whole stock buyback story seems like kind of a roundabout way of addressing this, right? If we’re worried about wages and we’re worried about workers, let’s try and give them more bargaining power. Let’s try and go back to union participation.

But to enact a law that actually pegs buybacks to wages, I think is sort of a clunky way of addressing this, and as Luigi mentioned, could lead to some backfiring.

Luigi: Yeah, I agree 100 percent with you. It’s a bit like saying we know that healthcare in the United States is very expensive. One of the elements is that doctors in the United States tend to be paid more than in other countries. Is the solution forcing a reduction mandate that all doctors are paid half of what they’re paid today? No. That would be a crazy way to go about fixing the problem. We need to introduce more competition in the system, and we need to introduce a lot of other things before we go down that path.

And I think that the same is true for wage stagnation. I don’t think the way to fix wage stagnation is to force companies to invest in bad investments.

Kate: And I think that the most practical proposal that certain people have put out there in terms of buybacks and dividends, buybacks in particular, is that, all right, let’s not try to link them to anything. But let’s just put a limit on how much companies can pay out so they’ll be forced to invest more or pay higher wages.

I think the practical reality of what would happen is that if companies could only pay out a limited amount of their cash or they could only buy back a limited amount of stock, either they would just pay more dividends if that were allowed, or if dividends were also restricted then they would just sit on the cash, right? There’s nothing stopping a company from just having a bunch of cash in the bank account. I mean, in reality they would invest it in Treasuries and stuff. But essentially, they would be sitting on low-yielding assets, and that would make investors angry eventually, because like I said, they could have paid that out to investors who would put that to better use.

Luigi: Actually, I would push the argument even further. If I know that I might be constrained in my ability to return cash to investors in the future, I might start to do it earlier. At a time in which I still have valuable investment opportunities, I will start doing buybacks because I’m substituting for buybacks that I cannot make in the future. Rather than increasing investments, this limit might reduce investments.

Kate: That’s a good point.

Luigi: Do you think there is any validity, if you work hard, is there any validity to the Schumer and Sanders argument?

Kate: Unfortunately, I think it’s the sort of thing where they’re right in spirit but they’re wrong in application. We should be worried, I think primarily, about the stagnation of wages. As I said, I think there are better and more direct ways of addressing this by empowering workers directly.

And when it comes to innovation and investments, I think that we should be a little bit concerned about the fact that these seem to be slowing down. But as you mentioned, I think the causality goes the other way, that we’re slowing down in the opportunities that are available to us. And that’s the reason that companies are engaging more in buybacks, not the causal direction that they claim.

Luigi: In preparing for this episode, I was reading the literature, and the following occurred to me.

Let’s take for granted that the long-term return that we see after buybacks is correct. There’s a debate over whether this additional return represents a risk or whether it really is a signal that companies buy their stock when the stock is undervalued.

Imagine that I am, for a second, a CEO that really cares about the value of my shareholders. And I see that the stock is trading at $20, but I know that the true value is $30. Why don’t I try to buy back the stock in order to bring it back to the true value? I think there is some evidence in that direction. So, let’s assume that this is the case.

I think the argument that the two senators make that this might discourage investments is not that crazy. Because imagine that I know that my stock is really undervalued and so I can make a return by buying the stock of, say, 30 percent a year. While if I can make a real investment, I make only a return of 20 percent per year. So, I give up a good investment—20 percent is a fantastic investment—for a better financial investment.

Now, from a societal point of view, that is by and large a transfer, because I buy cheap from the existing shareholders, and that benefits the rest of the shareholders but is basically a transfer. While the additional investment that creates value is a real addition to the capital that exists in the country. So, there is a substitution.

Now, this substitution will not take place with dividends. Why? Precisely because dividends are not that flexible. If I know that I have to pay a continuous stream of cash, then I’m not going to speculate on my own stock, because I cannot. I have to pay out the same amount all the time. But if I’m allowed to speculate on my own stock, I divert part of the cash that I would have invested in real investment for that.

I think that the argument, I have to say, is a bit more sophisticated than the one that the two senators use. But I don’t think it’s completely out of the feasible set.

Kate: Let’s move on to the argument that buybacks are a form of insider trading. It’s a way for executives and CEOs, who are the ones who make the decisions about whether or not the company should buy back stock, to opportunistically sell their shares at the same time that the company is buying back stock or right after the company has announced a stock buyback, when presumably the stock price is a little bit higher.

Is it possible in theory that CEOs are using stock buybacks to manipulate share prices for their own personal gain?

Luigi: I think it is possible, definitely. And it’s more than that.

One of the commissioners of the SEC, Robert Jackson, actually published some research showing that there is a remarkable correlation between the day insiders sell stocks and the day the company is buying stock. There is a clear potential for abuse and it would take very little for the SEC to force a bit more disclosure and avoid the problem.

I think that in this case, we don’t need to ban corporate repurchases like Sen. Schumer is suggesting, but having a little bit more transparency seems like a low-hanging fruit.

Kate: I agree. And in addition to Commissioner Jackson’s research, there’s also much older research by Christine Jolls, who’s a law professor at Yale University, who found that there’s a remarkable correlation between the period of time when executives were increasingly compensated with options and when buybacks became really popular. Not only that, but within each company, the ones in which executives are more compensated with options are the companies that use buybacks increasingly or use more buybacks and dividends.

The whole idea behind options is that if you’re compensated with an option and a company pays a dividend, the share price drops when you pay a dividend. And so that makes your option less valuable. If you’re a CEO and you have a bunch of options, why would you make a decision that makes your share price drop?

Luigi: Yeah, it’s basically a mechanical reason why CEOs compensated with stock options don’t like dividends. But again, it’s a little bit silly, because compensation committees can very easily adjust stock prices for dividends. So, it’s just out of laziness from the compensation committees. It’s not that this cannot be easily fixed.

Kate: That’s true. But it is sort of puzzling that this has been known for a while and yet we haven’t seen compensation packages change that much.

Luigi: Yeah, that’s true. I think that compensation committees are pretty lazy.

One factoid that is important to know is that whenever a stock buyback is announced, the stock price goes up by roughly 2 percent, at least in the United States. But then, in the two or three years afterward, there is a positive drift, so that the stock on average keeps growing more.

One of the objections to stock price manipulation is that, after all, these executives are pretty dumb. Because imagine that I time my purchase immediately after an announcement, it’s true that I gain 2 percent if I bought the stock before, but also I lose 8 percent on average in the next three years. So, if they are doing this manipulation before they are put in jail, they should be fired because they’re incompetent.

Kate: I’m not sure that I entirely subscribe to the idea that that’s a sign that CEOs are dumb. Because if you’re a CEO, a lot of your compensation is in the form of the stock of that company and, in many cases, options of that company, which means that you have a lot of your wealth tied up in this one enterprise. And the first thing that financial economists will tell you is that you should diversify, right? You’re taking on too risky, too concentrated of a position.

And even though it makes sense for the board of directors, for shareholders, to compensate CEOs that way so that they make decisions about the company that are aligned with the long-term interests of that company, you as a CEO, as soon as you get stock, unless you have really good positive inside information about the company, from a diversification perspective, it makes sense that you would want to sell as soon as you can.

Luigi: I think you’re absolutely right on this point, Kate. There is a big difference between a 2 percent return in one day and an 8 percent return on average over a year. Because the standard deviation, the variability around that 8 percent is huge.

As a result, a CEO is very much tempted to sell immediately after a 2 percent return and is much less tempted to hold on, because as you said, there’s a lot of risk involved in that 8 percent. And already the CEO is not particularly well-diversified, and so holding on to enjoy that extra return might be quite expensive in terms of variability.

Kate: I also think it’s worth discussing why a stock price should even increase upon the announcement of a stock buyback, right? It’s not obvious that it should increase. If you’re taking cash out of the company and you’re just repurchasing shares in the open market, then it seems like the stock price shouldn’t change that much, right? You’re not actually ...

One of the common misconceptions about stock buybacks is because there are fewer shareholders, that increases the value of each share, because future earnings go to a smaller number of shareholders. But you also have to keep in mind the company is using their own cash to repurchase those shares. And so any concentration of ownership is offset by the fact that the cash left the company. And so, absent other factors, it’s not clear necessarily that there should be a stock price boost upon the announcement of a buyback.

Luigi: Yeah. In the finance jargon, we say that if there are no capital-market frictions, if markets are perfect, then of course a buyback should have no impact on stock prices. However, in reality, there could be two reasons why the stock price goes up.

The first one is that investors are afraid that managers may spend that money on investments that are not worth it, also known as wasting that money. In the pinball example, if I am a pinball lover, I keep buying pinball machines at the time of video games or virtual reality. And that would be a waste. If I returned that money to shareholders. If I announce that I’m going to return more of that money to shareholders, that’s good news for everybody. That goes under the rubric of agency theory because it assumes that managers are not necessarily doing the right things for the shareholders.

Then there is a much more heterogeneity of valuation perspective that says I start to buy the stock from people that have the lowest valuation of the stock. So, imagine that I tender at the current market price. The first ones to tender are the people who don’t think that the stock will appreciate a lot. And so—

Kate: By the way, tender means to sell back.

Luigi: Yes, sorry. And so, by buying out the less-committed or the less-bullish investors, I am left with the most-bullish investors that will value the stock more.

Kate, if you were king for a day, how would you fix the problem? I should say, queen for a day.

Kate: I’m OK with king.

There are different problems, right? One is the insider gaming, wouldn’t say trading, but insider-gaming problem. And then the other one is stagnant wages and underinvestment.

I think that the literature suggests that the way that managers are compensated has something to do with the timing and incidence of stock buybacks, which isn’t great. But I also think that it’s not a huge amount of money that they’re getting, right? Maybe they’re getting a 1 percent boost. Over time, this might accumulate, but I don’t think that this is causing society’s problems. Maybe it’s something that the SEC should be somewhat concerned about, but I don’t think that it’s ruining America.

On the underinvestment problem, I think that it’s an unfortunate reality of where we are today. I don’t know necessarily that any of these plans that people have to force companies to invest are actually going to generate more growth. I think that the way that we need to generate more growth is to give poor people more money. And, like I said, on the wages, I think laborers need more power.

I guess what I’m trying to say is that the gaming side of it, I think is not that important. And the other big issues in our economy should be addressed by other means and not stock buyback policy.

What about you, Luigi? Do you think that buybacks are a capital-is or a capitalisn’t?

Luigi: I think it’s probably a capital-depends.

No, I’m 100 percent with you on the SEC ruling. I think that it takes very little for the SEC to bring more transparency. It’s not going to change the world, but I think it’s important to make people feel that they are all treated in the same way in the stock market. This feeling that, oh, if you’re an executive, you’re treated in a particular way, and if you’re not an executive, you’re treated a different way, so that us pension-fund holders are screwed all the time by insiders, it’s not a good way to run a society, and it’s not a good way to run a stock market. And in that sense it takes very little for the SEC to fix their rules. It’s pretty embarrassing they have not done it yet.

When it comes to the bigger fundamental issues, clearly stagnant wages are not going to be resolved by stock buybacks. I don’t think that banning stock purchases is the way to go. What I find funny to some extent is to this day they are tax-favored, less than they used to be, but they’re still tax-favored. I don’t see any reason why they’re tax-favored.

I am very skeptical of using tax policy to fix every problem. But on the margin, if I had to choose whether to make them tax-favored or tax-disfavored, I would make them slightly tax-disfavored.

Kate: Luigi, what if we banned buybacks and dividends? How would that work?

Luigi: The stock market value would go to zero.

Kate: Yeah, I think it’s important to understand that if you own a company, then there has to be some means of getting cash out of that company, right? Let’s say you bought that pinball machine, but you were never allowed to empty its trays. What would its value be? Zero.

At the end of the day, I don’t see buybacks as a good or an evil. It’s just something that’s supposed to happen, right? If you bought a pinball machine, you would expect that eventually you’re going to take some of those quarters out of the pinball tray. If you were not able to do that, that wouldn’t make any sense. But it’s also not a huge benefit to society. It’s just the definition of a stock. It’s the definition of ownership, that when your company makes money, eventually you should be able to get that money.

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

Kate: OK. Luigi, I have a question for you. What do Mark Zuckerberg, Elon Musk, Gary Johnson, and Milton Friedman have in common?

Luigi: I think the first three have in common universal basic income, and—

Kate: You’re not allowed to say that.

Luigi: Why?

Kate: Because that’s the answer.

Luigi: I don’t think that actually Milton Friedman was in favor of universal basic income, more of an earned-income tax credit, but anyway.

Kate: All right. What if I added Andrew Yang to that list?

Luigi: I will stick with my answer.

Andrew Yang: If you’ve heard anything about me, you’ve heard that there was an Asian man running for president who wants to give everyone $1,000 a month.

Speaker 4: Universal basic income, $1,000 a month for everyone.

Andrew Yang: Yes, that’s exactly right, and we need to make this move because we’re in the midst of the greatest economic and technological transformation in the history of our country.

Luigi: You probably have heard a lot of debate around this concept of universal basic income recently. Just a crash course for the few of you who may have missed it: The concept is that the government would periodically give cash payments to citizens without any means tests and without any work requirements, helicopter cash coming to you without any strings attached.

Kate: As you can imagine, this concept is highly contentious. There’s been a lot of talk around Alaska’s UBI, the Permanent Fund, randomized experiments in Africa, and Finland. I think YCombinator is running a UBI test right now. But there are still a lot of important questions about what the effects of the UBI would be.

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

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 episode, we’re going to get into the economic outlook on how UBI might work or not work. But before we do that, we’re going to explore what conditions would necessitate a UBI. And do those conditions actually exist today? Why is this conversation happening now? What is it in response to, and why are people so excited about it?

So, there are questions of, how do we fund a UBI? Will it lead to disincentives to work? Does it actually fix the problem of poverty? But before we get into that, I want to pose a slightly different question, which is, why now? And I think the answer really stems from techno-anxiety, from this idea that robots, AI, machine learning, it’s all becoming more advanced, and it’s eventually going to displace jobs, to the point where there just won’t be enough jobs for everyone in the economy. And in order to make sure that there’s sufficient aggregate demand for goods and services, we need to pay people the UBI so that they can meet their basic needs.

Speaker 5: There will be fewer and fewer jobs that a robot cannot do better. What to do about mass unemployment? I think, ultimately, we will have to have some kind of universal basic income.

Andrew Yang: The reason why Donald Trump is our president today is that we automated away 4 million manufacturing jobs in Michigan, Ohio, Pennsylvania, Wisconsin. And my friends in Silicon Valley know full well that we’re about to do the same thing to millions of retail workers, call center workers, fast food workers, truck drivers, and on and on through the economy.

Kate: There has been massive job displacement as a result of automation that’s been going on for centuries. Between 1900 and 2000, the fraction of US workers employed in agriculture fell from 41 percent to 2 percent. So, today everyone’s talking about how automation is going to reduce the need for truck drivers and people who were involved in transportation. But imagine living in 1899, when 40 percent of jobs are going to be destroyed by these technologies that we’re inventing, and yet unemployment now today is at historic lows. What we’ve seen over and over again is that there is new technology that’s created that creates new jobs.

Luigi: I think you’re absolutely right. It’s important to distinguish between the technological obsolescence of the existing workforce and the employability of future generations. The Luddites, when they complained against the introduction of textile machines, were right in the sense that those machines were displacing them, making them less valuable, they were destroying that human capital. There was increasing productivity for the economy. This was the beginning of the Industrial Revolution as we know it, but it was the end of most craftsmen as we used to know them. I think that those people were heavily penalized by the introduction of those machines, and they fought very aggressively against that introduction.

But it is not that that introduction destroyed the number of jobs overall in the economy. It actually created more jobs and led to an expansion of the economy. The question is, how easy is it to absorb those people that get displaced, and also at what wages can they be absorbed?

Kate: I think from at least an empirical perspective, the interesting question is, why has it been that other jobs have arisen at roughly the same rate, or at a rate that has been able to make current labor conditions OK in the past? And will that continue to happen in the future? Which is to say that, is there something fundamental about innovation and automation that necessarily creates jobs at the same time, so that we’re on a stable job-growth path? Or were we just lucky in the past hundred years, and now the nature of automation is such that we’re going to really start hurting?

Andrew Yang: Here in the 21st century, a lot of the economic rules we take for granted have stopped applying. You can build a very successful, profitable company that does not employ many people, and if it does employ people, you don’t have to treat them well. You can make them all independent contractors and gig workers. So, the things we take for granted have broken down, and we have to start solving this problem by evolving our entire system.

Luigi: I think it is highly possible. I think that it is not guaranteed that the future will look like the past. However, the problem is not so much whether there will be jobs in the future. The problem, in my view, is whether there will be jobs that are worth adding, jobs that give you a decent amount of income. If the price of labor goes to a very low number, many of us will hire people at very low wages to do menial tasks. When I was in the Italian army, I had to serve in the military because it was mandatory. I used to carry up bedsheets for three flights of stairs, up and down for an entire day. And why? Because the cost of the elevator was higher than the cost of my time, because they were paying me nothing.

Kate: But they had an elevator and they made you do that anyway?

Luigi: No, they did not invest in the elevator—

Kate: Oh, I see, OK.

Luigi: It was not worth investing in an elevator if you have free labor. What I’m saying is that if the price of labor is low enough, then you substitute. We know as economists that you substitute, so instead of adding capital, you have labor. But I can tell you, I was not very highly productive there.

Kate: Right. I think that this ties into an interesting paper by David Autor from MIT: “Why Are There Still So Many Jobs? The History and Future of Workplace Automation.” And the point that he makes in this paper is that he thinks most people are overly concerned with this idea about automation and labor substitution. But actually, there are reasons to be positive about automation. It leads to labor complementarities, what we were talking about before, which is that there can be jobs that are created as a result of automation.

But something that has happened is that automation has been linked to polarization of employment, which is to say that over the past hundred years or so, as a result of increasingly advanced technology, we’ve seen more jobs at the high end, which is to say professionals, lawyers, doctors, things like that, and an increase in jobs at the very low end, house cleaning, hair and makeup.

But there have been a pretty large swath of jobs in the middle that have disappeared as a result of automation. And his hypothesis for this is that, all right, it’s pretty difficult to automate creativity. It’s pretty difficult to automate really advanced tasks, and so we still need people for those things, and we pay those people a lot. At the low end, let’s say when it comes to cleaning a house, you probably could create a robot, right? We have Roombas and stuff, but we could create more advanced robots that clean houses, but because it already is pretty cheap to pay people to do these things, we don’t really need to create those robots. And so those are the driving forces between this disappearance of the middle jobs, the jobs in the middle end of the income spectrum have been replaced, and so that’s led to further polarization.

Luigi: But I think that the future is going to bring more of the past, more jobs becoming obsolete and more new jobs that are created. What I think is more challenging is, to what extent are there limits on the human side? When people moved massively from the countryside to factory jobs, two things took place. Number one, there was a massive movement for universal education. In fact, the states in the United States that pushed for mandatory high schools were exactly the states that were more agricultural, that saw these needs for training their workforce. So, that allowed people to have the skills to do more-complex jobs. And, two, we were lucky that at the same time manufacturing exploded, creating jobs that people leaving agriculture could take.

My fear is not that there will not be jobs in the future. My fear is that the jobs that will be available for people that lose their job in manufacturing or in services are either very low-end jobs that do not pay very well, or jobs that are above the skills of the people that are losing the jobs.

So, if you lose a job as a truck driver, it is not obvious that you can become a webmaster, and it’s not obvious that even after some training you can become a webmaster. We need to think about whether technological innovation is outpacing our ability to train people or even the intrinsic ability of a large fraction of the population.

Kate: I think I agree with you, and I’m actually even more pessimistic than you. I think that the nature of technology is changing in a way that’s not good for us. Even though, historically, automation and innovation have gone hand in hand with complementary technologies that have led to new types of jobs, I think that that’s slowing down. The types of jobs that are displaced in the future by AI and machine learning and neural networks, I don’t know that they’re necessarily going to be associated with an equivalent rise in other types of jobs. What types of innovation are taking place now are focused more in the area of pure replacement.

For example, McDonald’s introducing new panels so that you can order on a screen, rather than having to order from a person. That’s something that just directly replaces jobs but doesn’t necessarily go hand in hand with other types of new-job creation. I think that, more and more, innovation is along those lines, and less of total, new disruption that creates a ton of jobs, which we’ve seen in the past century.

Luigi: But, sorry, the McDonald’s innovation is no different than the telepass that allows you to go through a highway tollbooth without the person asking for money. That kind of innovation has always taken place. I think it is very positive, because it’s not a particularly exciting job to be at a tollbooth or to be at the counter of a McDonald’s. Even if they don’t directly generate complementary jobs, I think that the higher productivity and the higher wages they can afford will create other jobs in other sectors. We have many more jobs in entertainment today than we had in the past. Why? Because people spend more of their income on these other activities. If I don’t spend my income at McDonald’s, maybe I spend some of my income at the gym, and I want a trainer to help me train in the gym. So, I think that there is a natural substitution.

Kate: I think the question of natural substitution is an empirical one, right? As some jobs are replaced by job-replacing technologies, does that necessarily lead to a one-for-one increase in other forms of jobs? So, for example, the one that you gave is in entertainment. I think that that natural rate of replacement is less than one. And the reason that we haven’t seen really low unemployment in the past is just because we’ve gotten lucky with other completely different, new forms of disruptive technology. Let’s say people spend less on McDonald’s, McDonald’s becomes cheaper, it’s also quicker to go there, so they have more time and more money. Let’s say they spend that on playing games, they play phone games. That’s not necessarily going to lead to an equivalent increase in jobs.

And I think the fact that we have seen roughly equivalent increases in the past is just a matter of luck, not an economic law. At the end of the day, I think it’s sort of a matter of faith, right? We don’t know whether the future will look like the past. We don’t know what the sources of innovation will be, which is why I simply think that I’m more pessimistic than you.

Luigi: Yes. But we can do things to be prepared. Even if we don’t know for a fact what the outcome will be, there is a clear need to better train younger generations, and in particular better train the lower end of the income distribution. In America, particularly, we’re leaving behind a significant fraction of the population in training that should be addressed, because there are a lot of job postings that don’t get filled for a lack of people with skills. So, I think there is a lot that can be done on that margin.

Kate: OK. But bringing this all back to the UBI, and why have we been talking about jobs and automation and techno-anxiety? Because, for the most part, that has been what’s been animating the debate on whether or not we should have a UBI here. I think this conversation has pointed in the direction of a more-nuanced version of that. So, I’m going to call this Marxism. Marxism is obviously a broad term, but Marx proposed this idea that robots are going to become so powerful and so advanced that they will displace jobs.

I would like to amend that and say that there’s a strong form of that theory, which I sort of actually agree with a little bit, which is that automation will just eliminate jobs, but then there’s a weak form of that, which is that, OK, maybe automation doesn’t eliminate employment, but maybe it polarizes employment, and most of the job opportunities that are out there are at the lower end of the income distribution. They barely allow you to earn enough to survive. So, it sounds to me like you don’t agree with the strong form idea, Luigi, but that you do sort of agree with the weak-form, automation-anxiety idea.

Luigi: I think it is enough to necessitate some form of support at the lower end of the income distribution. If a job I can take with all my efforts is not a job that allows me to survive, I think that I should have some form of subsidy, and whether the UBI is the better way to do it or whether unemployment insurance is the better way to do it, this is a matter for discussion.

Kate: Yeah, I agree. I do think that this has played out historically, this polarization of employment opportunities. I don’t think that that on its own necessitates a UBI. I will agree with what you said that that necessitates welfare programs that are aimed at people at the lower end of the income distribution, but why that money should necessarily go to the people at the top of the income distribution is not clear to me. And if that’s the case, I think it’s a much stronger argument for a better social safety net, not necessarily in the form of a UBI. But I do think that there are other factors that make a UBI more compelling.

Luigi: So, what are these other factors, Kate?

Kate: Before we talk about specifics, I think it’s worth having a discussion about how we pay for all of this. Andrew Yang’s proposal for a UBI is something on the order of $1,000 per adult per month, and I think that would amount to about three-and-a-half trillion dollars, at least in gross terms. Would we be able to afford that as a country?

Luigi: I think that the idea of paying $3.6 trillion seems crazy to me, because this is almost twice what the income tax collects today. So, we would need to triple the income tax in order to pay for that. I think that this would generate a revolt. However, as many commentators have recognized, we are talking here about what is called the gross cost of UBI, because, for a large fraction of the population, people will be both receiving and paying the UBI. So, the net cost for that fraction would be zero.

The best estimate I found is actually from a colleague of yours, Kate, Karl Widerquist, who tries to estimate the actual net cost of UBI. His idea is, if you’re making zero today, of course you’re going to receive $12,000 a year. But if you are making a bit more than that, you are going to be phasing out that $12,000 with some taxes you pay on the other side.

When you do that, what you find out is that the number of people who will receive some support will be on the order of roughly 100 million adults and 30 million kids, with a household income that is less than $55,000 a year. If you do that calculation, the net cost of UBI is roughly half a trillion a year, which still means increasing your income tax by 30 percent. But I think that is more sustainable, though it clearly is going to be a gigantic social program.

Kate: What confuses me a little bit when we start getting into net costs is that it necessarily assumes some form of payment for the UBI, right? What if we don’t increase taxes on individuals at all, but we increase taxes on corporations or, I don’t know, on fuel? I think the discussion of net costs depends heavily on how you’re financing the UBI. And I think it’s worth mentioning that Andrew Yang’s big proposal is that we introduce a VAT tax, a value-added tax, which is sort of like a sales tax, except with the sales tax that we’re used to in the United States, you’re taxed at the very end of a sequence of transactions. So, when you as a consumer buy some good, you have to pay a sales tax.

But everyone who was involved in the production of that good, maybe there were 15 steps along the way, where each person made a component and then added that, and then it was ... it all became one big good that was sold at the end of the day, a VAT tax would tax each of those producers at all the intermediate stages on whatever value they added in the production process. This isn’t something that we have in the United States today, but it is something that they have in Europe, and a lot of economists argue it’s a more efficient tax. And so, I think one of Andrew Yang’s statements is that we would raise more revenue with a VAT tax rather than our current sales-tax system.

Luigi: Yeah. But at the end of the day, we’re still paying for that amount, and this is a 10 percent value-added tax, I mean, roughly 10 percent higher prices for everything we buy. And so, we are all taxed at 10 percent on our consumption. Now, as a European, I can tell you a lot about the experience of the VAT in Europe. First of all, people have thought about the regressivity, and what they have done is they’ve introduced different tax rates depending on the goods. So, if you are buying bread, generally VAT is at a very low rate. If you buy diamonds, it’s at a very high rate. So that is a way to compensate for the regressivity.

But it is a very efficient tax. That’s part of the reason why conservatives don’t like to introduce it in the United States, because once you start to introduce it, you’re going to go up and up. Just to give you a sense, in Germany, the VAT is 26 percent. If you start to put a 10 percent VAT on top of the sales tax of most states that are between 8 and 9 percent, you’re going up pretty close to 20 percent. Some people will consume more, some people will consume less. So, I think some people will be taxed more, some people will be taxed less, and some people will net gain, probably the people at the end of the income distribution, and some people will net lose. But whether you finance it with the income tax, with a corporate tax, with a VAT tax, there are people who are taxed, and there are people who are net beneficiaries.

Kate: Another question about the funding of the UBI is whether it would replace any other social-welfare programs, right? If we got rid of Social Security, if we got rid of Medicare and Medicaid and food stamps and everything, and we replaced it with a UBI, would that end up helping or hurting poor people? And this is an important part of the discussion, one that’s often pushed aside, especially if you’re running for president. I’m not sure that Andrew Yang has been too explicit about this, but his proposal for funding the UBI does involve some cutbacks on certain social-welfare programs. I think, in particular, there would be an option if you’re on food stamps, and if you’re receiving housing subsidies, then you would either be allowed to continue using those food stamps and receiving the housing subsidies, or receive the UBI, but not both. So, there is some sort of substitution there. Obviously, there are some progressives who think that we shouldn’t cut back on any social-safety programs at all.

And then I think the reason that libertarians, some at least, like Gary Johnson, support the UBI, is because they think that we should just do away with all welfare programs and replace it with the UBI, because that would reduce the reach of the government. A lot of, I think, how you view UBI should depend on what’s in the background, right? How are you paying for it, and what are you cutting?

Luigi: I agree. But we have not tackled the fundamental question, which is, why is UBI better than targeted welfare programs?

Kate: I think that’s a great question. To some extent, the answer is that it might just be more efficient to implement. For example, if you think about cash assistance directly to poor people in the form of temporary assistance to needy families, or TANF, I think that back in 1996, if you thought about all people who were eligible for cash assistance, something like over two-thirds of them were actually receiving it through this program, whereas today, that number has fallen to less than a quarter. A lot of our welfare programs just aren’t very good at getting cash to people who need it. So, if we had a UBI, maybe that would just be a more efficient means of redistribution, because money wouldn’t get siphoned off and lost along the way.

Luigi: Yeah, but if you really have a UBI for everybody, then you are back to the $3.6 trillion cost, which would be very large. And imagine a program that needs to raise twice as much as the income tax raises today, it would go through an enormous amount of administrative cost. So, it seems to me that at that level it is a pretty crazy idea.

Kate: I don’t care about the administrative costs as much when it comes to chasing after people’s money, though, right? If we need to spend more in making sure that billionaires can’t dodge taxes, then fine. But if what we’re doing right now is we’re spending a lot administratively on making sure that poor people can’t get the money that they’re entitled to, then that worries me.

Luigi: No, but Kate, you cannot support a Universal Basic Income only by taxing billionaires. There are not enough of them. They need to tax you. They need to triple your income tax.

Kate: OK. I know.

Luigi: How do you feel about tripling your income tax?

Kate: How would I feel about tripling my income tax? In percentage terms, that would be more than a hundred percent, so that wouldn’t make any sense. But yeah, I wouldn’t be a huge fan of paying a 95 percent effective tax rate, but if it were something more like 50 to 60 percent, I think I would be OK with that.

Luigi: Yeah, but that’s not enough to pay for the Universal Basic Income.

Kate: Maybe it is. It all depends on what else you’re cutting.

Luigi: I think that the idea of having better-targeted welfare programs is good. The idea of making it easier for people who need the money to get that money, I think that’s good. I think that the universality of the program, unless you have an enormous amount of natural resources like Saudi Arabia, doesn’t strike me as a good policy, and even in Saudi Arabia, I’m not so sure that this is the way to go, because what we don’t know is, what are the long-term effects of a generalized Universal Basic Income? We have a lot of experiments for a short a period of time, with relatively small amounts, because even the Alaska project is, what, $1,000 per year, roughly? It is not some life-changing amount. But if you start to have massive programs like in Saudi Arabia, where half of the population lives on dole by the government, does this really promote a society that wants to educate itself, become better and work? Probably not.

Kate: That’s a fair point, but I think it’s worth mentioning that the little empirical evidence that we do have works against your point. The main concern with the UBI is that it will discourage labor-force participation and cause inflation. Historically, empirically, that isn’t what happened. The main countries we can look to are Iran and Saudi Arabia, which have pretty sizeable UBIs. Alaska, as you mentioned, has had the Permanent Fund, which ... Was it $1,000 a year? And in none of those instances is there evidence that it led to an increase in inflation. In fact, I think inflation went down after Alaska introduced a UBI. Same in Kuwait, actually.

And in terms of labor-force participation, the evidence is that in Alaska there was no significant effect. In Iran, there was no significant effect except for the youth population. I think young people were, to some extent, discouraged from entering the labor force for the first time after they instituted a UBI there. And I’m not sure that we know enough from Saudi Arabia about how it directly affected its labor force. So, I don’t think that there’s a smoking gun that a UBI would necessarily lead to inflation or people never working. But your point earlier was that, how much can we really infer about the external validity of these experiments, because they haven’t existed for that long? And I do agree with you, especially to that point about youth labor-force participation in Iran, there is concern that in the long run, this would lead to a decrease in people getting jobs.

Luigi: Yeah. I think that we tend to underestimate the long-term effects of welfare. There is actually a Swedish economist, Assar Lindbeck, who first pointed out the fact that when you introduce a welfare program, you are piggybacking on the preexisting social norms. And, to some extent, you have the best of both worlds. You have the benefit of the transfer without the immediate undermining of social norms. But as the welfare becomes part of the social construct, then people develop different social norms, and then this might have long-term negative consequences. So, the result in Iran, where the young people are less willing to work, I think is pretty scary in my view, because if you don’t enter the labor force early on in your life, you are unlikely to enter later in your life. This is a permanent effect that could easily last for 40 years. Before we do any massive program like this, I think we need to have better evidence, because the irreversible effect can be devastating.

Kate: But Luigi, I hate to say it, you’re sounding a little bit like you’re repeating the conservative refrain, which is that we shouldn’t have direct cash assistance to the needy because it will make them lazy.

Luigi: Look, there is a concern about that. In particular, the essential point about the Universal Basic Income, and the essential difference vis-a-vis targeted welfare programs, is that Universal Basic Income is a right to everybody, unconditional of whatever you do. And that, in a way, is a change in mentality. One thing is assistance for people who are down, who have been hit by a disease, who have been hit by a shock, that I am all in favor of as part of some social safety net. A right, regardless of what you do, I think does create an entitlement that is dangerous in the long term, because we’re not sure that we can pay for it, and we’ll create a different attitude vis-a-vis your participation in society. Not to mention, I think most people want some dignity in their job, not just the income, and so, by creating this, you are reducing the pressure to create jobs that might also give them some dignity.

Kate: I think that that dignity argument works against you, though. I think almost everyone is smart enough to know that there is dignity in work and being a constructive member of society, and that if you receive $12,000 a year, that you’re not going to be so distracted by that that you’re just going to give up on that dignity altogether. I don’t think that people at the lower end of the income distribution would really be lazy, as some people put it. I think that they would still look for work. I think that a lot of the people who can’t find work are trying to get work, and they are looking for work. It’s just that in some cases, it’s difficult to find. And I think that there is some amount to be learned from the empirical experience so far, which is that there isn’t overwhelming evidence that it discourages labor-force participation. I think it’s because people do fundamentally like working.

Luigi: I think that the at the level that is provided in Alaska, for sure, if we’re talking about $1,000, it is not going to dramatically change anybody’s incentive. When you introduce a marginal tax rate of 50 percent, like many of this Universal Basic Income de facto will introduce for people in dual-income families, I think that the incentive for one of the two not to participate is pretty strong. You receive the money unconditionally, you pay the money conditionally. So, if you work, you pay more in taxes, but you still receive the money on the $12,000. On the margin, the incentives to not work will be increased, because people say, why should I pay more? That’s a big difference with Alaska, if you pay this money out of a fund, there’s no taxation. So, there’s nothing that is discouraged. You don’t discourage people from working.

In a system where you increase the taxes on everybody, whether this is VAT or income tax to pay for the Universal Basic Income, it’s true that most people receive money with one hand and pay with the other, but it’s also true that they receive unconditionally, while they pay conditionally. They pay conditionally on consuming or working. And so, whatever is taxed, they’re going to do less. So, either consumption or work, they’re going to do less. I think all these stories about Alaska not having any effect on labor income is only valid on the ethical consideration that people don’t change their ethics to work when they receive some money, which is completely moot when you receive $1,000, because it’s hard to imagine $1,000 would change your ethics.

If you start to receive, with a wife and kids, $40,000 a year, for most of the United States, $40,000 a year is a pretty decent income to live on. And then the question is, are you still motivated to work, or does the ethic of working change when you receive $40,000 a year? I think that that’s a more likely scenario. I think that that’s where my concern is vis-a-vis the UBI.

Kate: Luigi, I think that one thing I definitely agree with in what you just said is that a lot of the incentives or distortions that arise from a UBI depend on how it’s financed. In that regard, we can’t necessarily infer that much from experiments that we’ve seen in Alaska, Saudi Arabia, et cetera, because those experiments in UBI were largely funded by pools of wealth generated by natural resources in those areas, and that wouldn’t really be the case if we had a UBI in all of the United States. So, instead, we would have to finance it. Perhaps through higher taxation on your income, which might actually discourage incentives to work, or higher taxes on sales, things that are sold. The VAT tax, as Andrew Yang proposed, which might discourage people from consuming. And so, I agree with you in that regard.

To be fair, there are other sources of financing that Yang is proposing. He’s saying, let’s remove the Social Security cap. Let’s introduce a financial transactions tax. Let’s remove favorable treatment of capital gains. He even wants to introduce a carbon tax, I’m not sure. There are other areas, as well as cutbacks on certain welfare programs that would all, in combination, pay for his proposed UBI.

Luigi: Yeah, but I still don’t understand why this, vis-a-vis not a negative income tax or a targeted welfare program. I still don’t see the benefit, given the enormous administrative costs and burden of such a proposal, I don’t understand why it’s so popular vis-a-vis some more traditional form of welfare.

Kate: I think that’s completely fair, and I agree with you on that one. At the end of the day, if what robots have done is polarize our employment but not necessarily eliminate jobs, then it seems like the objective should be helping poorer people, not necessarily giving everybody money. I think that the more compelling argument for UBI is if welfare is so administratively costly, and introduces so many potential loopholes that it’s completely ineffective. I think some, not all, but some of our welfare programs are pretty poorly administered, and when it comes to administration costs, I think the government is slightly better at getting money that it wants than dispersing money that it doesn’t want to disperse. So, to the extent that you think that that’s true, that is one argument for the UBI, but I’m not sure that completely justifies the UBI.

Luigi: You may actually argue that some of the disincentive effect to work might be useful if you want to keep up the wages of people who are working. So, part of the story is, if you are desperate, you start to compete to work for any amount of money, and that will decrease the wages of everybody at the low end of the income distribution. If you have a minimum income, then people will not be working below that minimum income, and that will force employers to offer higher wages. That is not a trivial benefit in a world in which we have this polarization. So, going back to the point that Kate was making earlier about polarization, if you want to protect the lower end of the income distribution, I think that that is a good way to do it. So, in general, I’m all for simplicity. But not if it implies raising $3.6 trillion. That, to me, does not seem to be a very simple program.

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

Luigi: Today, we have a very important announcement to make. Kate is getting married. Congratulations, Kate!

Kate: Thank you.

Luigi: Now, we have an important question. Are you getting married in spite of your student debt?

Kate: I think, first and foremost, I’m getting married for love, but no. I recently finished paying off my student loans. And now that it’s paid off, I do feel a lot more comfortable about spending another ridiculous sum on a wedding.

Luigi: Not all millennials are so lucky as Kate. In 2018, there were 45 million Americans with student debt for a total of $1.5 trillion. If you do the math, each is $33,000 in debt. This has not always been the case. In 2004, the number of people with debt was only 30 million, for a total that was roughly $250 million. So, it was only $8,000 per person. This is a topic that has come up often during the presidential campaign, because people blame the debt, the student debt, for everything from the decrease in marriages to the decreased demand for houses, to people not working, and so on and so forth.

Kate: But to be fair, Luigi, you’re even luckier. You didn’t have any debt when you graduated from college, did you?

Luigi: You’re right. I come from a country where university education used to be mostly free. Now, I attended one of the few private universities, which did have tuition. It was relatively small, and I was lucky my parents paid for it, but it wasn’t a foregone conclusion. I remember when I decided to go to this university that my father was concerned about the cost. At the time there were no student loans available in Italy, so I could not borrow even if I wanted to. If my parents decided that the burden was too big, I would have gone to a nearby public university, and most likely I would not be here today.

Kate: The debate being had, particularly in the Democratic presidential primary, is about whether we should be moving in that direction in the United States. Which is to say, should we have more completely free public schools?

Kamala Harris: We need free community college, we need to increase Pell grants. We need to refinance student loan debt ...

Elizabeth Warren: To make college universally available with free tuition and fees.

Pete Buttigieg: It’s logical to me that if you can refinance your house, you ought to be able to refinance your student debt. I also believe in free college for low- and middle-income students for whom cost could be a barrier.

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

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 this episode, with Democratic presidential candidates making the student debt crisis one of the leading topics of the debates, we give an in-depth economic look at the idea of free college tuition. We’re going to explain the history of how we got into the student-debt crisis and give some ideas about what we could actually do about it.

We should probably spend a little bit of time discussing the candidates’ plans when it comes to free public education or when it comes to the forgiveness of debt. Bernie Sanders and Elizabeth Warren have come out as the strongest proponents of the elimination of debt. So, I think Bernie Sanders’s plan is to get rid of basically all student debt, all $1.5 trillion for everybody, regardless of how much money you make. And he also wants to make public schools, historically black schools, free.

Elizabeth Warren proposes some part of that, which is that she wants to reduce the student-debt burden, but it to some extent depends on your income. So, if you’re making over $250,000 a year, it doesn’t matter how much student debt you have, you’re not going to get any forgiveness. Whereas if you’re at the bottom end of the income distribution, you can get forgiveness of up to $50,000. So, it sort of depends.

Luigi: There is a recent paper by Adam Looney at the Brookings Institution that analyzed Warren’s proposal. And he finds that the bottom 20 percent of borrowers by income will get only 4 percent of the savings. So, overall, it is a pretty regressive initiative, because there are two groups that have a lot of debt. One is people attending for-profit colleges, the other is people attending major universities. Those guys tend to have a really large debt, but they represent the upper class of the income distribution, and they are going to do fine the rest of their lives. So, it is as if we were canceling your mortgage debt. Who has the most amount of that? The rich people who bought the big houses.

Kate: I think that the loan-forgiveness element, a lot of the rhetoric around it has to do with equality of opportunity. But I don’t think in practice it really has anything to do with that. If anything, the data has suggested that more federal loans have made college tuition more expensive, and people at lower income levels struggle more with these loans. And that the programs designed at relieving these loans benefit higher-income people disproportionately. So, I think what the real objective is, is to boost housing prices. Basically, it’s a bunch of people who are my age who can’t afford houses and want to be able to start buying houses. And, to be fair, that’s an important economic consideration to have young family-starters to be able to afford houses. But if that’s really what it would benefit, we should maybe frame the question in that way.

Luigi: I agree 100 percent with you, but I will add an extra element. College students and people just coming out of college are very active during the primaries. It’s a pretty good way to get easy votes promising to give a gift to all of them.

Kate: Well, that’s too cynical for me. Luigi, you’re from Italy, you’re from Europe, where most university education is free. So, do you agree with the Bernie Sanders, Elizabeth Warren plan to make public schools have free tuition?

Luigi: No, I’m not in favor of free university tuition. Milton Friedman used to say that there is no free lunch. When you eat and you don’t pay, somebody’s paying for you. The same is, of course, true for universities. So, the proper question is not whether universities should be free, but why taxpayers, i.e., me and you, should fully subsidize the cost of university education?

Kate: But we do the same thing for primary and secondary school. Why shouldn’t we do it for college as well?

Luigi: You’re right. Primary and secondary education are free, and you see the effect on quality. America has the best universities in the world, but this supremacy will not last very much longer with free education. And America used to have the best elementary and secondary education, but it doesn’t anymore.

Now, there’s also another important difference. Primary and secondary education are mandatory. So, it is necessary to ensure that everybody can go. Not only is college not mandatory, but in the States, less than 60 percent of the population goes. In Italy, it is actually only a quarter. So, this 60 percent tends to come from richer families and up in the top quintile of the income distribution. Why should poor taxpayers who don’t send their kids to college pay to send my kids and your kids to college?

Kate: OK. I think that there’s several things that we can discuss in that statement. First of all, going back to what you said about the quality of American primary and secondary education. Your assertion was that they’re not as good partially because they’re free. But that doesn’t make sense to me. I mean, if we’re comparing educational outcomes across countries in which almost all of those countries have free primary and secondary education, then it doesn’t make sense to say that the United States is not as good because it’s free.

If anything, I would argue that it’s the separating equilibrium that we have in the United States, which is to say that there’s some really good private schools that get all the best people. And because of the way that we fund public education, we have this system where there’s a really good set of schools and a really bad set of public schools. I would argue that that’s why our educational system has deteriorated. It has nothing to do with the fact that there is free public schooling.

Luigi: I think you’re partly right, but only partly. I think it’s true that in most places in the world it’s free, but the way it is paid for is different. For example, in Sweden … everybody thinks about Sweden as a socialist country, but in Sweden there is a pretty big chunk of schools that are funded through vouchers. So, there is a very strong connection between people attending and people paying and the quality of what they receive. And this is what you generally tend to lack when you have a free product, because people tend not to complain very much about a free product.

And I can tell you in a lot of situations I’ve seen in Europe, you see a very low-quality product that is offered for free to people who don’t complain very much, because they don’t pay anything. I don’t think that’s the equilibrium we want to have. I think that we want to have a system where people even in primary and secondary education are accountable for the quality of the product they offer. Which, of course, can be done with vouchers or other systems.

Kate: Sure. I don’t think it can be done by linking public-school funding at lower levels to property taxes for that area.

Luigi: I completely agree. If you are saying that the United States has the most crazy system—

Kate: Messed up.

Luigi: —to fund primary and secondary education, I think you win the prize.

Kate: This is probably a topic for another episode, so maybe we’re getting a little bit distracted. But I’d also like to take issue with the second part of your statement, which is that it’s not necessarily fair for poorer taxpayers to be funding public college, when it’s the case that it’s generally wealthier people who end up going to college. So, in some sense, it would be a regressive subsidy. A, I think that it’s good when all smart people are educated, and so in that sense, I hate to say it, but a rising tide lifts all boats. It’s best for everybody in a society when the right people are getting educated, even those at the top and the bottom.

Second, I think that even though the data doesn’t necessarily support this very strongly, at least the spirit of making public education free at the college level is so that it can be more equal access. Which is to say that more black, African American, Hispanic students, people from poor backgrounds, can have access to college where they otherwise wouldn’t.

And, finally, and I think that this is probably what I most strongly believe in, poor people shouldn’t be paying that much in taxes anyway. So, most of this would be funded by wealthier people to begin with.

Luigi: Yes. But given the fact that there is a budget constraint, if you think that you can print money and pay for everything, then you have no problem. But if—

Kate: Are you accusing me of being an MMTer?

Luigi: That’s for another episode. But what I’m saying is that if there is a budget constraint, you have to think about how to make resources work in the most effective way. And think about one of your goals, which I think is very important, which is to promote access to lower-income people. Do you really think that the best way to promote that access is to give free tuition to the university? Or is it to invest that amount of money to make the primary and the secondary schools much, much better in poor neighborhoods?

I give you the example of Brazil. Brazil is the most interesting example, because there is free university in Brazil, but the primary and secondary schools are so terrible that only the rich kids who went to private primary and secondary schools can reach college. And that—

Kate: I hate to say it, but I think that’s the system that we have in the United States now.

Luigi: I think it’s going in that direction, but the way to fix it is not by giving free tertiary education. It is actually to dramatically improve the primary and secondary education.

Kate: OK. I agree. If we’re talking budget constraints here, then where should the first dollar be spent? There are probably better places where it can be put to use to help more people, i.e., in lower levels of education. But if we’re just talking about the issue of, will it help society overall to make public schools totally free, I think that there’s some merit to that.

Luigi: But I think it will help society overall to give a free iPhone to everybody. There are so many things that, if they are free, they might help society overall, I’m not so sure you want to do that. I think we need to be careful in how we use public money. Given that I’m glad that, at least, we agree on this, that there is a budget constraint.

Kate: Well, I would probably be giving people more iPhones before I spent so much on, say, multimillion-dollar drones and various elements of the defense budget. But again, that’s a conversation for another day.

Luigi: This brings us to the core of the discussion today, which is, how did we get here? Because you go to England, you go to Canada, you don’t hear about people being overwhelmed by the amount of debt they have. But you do hear it in the United States. And, honestly, I’ve been around enough to know that 20 or 30 years ago it was not such a big problem. It did exist, but it was not such a big problem. So, I think it’s important to understand how the problem has ballooned to this level in such a relatively short period of time. Remember, the numbers I said at the beginning were, we went from a quarter of a trillion to a trillion and a half in less than 15 years.

Kate: OK, so where to start? Well, federal student-lending programs were first established in 1958, and they were subsequently expanded several times, notably under the Higher Education Act of 1965. The main federal lending program today is the Federal Direct Loan Program, created by the Higher Education Amendments of 1992. And the way that this works is that loan limits are set by legislation, and loans can only be used to meet educational expenses like tuition and other costs of attendance.

Luigi: What happened very recently that led to the explosion of the amount of debt, is not so much that university tuition has become more expensive. It did, but that alone cannot explain the phenomenon. It is not that there has been a boom in attendance. The real reason is that there was a relaxation in the lending standards. Before 2006, you had to have more than 50 percent of your students enroll in no online or correspondence courses in order to qualify as a college for this federal program. The removal of this rule led to a sharp increase in the enrollment in for-profit institutions, most of them online. And those schools account for approximately one-third of the increase in new student-loan defaults between 2000 and 2010.

Kate: We talked a little bit about the legal history of the expansion of federal student loan programs, but still, does that address the question of why colleges have become so much more expensive?

Luigi: No, it does not, but I think that we should distinguish three factors. Factor number one is you see a dramatic increase in the sticker price of college. De facto, you also see a dramatic increase in grants that are reducing that cost. And I’ve not seen any serious study of this, because most of these grants are dark and they’re not disclosed, but my impression is that the real price, at least when it comes to business school, the real price has not gone up. It has been pretty flat in the last 10 years.

Luigi: The second issue is that the existence of subsidized loans does increase the cost of college. If you are in a sector where the supply is not perfectly elastic, and you increase demand, you inevitably increase the price. The third aspect, which is often ignored, and this is a bit more technical, but we know that increasing prices are very much dependent on the labor content of a product.

If you are producing computers, where you have incredibly large productivity gains, the price has dropped tremendously, in nominal terms, let alone in real terms. If you go into a profession where the productivity gains are not that big, and maybe that’s part of the problem, but we teach more or less like Socrates used to do. Maybe we have PowerPoints, but that’s the only invention in the last 2,500 years. I think that productivity has not increased, and as a result, the prices in nominal terms have to increase more than inflation. They have to increase in real terms. So, that’s one last reason why university tuition has increased so much.

Kate: Yeah, that last one is known colloquially as the Baumol hypothesis, right?

Luigi: Yes, it is. But I was trying to avoid the jargon.

Kate: I don’t know. I thought people might want to have that one in their back pocket.

Luigi: I don’t think that it’s called a hypothesis, I think it’s the Baumol theory, or Baumol something. It’s not a hypothesis. I think that there is evidence suggesting that’s the case.

Kate: Yeah. Baumol’s cost disease.

Luigi: Well done.

Kate: I’m not going to lie. You had mentioned this before the podcast, and I wasn’t very happy about it. Part of me is not happy to learn that when you expand federal subsidies, federal grant programs or loan programs to low-income students, that’s the cause, or part of the cause, of the increasing tuition. I wish I could disprove you, but unfortunately, this is what the majority of the research in this area finds.

But Luigi, certainly there are elements that we’re missing here, right? Don’t you think it’s possible that universities, colleges, could be colluding, and that’s part of the reason for the tuition increase?

Luigi: I think that universities are very likely to collude on the price of teachers. We see remarkable similarities in the price of assistant professors at entry. And, as we know from economics, when you see identical prices, there could be two things. Either perfect competition or perfect collusion, and I suspect it is more the latter than the former.

But I’m not so sure that there is such a gigantic sensibility to prices. So, if I were to discount massively, would I get many more students of the quality I want? Not necessarily. In fact, I would say that it is the opposite. One big question is why universities, especially the ones in high demand, have not expanded to provide the same product at a lower price. What we observe is that Harvard is turning away a lot of willing customers, and many of those of pretty high quality. So, it’s not like on the margin the guy they are not admitting is much worse than the guy they admitted.

They could admit probably three times as many students and not impact quality at all. The question is, why don’t they do it? And part of it is because Harvard Yard is so limited and they can’t expand it. No, you’re laughing, but I think it does play a role, because if they had to create a second campus, nobody would want to be on the second campus. It would be like a child of a lesser god. But the other part is that these are not-for-profit institutions. I think they are run with the interest of maximizing the benefits of the faculty, not with the interest of maximizing profits that will lead them to expand. Faculty don’t necessarily want a massive expansion, because that will lead to dilution of the faculty. But also, they don’t want a massive expansion of students, because they might be actually working more, God forbid. And then, so the result is that universities tend to restrict supply.

Kate: What do you do when you have this system where the demand for college education increases a lot? The good schools in your country refuse to expand the number of students they’re admitting. And then you have a bunch of for-profit schools that pop up. They exploit your grant subsidy program, to some extent exploit the students as well. What’s the solution?

Luigi: I think it needs to be a bit more complex than a political one-liner. Let’s start with what we already agree upon, that we should eliminate subsidies for for-profit institutions in terms of guaranteed loans. That would be a first step.

Kate: I think that the solution, when it comes to for-profit colleges, is pretty clear. We should just abolish them. They don’t necessarily make up the majority of degrees that are granted today. So, I think that people graduating from for-profit colleges account for 10 percent, something on that order, of people graduating with degrees in the United States. But still, 10 percent is a lot. It’s up significantly since 30 years ago. And as you pointed out, yeah, in some sense it’s like a direct transfer from the government to these for-profit colleges. If you’re guaranteeing the loans, and they just want to make as many profits as possible, then it’s a pretty clear business model. You just accept everybody and you try to exploit every penny out of them.

Luigi: Wait, wait, wait a second. I don’t think that they should be abolished. If I want to start a for-profit college, it’s a free country. I should be able to do it. The question is, why should I be subsidized to do it? Because, currently, as long as I have some accreditation … and, by the way, the accreditation is done by a board that many of the existing colleges are on. So, it’s basically like the fox in charge of the chicken coop. Once you have the accreditation, then you can have your students take out as many loans as they can, and those loans are guaranteed.

I think that if you are a for-profit college, you should take on the risk of your investment, at least part of the risk. So, if a student comes to me, the student takes a bunch of that. I, as a college, take the rest of that cost on my books, because I’m betting on the success of the students. And I can guarantee you that the quality of the education would go up, and the success rate of students would go up, and the amount of defaults would go down.

Kate: I guess I just have a more extreme view, which is that I just don’t think that they should exist at all. Certainly, they shouldn’t be eligible for federally subsidized grants.

Luigi: OK. We start from what we agree on and then let’s build on that, OK? I think we probably both agree that we should boost public universities. In my view, one of the unique features of the United States was an intense competition between good state universities and private institutions. And the two were both checking each other out, to some extent. The fact that you have a private alternative reduced the ability of the state to be too controlling of the university. But the existence of a good public option was keeping at bay the private institutions’ ability to price whatever number they wanted in terms of tuition. The University of California is a great example. Now, as we know, the funding for this has been going down, and the quality also has been going down, so I think that, rather than forgive student loans, I will go more in the direction of boosting public universities.

Kate: I agree with you on that one. Going back to the budget constraint conversation we had, if you have a fixed amount of money, and you can’t do all of the good stuff that you want to do, where should your first dollars be spent? I think that that’s probably it. Most states have pretty good state schools. We should be investing in making them even better and also expanding the number of students that they accept, that they’re able to accept.

One of the objectives of the initial California plan was to focus on matriculation. And part of the reason that community colleges, in particular, really struggle is because not enough people finish school. It’s hard to convince people to stay in school when they’re racking up a lot of debt, when they could be making money as an alternative. So, I think that we should expand initiatives to keep people in school once they’ve started. And, similarly, follow other leads that have been successful.

Luigi: Yeah, but this is exactly the point. I think what we should try to do is create the incentives for people to succeed in education, not just to enroll in college, not just to get a degree. But actually to succeed in education and life. My proposals would be, on the one hand, as I said earlier, I think it would be good if some schools took on some of the risk of their graduates. That would be a way to motivate them to do better. But also, paradoxically, trying to create a market for so-called equity financing your investment in education instead of financing it all with debt that you have to repay no matter the outcome. You finance it with a fraction of your future income. And so, if you are super rich, you’re going to pay a lot. And if you’re super poor, you’re going to pay very little.

Kate: Isn’t that just indentured servitude?

Luigi: You are absolutely right that if pushed to an extreme, it does run against the 14th Amendment. However, there have been some early examples of contracts like this that have survived. I think that if you limit what is the amount … if you give up 100 percent of your future income, that’s indentured servitude, absolutely. But if it’s capped at 20 percent or 10 percent or 15 percent, I don’t think that will run against that limit. And I think it is a way to create an incentive for somebody else who financed you to support you and help you in the choices. Saying, “Look, you need to choose this program of school or studies, because this program will lead you to more success and better earnings in life.”

Kate: OK. But we know that if frictions are too overwhelming, if there’s too much of an information asymmetry or there’s too much moral hazard, then that market will break down. I think that this is an example of where there’s just too much. I mean, it’s too hard to verify cash flows, it’s too hard to verify the income that you’re making. But, perhaps more importantly, there’s a huge moral hazard component, which is that if you know that someone has an equity claim on your own personal earnings, then you can just take a pretty bad job for six months, default and then eliminate that equity stake.

Luigi: I disagree, Kate. First of all, in the United States, tax evasion on your income tax is relatively low, and even if you move out of the country, you still have to file a tax return. So, if you can share your 1040, then people know exactly how much you’re making. The cash flow is verifiable, especially over a long period of time. Yes, can you play around? If I say that you have to give me 10 percent of this year, but not next year’s income, on the margin you can play around.

But if we’re talking about, you promise 10 percent of your income over the next 15 years, I don’t think there is a lot of unobservability there. And when it comes to moral hazard, do you really want to underwork for 15 years in order to penalize somebody that controls just 10 or 15 percent of your income? You have a choice of becoming an investment banker or a janitor, and you choose janitor in order to stick it to somebody who owns 10 percent of your future income? I doubt it.

Kate: Well, look, I’m sort of giving you a hard time about the idea of having a perpetual equity claim on an individual. I think a lot of people would just find that morally reprehensible, whether or not it makes financial sense.

Luigi: It’s not perpetual. I would say 10, 15, 20 years, not perpetual.

Kate: OK, Luigi, I still think that this is a pretty... I don’t know. This is coming out of left field, this proposal, at least relative to what the Democratic candidates are proposing. I personally think that if we had this sort of system, it wouldn’t be the type of system that would be available to everybody. Which is to say that the types of financial investors who are interested in taking equity stakes in people probably wouldn’t be doing that for people going to community college, but they would be doing it for people at the very high end for whom they have a big possible upside.

Luigi: Sorry, I disagree, because there is a startup here in the Chicago area that basically upgrades the skills of disadvantaged kids. What they do is they take mostly kids in poor neighborhoods, and they train them in some computer skills, and then they find them employment. And at the beginning, part of their salary is taken back by the company that trained them. The way they do it is, actually, they employ them themselves, and then they rent them out to these institutions or to these companies, and they get paid by these companies. And they are paid back only part of the salary. But that lasts for a couple of years, and then if they continue, they actually become fully employed by the ultimate employer. I think we should experiment. I’m not saying that this is the solution to all the problems, and I do know that there are some firms that are trying, but there’s a lot of resistance in that direction.

Kate: I think an interesting thought question is, what happens if nothing changes? What happens if the current debt level of $1.5 trillion of student debt just continues to stick around?

Luigi: There is a paper by my colleague Constantine Yannelis, looking at the history of the fluctuation of student loans. What he documents is that there are a lot of ups and downs in the amount of student loans that are driven mostly by regulation. So, when the regulation became more lax, you see a huge increase in the loans, and shortly after, you see a huge increase in defaults. Then, after that, you have a reaction, a political reaction. You have some restriction to the supply, you have fewer student loans, and then you have fewer defaults and things kind of level down.

Now, of course, the level has crept up dramatically in the last 10 or 15 years, so the problem of the adjustment would be more severe. But I think that this is not unique to student loans. We’ve seen that with the housing crisis. We’ve seen that with a lot of things where you have this boost in supply of loans, and then, when it becomes excessive, you have an adjustment. Now, the question we have is how painful this adjustment would be.

Kate: I’m a lot less technical than Constantine Yannelis, and so I like to think about it from an individual, anecdotal perspective. What happens to these borrowers? The issue is that there’s very different types of people, right? Let’s say you have someone graduating from Yale with $100,000 of debt. What are they going to do? Well, chances are they were restricted in what occupation they could take. Even if they wanted to become actors or writers, they probably couldn’t afford it. So, they’d probably have to do something that they don’t like to do for 10 years, maybe become consultants. They probably can’t purchase a house until they’re in their 40s and maybe they put off marriage for another couple of years, even though it’s hard for me to imagine that they would not get married at all. But yeah, I think it will eventually, for those types of people, have an effect on housing prices and also on birth rates in that strata.

What about the lower level? The lower end of the spectrum? If you went to a two-year college, if you dropped out after one year, you have $12,000 of debt, but you can’t get a job that pays you more than $18,000 a year. And then you have a kid. So, what are you going to do with that $12,000 of debt? They’re a good candidate for a hardship writeoff in bankruptcy. Some people can write them off, and especially if you went to a for-profit college that closed down, or if you can prove that you were somehow manipulated in your decision to go to college. There are exemptions where you can get that written off, even though I think Trump is trying to do away with them. I think there are options for them, but ultimately for both groups, it leads to a lot of hardship. It leads to a life of renting rather than owning. Oh, and then it leads to disillusionment with the system and radicalization.

Luigi: But I will make a big distinction between the two cases, in the sense that for the person who got $100,000 in loans because they went to Yale instead of going to University of Illinois, that’s a choice.

Kate: I mean, first of all, when you’re 17, 18 years old applying to college, you really don’t have that much choice. Especially if you have my Asian mother as I do. It was like, “These are the schools you’re applying to.” You have absolutely no autonomy. I had no idea what labor-market outcomes would be, what people got paid, what sort of jobs were available to me, what I was going to do in college. I mean, I think that kids are pretty in the dark about those things, and so I don’t think it’s fair to attribute all of the choice to them. And also, there’s a question of whether … yeah, you made a choice. Should you have to pay $18,000 when you graduate or should you have to pay $120,000 when you graduate? There’s a difference between something that’s a fair amount for any young person versus something that completely dictates the rest of your career set.

Luigi: You know, if you want to blame mothers, I’m always ready to do that. So, you have me on the same page.

Kate: Luigi and I both have overbearing mother problems.

Luigi: But this said, I think that maybe you should make the mothers pay. But no, more seriously, I think that we should make a lot of effort in trying to educate people.

Kate: Yeah. Jokes aside, I think that one thing that we both definitely agree on is that a lot of less-than-ideal college outcomes stem from less-than-ideal earlier school outcomes. High school, middle school, even elementary school. And it seems like we need to improve those in conjunction with any improvements to college if we really want a better-functioning educational system in the U.S.

Luigi: We all agree on that.

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

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

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

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

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

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

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

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

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

Luigi: Mickey Mouse, of course.

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

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

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

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

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

Kate: OK. I guess it was extended.

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

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

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

Kate: Can you explain that?

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

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

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

Kate: I don’t think so.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Absolutely.

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

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

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

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

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

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

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

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

Kate: Yeah. Originally it was 14.

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

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

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

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

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

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

Luigi: I think this is capital-was.

Kate: Oh, snap.

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

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

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

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

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

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

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

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

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

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

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

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

Speaker 5: No.

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

Speaker 5: Yeah.

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

Speaker 7: Your patents are open-sourced?

Speaker 6: Yeah.

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

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

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

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

Do you know anybody with a patent, Luigi?

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

Kate: On a trading, like?

Luigi: A trading mechanism.

Kate: Wow, that’s pretty cool.

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

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

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

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

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

Kate: Yes. Yeah.

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

Kate: Seriously?

Luigi: Yeah.

Kate: That’s insane.

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

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

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

Kate: Right.

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

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

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

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

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

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

Kate: Really?

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

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

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

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

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

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

Luigi: My patent is a way to underline audiobooks.

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

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

Kate: Oh, really?

Luigi: Yeah.

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

Luigi: Giuseppe.

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

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

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

Luigi: Wow. That’s a lot.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: Ten years?

Kate: Yeah.

Luigi: By that time nobody was watching TV anymore.

Kate: Exactly.

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

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

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

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

Luigi: Including your Uber driver.

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

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

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

Luigi: Wow.

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

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

Kate: Right.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: Good luck.

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

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

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

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

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

Kate: Good one, Luigi.

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

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

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

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

Kate: Oh, no.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: No, you don’t get to talk yet.

Tyler CowenOh, sorry.

Luigi: That’s quite all right.

Tyler CowenDo it over again.

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

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

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

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

Tyler CowenHappy to be here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tyler CowenTo hire people.

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

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

Luigi: Should we add any regulation to Facebook?

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

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

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

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

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

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

Tyler CowenYeah.

Kate: In any case.

Tyler CowenBig game. Bigger than a game.

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

Tyler CowenYou should. I hope you do.

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

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

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

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

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

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

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

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

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

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

Tyler CowenBut they don’t do that.

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

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

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

Tyler CowenThat’s not true.

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

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

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

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

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

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

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

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

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

Luigi: But in Europe . . .

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

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

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

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

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

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

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

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

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

Tyler CowenYou cover . . .

Kate: It’s whose deflator is correct.

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

Tyler CowenNo, not all big business.

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

Tyler CowenI agree. Our healthcare sector is very bad.

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

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

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

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

Luigi: Captured by the very business.

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

Luigi: Come on, opioids . . .

Tyler CowenThe Democratic Party . . .

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

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

Kate: I . . .

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

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

Tyler CowenLike many hospitals.

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

Tyler CowenOK.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Tyler, thanks for joining us.

Tyler CowenMy pleasure. Thanks to you both.

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

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

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

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

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

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

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

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

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

Nolan McCartyGreat. Thank you. Glad to be here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Nolan McCartyThank you.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: I know the feeling.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Fiona Scott MortonMm-hmm.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Fiona Scott MortonIt’s a lot of money.

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

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

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

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

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

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

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

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

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

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

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

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

Kate: And what about antitrust?

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

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

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

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

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

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

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

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

Kate: Thank you, Fiona.

Fiona Scott MortonYou’re welcome.

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

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

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

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

Luigi: The pushback to those ideas has been intense.

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

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

Kate: I’m Kate Waldock from Georgetown University.

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: What is a canton?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: That's called expropriation.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Speaker 3: . . . Slack . . .

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Speaker 5: Do you like listening to Capitalisn’t? There’s a good chance you’re interested in pioneering research and groundbreaking discoveries. Big Brains, another podcast from the University of Chicago, brings the work and ideas of the world’s smartest thinkers straight to your earbuds, with guests like David Axelrod . . .

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

Speaker 5: Richard Thaler.

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

Speaker 5: And Eve Ewing

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

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

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

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

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

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

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

Kate: Really?

Luigi: Yeah.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: But then, that’s fraud.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Oh, no.

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

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

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

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

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

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

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

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

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

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

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

Luigi: What should we worry about?

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

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

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

Kate: OK.

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

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

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

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

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

Kate: Yeah, exactly.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Speaker 3: What are you?

Speaker 4: I think it’s possible.

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

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

Luigi: And this is Capitalisn’t . . .

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

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

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

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

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

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

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

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

Luigi: I don't identify as any generation.

Kate: That’s a cop-out.

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

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

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

Kate: Wait, it’s socialist or liberal?

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

Kate: This is very confusing.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: Please.

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

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

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

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

Kate: No. Instagram and Snapchat.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: And most importantly, what isn’t.

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

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

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

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

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

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

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

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

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

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

Carey Gillam: Thanks for having me.

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

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

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

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

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

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

Luigi: In two or three weeks?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Carey Gillam: Again, yes.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: This is Kate Waldock from Georgetown University.

Luigi: And this is Capitalisn’t.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Hitler’s revenge.

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

Kate: Yeah.

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

Kate: That’s crazy.

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

Kate: Yeah.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: From an economic point of view, it’s important to understand that the optimal amount of pollution is not zero. Reducing pollution has a cost. We don’t want our house to be super safe at the cost of having no windows, because a house without windows would be safer, but it’s not a house we want to live in. In the same way, we don’t want to reduce pollution to zero, because the cost is prohibitive. However, it’s important to figure out what are the costs and benefits of pollution.

Kate: I’m glad you raised that point, because, I agree, it would be ridiculous to try to make pollution absolutely zero. But, at the end of the day, you can’t do a cost-benefit analysis if you don’t know what the pollutants are, and you don’t know what their costs are. I think that the real problem here isn’t necessarily the pollution itself, even though, obviously, excessive pollution can be a problem. It’s the fact that our institutions aren’t incentivizing these companies or aren’t requiring them to disclose enough information for us to be able to make that assessment.

Luigi: Absolutely. I think that, in an ideal world, the incentives provided by litigation, regulation, and reputation should make companies behave as if they were doing the cost-benefit analysis from a societal perspective. We need to think about how to realign these incentives. Unfortunately, this is not specific just to the particulate matter in the air or DuPont PFOA. It’s a more general problem, and to see another case of this in the next episode, we are going to interview Carey Gillam, an investigative journalist who has written a book, Whitewash, about Monsanto and a pesticide that is widely used around the world, Roundup. We’re going to discuss with her the possible solutions to these problems.

Kate: Before we go, I just wanted to insert a quick thank you to all of our listeners who responded to our feedback survey, some of whom got Capitalisn’t T-shirts. It really meant a lot to us, and it really helped us shape the direction of the show, so, again, thank you.

As Sen. Elizabeth Warren (D-Mass) jumps into the 2020 Presidential race, Kate and Luigi examine her legislative record and economic policy proposals, including several bold ideas to reform American capitalism.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

We just entered 2019, which promises to be the Democratic primaries year. Probably Trump will not receive a challenge—if he does, it will be interesting—but there are plenty of people willing to run for the Democratic primaries. What we’re interested in trying to figure out is whether any of those candidates have a response to the questions that we raise in this podcast.

Speaker 3: Breaking news, the highest-profile Democrat yet officially wading into presidential waters. In just the last half-hour, Senator Elizabeth Warren announced the launch of a 2020 presidential exploratory committee.

Luigi: So, in this spirit we’re going to start discussing the economic platform of Elizabeth Warren. Elizabeth Warren is a good example, not only because she’s the first one to start campaigning, but also because she’s written a lot and made a lot of proposals trying to deal with what she thinks is wrong with capitalism.

Kate: Don’t worry, we’re not going to do this on every single episode, so it’s not like the next 20 episodes are going to be us going through the Democratic slate. But we do think that Elizabeth Warren has an established record of her economic position. It’s not getting enough attention, and she is one of the big contenders.

Luigi: I think we should start by making a distinction between her and Bernie Sanders. Bernie Sanders has not declared that he will run, but I think that there is a profound difference in the approaches of the two candidates, even if some of the solutions might be similar and they’re often clumped together.

Kate: Well, I will say that I think one of the reasons they’re clumped together is because their overarching message is similar. I think their overarching similar message is that, A, they think inequality is a huge problem, so they really don’t like billionaires. And, B, they think that the stagnation of wages, particularly middle- and lower-class wages, is a huge problem. So, you’ll see them talking a lot about how big corporations are doing too well and they have too many advantages, whereas the little guys and the smaller companies have disadvantages. So, in that sense, I think very broadly they’re similar.

Luigi: Yes, but maybe, Kate, I’m old-fashioned, but I still give importance to words. Bernie Sanders calls himself, and probably is, a socialist, while Elizabeth Warren goes out of the way to say that she is a capitalist to her bones, that she loves competition. She is not a socialist at all.

Kate: I think that Bernie Sanders uses the term socialism as a rhetorical tool. I think the reason he throws it out there is because he thinks that too many people on the left are in the center-left and there needs to be some pull over further left. And so, by taking an extreme left position, he’s kind of putting himself further in the distribution, therefore making the average move over. Maybe I’m using too many statistical terms here, but I think that he himself would acknowledge that he doesn’t actually, truly believe in socialism in the central planning sense that most real socialists would. I just think that he’s way further left than many center-left candidates.

Luigi: Again, maybe it’s because I attribute too much importance to words, but Bernie Sanders comes from a socialist background. Elizabeth Warren, when she was younger, she was a Republican, and then she was confronted with some of the distortions in the marketplace and, particularly, how low-income people get screwed in the process, and she decided to do something about it. So, I think that this different history is quite important in understanding how different their approaches are to problems.

Kate: OK. So, let’s talk about Elizabeth Warren’s economic platform.

Luigi: Number one, there is one proposal that I have to say I love, and that is the Anti-Corruption and Public Integrity Act. I think it is a very elaborate proposal that she made in the Senate to overrule the current system of revolving doors in a way that is quite aggressive, but I think very much needed. The proposal goes from banning lobbying by former members of Congress for a lifetime to restricting lobbying by other federal employees for at least two years, but most likely six years, to a tax on lobbying above half a million dollars that is designed to finance a better staff for members of Congress.

I think that one of the justifications for lobbying is that members of Congress need to be informed, and lobbying provides information, and she said, why don’t we pay more people to collect information directly? I think that’s a pretty great idea. But I want to point out—and maybe this is because I’m an academic—but I want to point out an aspect of her proposal that is not very often discussed, but I think is fantastic, that requires disclosure of research, particularly research submitted to agencies. Many, many times you have lobbyists who buy research, even by famous people, and then they submit it to agencies as independent research. But the people that submit it don’t disclose where the money comes from, and it is not peer-reviewed.

Kate: Yeah, I think that’s a good point. I think I remember looking through one of Trump’s early economic plans, and, to be fair, I think this issue got a little bit better. But early on, if you looked through his citations . . . it was all research that was published by private companies or published in journals that economists have never heard of.

Luigi: Yeah, I don’t want to be too snobbish. I’m not saying that only stuff that comes from peer-reviewed journals or prestigious institutions is valid. I value ideas on the basis of the ideas themselves. However, when you come with empirical evidence, I think that the peer-review process is definitely a very good way to do that. I don’t expect it to be passed anytime soon, but I think it is not presented just as a flag. I think Elizabeth Warren believes that this is an important thing to do and is a first step in that direction.

Kate: The people that would have to pass it would be the ones who were directly harmed by it. So, it’s for that reason that it probably will never be signed into law.

Luigi: Yeah. It’s not easy to make turkeys vote for Thanksgiving, and so it’s not easy to have Congressmen vote for the fact that they will never get a job in the industry in the future. To be honest, I think there is a legitimate concern about the quality of the people in public administration. Whether we like it or not, having a job afterward is part of the career path of many politicians, and it is the only legal way that career politicians can make some money.

So, I like the fact that she is also considering, at least in part, not for the top politicians but for the staffers, ways to increase their salaries, because otherwise, the quality of the people involved will drop tremendously. There is a huge amount of uncertainty in political life, and if you don’t have any job afterward, only the desperate will take it, and that’s not the kind of political system we want.

So, Kate, do you want to talk about the Accountable Capitalism Act that is probably the boldest proposal that Elizabeth Warren made, and the one that has generated a lot of debate?

Kate: Sure. The Accountable Capitalism Act is a bill proposed by Elizabeth Warren that concerns corporations, the corporate decision-making process, as well as corporate boards of directors. There are several parts of this bill, but the main two parts have to do with how corporations make decisions. So, what are they maximizing? And, also, this idea that workers should be able to elect at least 40 percent of the board of directors.

In the Accountable Capitalism Act, the idea is that corporate decision makers, the CEOs, shouldn’t just be maximizing shareholder value, they should also be maximizing stakeholder value, where other stakeholders include employees, members of the community where that firm is operating, as well as customers. In order to make sure that corporations are maximizing stakeholder value rather than shareholder value, Warren proposes that, because companies need charters in order to operate, that large companies should have to get this federal charter that forces them to include the interests of these stakeholders. And if they don’t do that in their decision-making processes, then they can have that federal charter revoked.

The second part is a little bit more straightforward. Just this idea that the board of directors that typically oversees the CEO, the people who sit on it, at least 40 percent of them should be elected directly by the employees of the company.

I guess it’s worth mentioning that there’s another section that concerns political expenditures as well as political donations, and the idea behind this section is that if any corporation wants to make a political expenditure, it has to get at least 75 percent approval by all of its directors as well as all of its shareholders.

Luigi: I think it’s important for our listeners to understand that she proposes that all this should start when a company is above a certain size. I think, if I remember correctly, it is a billion in sales. So, if you are mom and pop and you open your little corporation to run your plumbing business, it’s not affecting you.

Now, this is a pretty strong intervention, because it is also sanctioned by another part of the legislation that says that the federal government can revoke this charter if the company is engaged in repeated and egregious illegal conduct. I don’t know how the two reconcile, but if illegal conduct is not to act in the interest of everybody, then this amounts to a death sentence in the hands of the US federal government, and that’s pretty strong stuff.

Kate: I agree. I also think that it’s easy to say, OK, all stakeholders should be considered when corporate decisions are being made, but if you actually want to maximize the welfare of all stakeholders, that’s an almost impossible decision to make. If you think about maximizing firm value, to say that that’s the same thing as maximizing stakeholder value, I don’t think that that’s true. Maximizing firm value is maximizing the value of your debt and maximizing the value of your equity. To the extent that bondholders and lenders can’t be exploited, it’s basically the same thing as maximizing shareholder value. And, of course, companies have to operate within certain constraints, and so they have to meet the law, and they have to make sure that they’re not polluting in any illegal way. And I think that there are a lot of laws and regulations that prevent negative externalities that companies impose on society.

But then to go the additional step and say, these companies need to be maximizing stakeholder value, which includes community and customer concerns, I do think that that really complicates their decision-making process.

Luigi: Wait, Kate, you have probably been a little bit too fast for most of our listeners, because what you said is correct, but you’re sneaking in a bunch of assumptions along the way that I think are useful—

Kate: Oh, yeah, like you never do that, Luigi.

Luigi: No, I never do that . . . are useful to unpack for our listeners. So, I think it is true that if all the markets for patrons of the firms—and patrons can be debtholders, can be customers, can be employees—if all these markets are perfectly competitive, then maximizing a firm’s value or maximizing shareholder value is the same thing as maximizing the welfare of all these parts together.

However, when some of these markets are not competitive, or when there are a lot of firm-specific investments, like if the workers have made some sacrifice in the past in order to work for this firm, then the story might be different. Then we have a situation in which you can maximize one at the expense of the others. I think that where Elizabeth Warren comes from is, she’s concerned that there is not enough competition in this market, and I disagree that the right threshold is a billion dollars, because you can be a billion-dollar firm with a lot of competition in all these markets, but I do envision situations in which you don’t have that competition, and then you do have to worry.

Kate: I agree that Elizabeth Warren is concerned about not just labor, but also the environment and climate change here, but I think it’s worth pointing out that she’s also in favor of a bill called the Climate Risk Disclosure Act, in which public companies would have to say exactly how they’re affecting the environment. To the extent that we would believe that that was true, that they were being completely honest about everything that they were doing to affect the environment and climate change, then to have the environment and just people living in the world be part of a CEO’s decision-making process, that, to me, it’s a little bit redundant with the other act, the Disclosure Act, and it adds a lot to the complexity of the decision-making process. It also opens up room, as you mentioned earlier, for the government to just attack any company that they think is not complying with the act in any way.

Let’s talk about the part of the proposed act that concerns labor relations directly. So, having 40 percent of the board, at least, be elected directly by workers at the company. What do you think about that?

Luigi: First of all, for our listeners, this is not such a new idea as the previous one, because this is what has taken place in Germany since World War II for the largest corporations. In fact, in Germany, they elect 50 percent of the directors, with the only caveat that in case of a 50-50 vote, the chairman’s vote counts for two votes, and the chairman is appointed by the shareholders. So, both systems leave the majority to the shareholders, but they give representation to workers. It’s called codetermination.

The evidence in Germany is that it was neither such a sort of fix for the problems nor a disaster like their enemies seemed to represent. I don’t think that really changed a lot, and now we know that industrial relations in Germany are, if you want, less conflicted than in the United States. I don’t know whether this is due to codetermination or due to the fact that the story in Germany is different. What I want to point out is, there’s a big difference between Germany and the United States. In Germany, people tend to have one job for life. The mobility in the labor market is fairly limited, and if you enter and work for Mercedes early on in your life, you stay there for most of your life. So, as such, having representation on a company board makes more sense. When you have a labor force that changes super-fast, that representation makes less sense.

Kate: Yeah, I think codetermination deserves an episode of its own, right? We could go through the literature that’s been relatively mixed on the success of codetermination. But I think it’s an important topic, and I think, if you’re interested as listeners, let us know, and maybe we can do another episode on that in particular.

Another thing I would add to what Luigi said about the differences between labor unions and labor representation between Germany and the US is that, who pays for the unions or who pays for the representation? In Germany, the laws are such that, if you have these committees set up within the corporation to help represent you on the board, then all the offices and everything those councils need in order to function are paid for by the company. Whereas in the US, if you’re part of a labor union, then, in a number of states, that labor union has the right to take a fraction of your wages as union dues. I think that that’s a huge part of why there are differences between the German system and the US system. A lot of US workers would support more representation, but they don’t like the idea of having to be forced to sacrifice part of their income to a labor union.

On top of that, in some regions and in certain occupations, there’s only one type of labor union that you can join. For example, when I was a grad student, I was part of GSOC-UAW, where the UAW part stands for United Auto Workers. Why am I, as a finance PhD student, part of a union with a bunch of autoworkers? I don’t know what their objective is. I don’t know if they have my best interests at heart. Whereas if I knew that . . . there was just a council within my own organization that was being paid for by the organization, I would maybe feel a little bit more comfortable with that. So, I think that there are huge changes that need to take place within the United States to help reform labor rights in general, but I still agree with the spirit of this suggestion.

Luigi: Kate, I never thought of you as an auto workers’ union member. That’s a new side of your personality that I’m discovering. But the more important point, and I know, we probably need to postpone it to the next episode, but in a world of multinationals, worker representation creates a huge problem. You’re going to represent all the workers? So, you are going to have some workers from the Philippines, some workers from Cambodia, some workers from the United States, and in many of the US corporations, probably there are more workers not from the United States than from the United States. So, they should have the majority on the board.

Kate: Yeah, that’s an interesting point that I honestly hadn’t thought about. If you have different types of employees, like if you’re talking about Google, if you have high-tech employees, as well as janitors, is there a different weighting in terms of who gets more power, or is it just the raw number of people who work in each position? I think that those are all difficult issues to grapple with.

Luigi: When you bring up Google and the power that employees of Google have in shaping the corporate policies of Google, this proves the point that you don’t need to have votes to have power. Talented employees that are in short supply have a huge amount of power and can shape the direction of Google. So, in a sense—and this is what the finance literature suggests—the reason that shareholders have votes is not because they are the most powerful. In fact, they have the votes because they are the least powerful. Once they put their capital into the firm, they have no say, and they can be easily expropriated by all the other constituencies. That’s the reason why their interests need to be protected by votes. The bondholders can withdraw their money by not renewing the bonds, the workers can withdraw their labor by leaving the firm, the customers can stop buying. Maybe the only ones who don’t have a lot of power are the community at large, but we know that the local mayor does have some influence on the way companies are run. So, I think that there is a pretty strong argument to give a primacy to the shareholders in most cases.

Kate: The last thing I want to say about the Accountable Capitalism Act is that I assigned an extra-credit assignment in the class that I taught last semester, where I had all of my undergraduate students write an essay on whether or not they agreed with the Accountable Capitalism Act. I was shocked. I mean, OK, so to be fair, these are all business-school students, and so, they were learning from me about maximizing profits and things like that. But I was pretty shocked to find that 60 percent of them, roughly, did not agree with her proposal. On top of that, the ones who did agree, I think they were very thoughtful, and they said, “OK, this part I think is better than that part, but on the whole, I think that I agree with her spirit.” But the ones who were against the act were vehemently against the act. They were like, “Oh, it’s a no-brainer that we shouldn’t pass something like this. This is going to sink the country into communism.” I thought that it was interesting that the rhetoric of the people who are on either side was different.

Luigi: It is interesting, because she received a lot of criticism from the right on this proposal, and many people have talked about socialism or transforming American capitalism into socialism, because you bring some workers on the board.

Given the experience of Germany, I doubt that’s the case. But it is a little bit funny, and I picked up on an article that Richard Epstein wrote about this. He said, if you want to apply this in general, why don’t you have the dean of the business school also appointed by the janitors? That’s part of the process. What about the unions being represented also by consumers? Where do you stop this representation of our constituencies? Why, as a consumer, can I not be represented in the union that decides whether they strike, making it impossible for me to travel by train or by plane?

Kate: The third major part of Elizabeth Warren’s platform that we want to talk about is affordable housing. In particular, she has called for almost half a trillion dollars of investment to be set aside over the course of the next 10 years to go towards affordable housing for the lowest-income members of society.

Luigi: But what is interesting is how the bill is designed, because, first of all, it works on two margins. One, it has some incentives to get rid of local zoning laws that restrict the supply of houses in many neighborhoods. This is very much something that even the right side of the political spectrum will agree with, and it is fighting the so-called NIMBY, not in my backyard, that is a major cause of the increase in house prices.

In that part it shows, in my view, the capitalist side of Elizabeth Warren that is trying to work through market forces, but then the other side is that she thinks it is also important to build more houses, and she proposes half a trillion dollars over 10 years in building new houses. You wonder, where does she get the money? Actually, she is planning to get the money by increasing the federal estate tax. There was even an independent paper showing that this will be a balanced budget proposal, which means that richer people will be taxed to the point of half a trillion in 10 years.

Kate: Yeah, she says explicitly that these tax changes would only affect about 10,000 families.

Luigi: It must be that those people are really squeezed a lot, because raising half a trillion out of 10,000 people, that’s a challenge.

Kate: Yeah, absolutely.

Luigi: But one piece that I admire is that she seems to have focused on what are, in my view, the biggest problems of our time. One is the fact that wages don’t rise enough. The second is that there are problems with the cost of housing that economists have shown can have a major impact on the ability of the country to grow, and the third one is political corruption.

So, those three pieces, again, I’m not necessarily buying all the parts of all these proposals, but the fact that she has identified what I think are the right problems, and she has some interesting proposals on those problems, I think speaks very highly.

Kate: I think that something else that Elizabeth Warren should be credited for, and also part of the reason that big business doesn’t like her, is the CFPB, the Consumer Financial Protection Bureau, which was really her brainchild. I think she proposed the idea behind the bureau in 2007.

This is an agency that has gone after scams, basically. It’s gone after companies that cheated victims of 9/11 out of the money they were owed. They’ve gone after exploitative payday lending. They’ve gone after retirement scams or scams that were created just to ensnare old people. They’ve also tried to put limits on debt-to-income ratios, in essence limiting exploitation in the housing market, which is part of what contributed to the financial crisis. But, unfortunately, the CFPB has since lost a lot of its powers.

I have maybe one additional criticism. Maybe you can consider this minor, just by virtue of the fact that it has to do with my background as a bankruptcy researcher, but amongst bankruptcy academics, some of her findings have stirred up a lot of controversy, particularly some of her research related to personal bankruptcy and what causes personal bankruptcy. She’s argued that somewhere in the realm of 50 percent to 60 percent of personal bankruptcies are due to injury and health-related causes. And this has been hotly contested within the bankruptcy community. Some have even made allegations that these findings were politically motivated. In any case, at the end of the day, I prefer her as a politician than I do as an academic.

Luigi: The point here is not whether you like her or not. The point is that she has interesting proposals that speak to the current problems in capitalism. They might not be the silver bullet, and certainly we have identified a lot of her shortcomings, but they are serious proposals for real problems, and in the spirit of not trying to overrule capitalism, but trying to make it work better.

Kate: As we mentioned earlier on, though, this episode was motivated by the many similarities between Elizabeth Warren’s economic platform and the issues that we try to grapple with on this podcast. As 2019 progresses and more candidates announce—and by the way, this could include right-wing candidates as well—we want to keep the conversation going.

So, if there are any presidential candidates whose economic platforms you think deserve serious consideration on this show, let us know.

Pulitzer Prize-winning journalist Steven Pearlstein drops by to talk about the incredible shrinking newspaper -- especially the business section -- and why that's bad for the economy. His new book "Can American Capitalism Survive?" argues that the mantra of 'maximizing shareholder value' ultimately caused Americans to lose faith in the free market.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Speaking about what is not working in capitalism, I think that the media plays quite an important role in trying to expose the many things that don’t work in capitalism. This is not a recent innovation. Going back in history, there was a very important role played by the press and particularly by a journalist, a woman journalist, Ida Tarbell, who exposed the problems with the Standard Oil monopoly and created the political demand for intervention.

Kate: But the last two decades have fundamentally altered business journalism, from the relationship between journalists and corporations, to the business models of publications themselves, to the public trust in the media. We’re very fortunate to have as our guest today someone who’s been a prominent business journalist throughout this transformation, Steve Pearlstein. Steve’s a Pulitzer Prize-winning journalist. He has a regular column at the Washington Post. He’s the Robinson Professor of Political and International Affairs at George Mason, and he recently came out with a book called Can American Capitalism Survive? Steve, welcome to the show.

Steve Pearlstein: Thanks for having me.

Kate: Steve, can you describe to us how the relationship between journalists and businesses was when you first started in your career?

Steve Pearlstein: I started, actually, at, seriously as a business journalist, at Inc. Magazine, which in the 1980s was a very fat book. If you dropped it on your foot, you would’ve broken your toe. The reason was because there were all these ads for this new thing called the personal computer. It was the beginning of Silicon Valley, and Inc. was the magazine of small business. I got a pretty good view of the entrepreneurial sector, but Inc. and a few other magazines, Entrepreneur, were the only ones that covered that. Covering business was covering big business. There was, frankly, a very close relationship between the business press and large, public companies. They all had vice presidents for, essentially what they then called press relations, and reporters were organized by beats. You were the defense industry reporter, or you were the retail reporter, or, at a place like the Wall Street Journal, you were the GE reporter. There were probably two GE reporters at the Wall Street Journal.

I eventually went to the Washington Post, and then I started covering the defense industry. When I became the defense industry reporter, I had a meeting at every one of these headquarters. I met this head of PR, but I also met several executives and the chief executive. They wanted to meet me, and I wanted to meet them. Now, this is the days of the telephone. You’d call them up, and they’d call you right back if they didn’t pick up the phone right away. They would do anything, really, to accommodate you, to answer your questions, to arrange for you to visit someplace, to talk to who you ever wanted to talk to. There were some exceptions to that, but by and large, that was the way things worked. There were several things going on there. First of all, we were very important to them, and so they needed us. They needed us to talk to the world, in the case of the defense industry, to talk to Washington. They needed us to talk to investors, and they needed us to talk to their customers.

We played the game in an honorable way. We didn’t do things to screw them. If we said it was off the record, it was off the record. They didn’t do things to mislead us because they knew if they misled us once, that it was not going to be good the next time we came around.

I want to contrast that with today. Today, businesses, particularly public companies, and private companies too, they don’t need us. They feel, anyway, they don’t need us. They feel they can communicate with their employees, with their customers, and with their investors through different channels. Social media has greatly changed that but also specialized blogs. So when someone like me calls up, who may not be a beat reporter—and there aren’t many beat reporters left, I’ll get to that in a minute—they may or may not respond. Mostly, they don’t give you their phone number on the website. You have to hunt for it, or you have to send an email to some drop box, and they may or may not respond to you.

The general rule is they’re not interested in talking to you. They’ll answer questions, written questions, by email, and that’s the end of it.

Half of this is our fault. The reason it’s our fault is because there are very many fewer business reporters, we’re not organized by beats, or the beats are very broad. You don’t have the knowledge and the relationships with the company. That’s a function of how journalism has changed and the economics of mainstream media have changed.

Kate: Can you give us an example of your favorite company to cover and the types of relationships you established in doing so?

Steve Pearlstein: Lockheed Martin was one I had a very close relationship with. The guy who was the chief flack, as we used to call them—and that was not a negative term—I mean, we had each other on the speed dials. I had his home number. He had my home number. We used to go out and have dinner together a couple of times a year just . . . He never lied to me, and he would never mislead me. If I really wanted something, if I really wanted to talk to the chairman, he’d get me the chairman. They wanted me to be well-informed and knowledgeable. It wasn’t a time . . . It’s not gotcha journalism. We didn’t do a lot of stories about people complaining about chief executives doing sexual harassment. I got to tell you, that was not . . . We were worried about profits, and mergers, and who was winning, and who was losing. The way I like to describe it is that in those days, we covered business the way sports reporters covered sports. There were various teams, and they were competing against each other for the World Series, and we covered it like that.

We covered the stars, that is the executives who, often, big profiles were done of them. They were on the front pages of magazines. When was the last time you saw a business executive on the front page of anything in a laudatory fashion? It just doesn’t happen anymore. The other thing about CEOs, particularly today, is they really like to control. You can’t control the press. You have to get comfortable with the idea that you don’t know how the story’s going to come out. They hate that. These guys, today, are control freaks, and they do not like dealing with the press, in part, because of that. We talk back to them. They’re not used to getting talked back to. They say they are. They say, “Oh, yeah, my people talk back to me all the time.” Let me tell you, that’s a load of crap.

This is another reason they don’t like the press, because we’re not, in their opinion, respectful. By the way, if you want to know where this goes back to, it goes back 20 years, 25 years, to the early ‘90s and the stories we used to write about their compensation. This where the trust, not between the PR people and us, but between the executives and the press broke down, because we kept writing these stories about nobody deserves to earn this amount of money. Of course, back in the ‘90s, they were pikers compared to today. Anyway, that’s where it started.

Luigi: I come from a country where big advertisers were few, and when they didn’t directly own a newspaper, they were still so influential that they could get their view of the world in a pretty dramatic way. Back then, was that the case in the United States?

Steve Pearlstein: No. It just wasn’t, Luigi, there was an absolute wall. I told you that I was the business editor of the Post for a few years. There was a guy who used to do all the selling for the Washington Postto the car dealers in the Washington area . . . There were several of them, but he was the chief one. One day, he came down to talk to the auto industry reporter. That became a big deal. The managing editor complained to the publisher. There was a big meeting about it, and those guys were told, “Don’t you ever come on the fifth floor.” That’s how much of a wall there was. No, they had . . . We used to write articles . . . The biggest advertisers were the department stores. We used to have this retail reporter who was always driving them nuts, and they would get the call. They called the publisher, and the publisher would just say, “Well, thank you for calling.” That was the end of it. We never heard of it.

Kate: What do you think was the mechanism that allowed the wall to exist? It wasn’t regulatory, right?

Steve Pearlstein: No, no, no. It was culture, and norms, and it was . . . We needed to protect our credibility. That was one way we protected our credibility. You see it even today in the Wall Street Journal. There’s a wall between the editorial department, which as you, if you read the Wall Street Journal, you’ll know is a very conservative editorial department, and the news department. Those guys, news people, play it absolutely straight, or at least they did before Murdoch took over. Their reporting was as unbiased as anyone else’s reporting at the Wall Street Journal. The editorial department had nothing, so it’s not just advertisers, but the editorial department were walled off. It was enforced this way: In the competition for good journalists, good journalists wouldn’t work for a place that allowed advertisers or the editorial department, or the publisher to affect your news coverage. Not only was it important for credibility for the public, but if you wanted to attract the best journalists, you had to have that wall.

Luigi: Can I try a different theory, maybe less romantic—

Steve Pearlstein: OK.

Luigi: I view the journals of yesteryear as a kind of oligopoly. They were making a lot of profits.

Steve Pearlstein: No doubt about that.

Luigi: We’re using journalists as people, now, as the fashion industry uses haute couture. It is like you use haute couture to attract the reputation, attract the big designers. Nobody actually buys haute couture. Haute couture is completely sort of a losing proposition—

Steve Pearlstein: Right.

Luigi: —but it is a good barrier to entry, a good way to create reputation, and a good way to attract talented designers. I think that the newsrooms of old newspapers were exactly that. The competition brought by online advertising and so on and so forth destroyed those monopoly rents. The news departments are going down the tube as the haute couture departments of fledging fashion houses.

Steve Pearlstein: Well, the analogy is apt except for one thing. A lot of people did wear our clothes. That is, we had millions of readers who did read us. That’s all we cared about. You’re right, having a quality journalistic product attracted the advertisers because it attracted the readers. We were the intermediary between the advertisers and the readers. The newsroom attracted the readers, and then the advertising department sold our product to the advertisers, and, effectively, the advertisers paid for the news. You did pay something for the newspaper, but what you really paid for was the printing and the delivery. The news, the gathering, and the writing, and the editing, and the display of the news were actually paid for by the advertisers. When there were less advertisers, there’s less news or less resource going to the news.

Luigi: Absolutely. Our listeners will remember when we discussed the multisided platform. Multisided platform is a new concept in economics, but it is not a new sort of a business model.

Steve Pearlstein: Right. No.

Luigi: The newspapers were exactly a multisided platform where the sides were the journalists, the readers, and the advertisers.

Steve Pearlstein:Like other multisided platforms, they have a tendency to winner-take-all competition because the advertisers want the place with the most readers, but it turns out the readers want the place with the most advertising. I’m not talking about the display ads. I’m talking about the classified ads. The reason that there was only one newspaper in every major metropolitan area until the 1990s, now there’s zero sometimes, but there was one, was because that was the paper that got ahead in the competition for classified advertising. That was a big source of revenue and much more profitable than other kinds of advertising. Once you got ahead in that, you basically won the game, because all the advertisers, classified wanted to go to the largest classified, and all the readers wanted to go to the largest classified. It’s like a natural monopoly.

Kate: Excuse my ignorance here—

Steve Pearlstein: Yeah.

Kate: —but who is mostly paying for the classified ads? Those weren’t necessarily personal ads. Right?

Steve Pearlstein: No, the people . . . No, well, they are. They were personal ads.

Kate: Really?

Steve Pearlstein: But they’re not personal ads like for dating. They were personal ads for selling—

Kate: That’s what I have in mind.

Steve Pearlstein: No, no, no. That was a small part, and we regulated those very, very, very heavily. No, it was for real estate, and used cars, and jobs. That’s how people, you forget, you’re too young. You forget that that’s how people got jobs. There was no online matches. It’s much more efficient now with cars, and real estate, and jobs. The online world . . . Craigslist ruined the newspaper business, basically. I mean, if you wanted to . . . it wasn’t Google. It was Craigslist that ruined the newspaper business as a business.

Luigi: Yeah, when I joined Chicago in 1992, and I looked for an apartment to stay, I bought the Chicago Tribune. I went through the classified ads of the Chicago Tribune. That’s the reason why I bought the newspaper, and the people who were renting apartments were paying to post their ads in the Chicago Tribune. That was really the focal point of the market at the time.

Steve Pearlstein: Yeah, and that was far and away the most profitable part of the advertising because people paid ... They only had these little things, and so they paid per line a very high amount compared to the number of lines you bought if you were a department store. But also, it was no sales cost involved. They called you. You didn’t have to call them.

Luigi: But I wonder to what extent, also, this brought a segmentation in the political views of the newspapers, because if you were the local newspaper, you were trying to cater to the largest possible market. You are naturally a moderate in position. You couldn’t be a radical on the left or the right because you wouldn’t get the market.

Steve Pearlstein: It was mass media, and so you had to be mass. They tended to be centrists. Sometimes editorial pages would go left or right, mostly right. Again, the editorial pages were separated from the newsroom, and there was a sort of professional attitude about how to cover the news objectively and fairly. People scoff at that now, but the truth is, there just was a way of doing things that we passed on from generation to generation. We didn’t, in our generation we didn’t go to journalism school, but it was learned on the job. One of the things you learned was how to be fair and balanced. We didn’t kid ourselves. Journalists, by sort of self-selection, tend to be liberal because they tend to be antiestablishment. They don’t get paid that much. They tended to be liberal, but we didn’t try to slant the news in one way or the other in terms of party or ideology. We were equal-opportunity assholes. Whoever has power, we tried to take them down a notch.

Luigi: So, how do we fix this problem, because I believe that the press was far from perfect in the past, but it was playing a very useful role. I think the business model allowed it to play this role. Now, that business model has been destroyed, and I don’t think it’s been substituted by an alternative so far.

Steve Pearlstein: It is being substituted, Luigi. The new business model, and we can see it in the Wall Street Journal, in the New York Times, and in the Washington Post, is now the readers will have to pay for the news. There was a time when the internet was fairly new, when there was a belief, and it came from Silicon Valley, that content ought to be free. Well, content, in the case of news, can’t be free. So, what’s happening now is, first of all, people who care about news and care about having edited news, curated news, quality news, factual news, are willing to pay for it. They’re willing to pay, I’m just throwing out a round number, a dollar a day to get a good newspaper—only it’s not a paper anymore—but to get a good news product. They’re willing to pay half of what they pay for a cup of Starbucks coffee, or a third, every day.

If you get a couple of million people, three or four million people willing to do that around the world, now you don’t have to worry just about your local area. You’re going to be able to put out a good global news product.  The Timesis well on its way to doing that. I think we at the Washington Postare on our way. The Wall Street Journaland the FThave an advantage, because the people who buy it actually are not people. They’re businesses that are buying, so they’re not that price-sensitive.

Luigi: I thought businesses were people, no?

Steve Pearlstein: Well, right. Anyway, so there is a new model, but what’s going to be the new model is there’s only going to be six or seven English-language, full-service, global news organizations around the world. They’re going to be print. They’re going to have video. They’re going to have podcasts. They’re going to have everything. They’re going to be global, and there’ll only be room for six or seven of those, because it’s only going to be a dollar a day, so you need several million. The loser in this is going to be local news coverage, because they can’t aggregate that number of paid readers. That’s going to suffer, but in terms of national and international news, and I would add sports news and global business news, there will be a product, and it is evolving. But remember, Luigi, that just at the height of the major newspaper era, there were something like, I’m guessing, 1,200 daily newspapers in the United States alone. That was so fragmented. You need consolidation, but with consolidation comes the neglect of local news.

Luigi: I would like you to elaborate, because I think it’s quite important. This generates a fragmentation, because if you are trying to please your customers, and especially if you’re trying to extract more of the surplus from your customers with higher prices, you’re going to cater to their ideological biases, and so the middle-of-the-road media that facilitated the common conversation in the United States are replaced by super-partisan media that make it more difficult for people to talk. I remember, you probably know the name, but there was somebody who said, “You are entitled to your opinion, but not to your own facts.”

Steve Pearlstein: Yeah, that was a senator named Daniel Patrick Moynihan.

Luigi: Yes, and so that, I think, used to represent what politics was. Today, politics has its own facts.

Steve Pearlstein: Well, I will say that there’s probably going to be a bifurcation. There is a market for straight, factual, smart news. Basically, upper-middle-class professionals want that. They do want the facts, and they do want smart, balanced analysis. They have the most money, and so there will always be one, or two, or maybe even three competitors who are trying to get them, because that’s where the money is. By the way, they’re also a good advertising audience. Advertising won’t drive this thing, but they are a good advertising audience. So, there will be them, and then there will be others who prefer a more biased news.

Just to give you an example, if you were running General Motors, you want to know what’s going on in the world, and you want a straight shot at the facts of what’s going on in the world. You’ll make your own opinions about it, but you don’t want your news tilted. There are still a lot of people, academics like yourselves, who are going to want that, and there’s a lot of people who want basically straight news. To have straight news doesn’t mean you can’t have commentary. You can either have slanted commentary or you could have a mix of commentary. Again, this audience that I just described probably wants to read a good conservative columnist and a good liberal columnist, as I do, and I suspect you do.

Kate: I’d like to talk a little bit about your book.

Steve Pearlstein: OK.

Kate: You focus on one important norm that changed at businesses, which is the idea of shareholder value maximization. What were CEOs maximizing prior to that idea, and what caused the shift?

Steve Pearlstein: Well, what they were maximizing was, perhaps, their own reputations, perhaps the size of their companies, and, putting it in the best face, they felt they had a number of stakeholders to which they had to pay attention. They saw their jobs as balancing the interests of these various stakeholders in order to maintain the long-run viability and success of the enterprise. In the 1950s and ‘60s, chief executives, top executives, had as much power as they do now, or more. Boards were actually more easy to sway. And no one would ever have considered paying himself what these guys pay themselves now. The reason was not only because their employees, whether they were unionized or not, would have not liked that. They would have seen these employees when they go out to the soccer game, or when they went downtown on Main Street to do shopping, or whatever, they ran into their employees, they wouldn’t have wanted to jeopardize those relationships. They didn’t want their employees to become unionized and socialist, so that’s another reason that they didn’t do it.

They wouldn’t, but here’s another reason they wouldn’t do it. They wouldn’t do it because when they went to the country club, one of them would have said to the other one, “Don’t do that. You’ll make us all look bad.” There was a sense, in those days, that they all had to stick to certain norms for the good of all business, so that business was well-regarded and trusted, so people didn’t join unions, so they didn’t vote socialist. There was also a period coming out of World War II, and there was a lot of shared sacrifice during World War II. Women went to work together in the same factories. Men served together of all different classes. There was a lot of sacrifice going on, in terms of people giving up certain consumer goods and rationing. So, coming out of World War II, that sort of thing would have been unseemly, the sort of individualistic “I’ve got mine, I don’t care whether you get yours” kind of thing. That would have seemed unseemly.

Now, obviously, as you get farther and farther from the war, that wore off, so that’s one reason the norms changed. The other reason was because of Wall Street. The period of the ‘70s was really a lost decade for investors. They made no money. If you invested in the broad stock market during the 1970s, on an inflation-adjusted basis, because we had pretty high inflation, you would have lost money. By the early ‘80s, Wall Street had pretty much had it. Here’s what happened: Big US companies used to earn rents in a closed economy, and they shared those rents with their employees and a little bit with their customers, but not really, but they shared it with their employees and their communities. Then global competition came, and they lost their rents. Their first instinct was actually not to take it away from their employees and their communities. They basically took it away from their shareholders, and that was the lost decade. After that, the shareholders said, “Hey, enough of that,” and you had this market for corporate control that developed during the 1980s, the hostile takeovers.

You had to change a lot of social norms in order to for that to happen. It used to be that white-shoe investment firms wouldn’t handle a hostile takeover, and that white-shoe legal firms wouldn’t handle one, and there was no bank that would finance it. So, there had to be a whole new system that developed, and it was out in California. It was Mike Milken and his company, Drexel Burnham Lambert. They provided the investment banking. They created junk bonds to finance it, and they went around the establishment system, so you had these corporate raiders who were considered low-life by the executives and the other people on Wall Street.

They started doing these things, and they basically revealed that a lot of these companies were not run with anything like the investors in mind. They said to investors, “Let us take over, and we’ll make you first.” They did that a few times, and then all of the sudden the norm was changed. Everyone felt that if they wanted to avoid a corporate takeover, they’d better run their companies that way. A lot of people in academics then jumped on and sort of came up with the economic and legal justification for maximizing shareholder value, and we’ve basically had shareholder capitalism ever since.

Luigi: But there’s one fact in your picture that you seem to ignore, which I think is equally important. Back in the days where people were not paid a very high salary, tax rates were 91 percent, so they changed the tax system, to some extent, to favor the emergence of some of those differences, because it’s not that the executives of the time were poor and were sacrificing their life.

Steve Pearlstein: I was a kid in the 1950s and early ‘60s, so I can’t say this from personal experience, but I have talked to people about this. First of all, nobody paid a 90 percent tax rate. There are liberals and conservatives who love to bring that up all the time. Nobody ever paid that, so unless you got this sort of windfall that you couldn’t arrange to avoid it, nobody paid it. For one thing, they could have paid themselves in stock, and that could have been taxed as capital gains, and that’s one way they did do it. That’s one way they still do it, so that’s the primary way in which you would increase your compensation if you were a chief executive, and that was still available at that time.

Kate: All right, so another trend that you talk about in your book is a shift in culture, and the shift in trust, and communication, and cooperation amongst citizens themselves. Do you think that that was part and parcel with the shifts in business attitudes towards maximizing shareholder value, or do you think there was something else going on at the same time?

Steve Pearlstein: A lot of what I consider to have gone wrong in American capitalism stems from maximizing shareholder value and that view of corporate purpose. I don’t think it’s a leap to say that one of the relationships that got strained badly was the relationship between workers and companies because of that. But there’s a second thing, which is the inequality question. The rise of income inequality has eroded social capital, has eroded the trust that we have in each other, and has resulted in things like a polarized politics, which makes our government dysfunctional. That, too, is not good for business. It’s not good for an economy if your government can’t respond in a timely fashion to changes in markets and changes in technology. Eventually, if your politics gets ossified, you’re not going to have a good economy.

Luigi: There are some key ideas in your book on how to sort of save capitalism or make capitalism survive. Can you summarize them for us?

Steve Pearlstein: Sure. Well, as I said, this all goes back to the 1980s when our economy had gotten uncompetitive, and we needed to do something to fix it. There was a real serious threat that Japan would overtake us, that Germany would overtake us. We had all these competitiveness panels and that sort of thing. I mean, it was a serious threat, and we needed to do something. And we did, but we did it by embracing a set of ideas, which at the time were quite useful. Ideas like the purpose of a corporation is to maximize shareholder value, or that greed was good. We needed people to be hungry in that way in order to have a competitive, entrepreneurial economy. Or, as things became more unequal, we said, “Look, don’t worry about income inequality. What matters is equality of opportunity, not income.” Or we had the idea that you could divide the pie more equally, but if you do that, you’re going to get a smaller pie.

There is some truth to all of those ideas, but when you push them as far as they have now been pushed in the last 30 years by the market fundamentalists, it turns out that they’re not true. If you come to realize that, then the solutions, it seemed to me, are a lot more apparent on what you can do and should do, which is not to have the pendulum go back to the 1960s and ‘70s. It’s not to become like socialist France, but maybe we have some things to learn from Germany, or Denmark, or Sweden. Maybe we have some things to learn from Japan. Maybe we have some things to learn from Chile, but our conversation about a lot of these things has gotten awful stale. Either you’re free market or you’re anti-free market. I haven’t found that, in recent years, to be a very satisfying conversation.

Luigi: And, by the way, countries like Sweden that are often indicated as socialist countries, they do have, of course, a higher level of distribution of income. But in terms of competition, in many dimensions, they’re more competitive than the United States. I was shocked to arrive at the Stockholm airport, and there are multiple cab companies competing one against the other.

Steve Pearlstein: Yes.

Luigi: You can make your price, and this is true not only, of course, in the cab companies, but in a lot of sectors. I think that the Swedish system, or even the Danish system, has tried to protect and push competition in a way that is not true in this country.

Steve Pearlstein: And particularly like that because there’s less regulation, but in order to do that, they have to have the safety net underneath people in order to do that, because you can’t have that kind of creative destruction that comes from that competition if everyone has so much on the line, that if I lose this, I don’t get health care. That’s exactly the kind of thing we have to talk about, but you can’t have that conversation today with most Republicans in Congress. Let’s do this tradeoff: less regulation with a better safety net. They will only have half the conversation. I wish we could have more of that kind of conversation, Luigi, because we would be a lot more fun, and much more productive, and it would be better for our economy.

Luigi: We certainly can have it in this podcast.

Kate: Steve Pearlstein, thanks for joining us on the show.

Steve Pearlstein: My pleasure.

Fahmi Quadir thinks short sellers get a bad rap. Known as the "financial assassin" for helping expose fraud and misconduct at Valeant, she tells Luigi that Tesla might be next. But Kate isn't convinced -- she thinks journalists and regulators are the real heroes.

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

For a capitalist system to work properly, we need information to be produced and disseminated. While there are a lot of mechanisms to collect and distribute good information, information that is positive and rewarding, it’s much less easy for negative information to be collected and distributed. So, who makes sure that fraud is identified and exposed? One crucial role in this is played by short sellers.

Kate: So, who are these short sellers, or what is short selling, exactly? It’s kind of like the opposite of buy low, sell high. You sell high first and then you buy low. There’s a question of how you do that, right? How can you actually sell high if you haven’t bought yet?

The mechanics of shorting involve you first borrowing a security, so let’s say borrowing a share of stock from somebody else. They have to be willing to let you borrow it, and so you have to talk to your broker, your broker talks to their broker, you make sure that everyone is on board with the borrowing agreement, but you borrow and then you sell it in the market immediately.

Then, later on, if the stock price falls, you buy it back from the open market, and then you return it to the person you borrowed it from. That way, if the stock price did indeed fall, you would make money on the amount by which it fell.

Luigi: Short selling is an extremely risky business for two reasons. Number one, the upside is limited. At best, the stock goes from the current price to zero. At worst, the stock price keeps rising and your loss is infinite.

Second, even if you have the right bet, but in the middle of your position, the person who lent you the shares decides that they don’t want to lend you the shares anymore, and they ask for it back, you are forced to buy back shares in the middle of the trade, and at a time where you might be in a situation where other short sellers are trying to do the same, and that pushes the prices up, making your losses even larger. That’s called, in jargon, a short squeeze.

Kate: I think this idea of unlimited downside is sort of a fiction, though. The reason that if you take a short position you usually need to post collateral is that eventually, if people are worried about your ability to repay the security, then, as you mentioned, they’ll either demand the security back or they’ll take whatever collateral you’ve put up in order to protect themselves.

At some point, if you’re losing enough money on a short position, it will be closed out. You’re not going to lose an infinite amount of money.

Luigi: You are right, but I think the reality is asymmetric, that there is more to be lost than to be gained. And remember, on average, stock prices go up, and so, on average, you lose money. So, you must be particularly good in identifying the bad stocks in order to live as just a short seller.

Kate: And precisely because of this, there aren’t that many funds that have a pure short strategy, which is to say that they only take short positions. There are a bunch of hedge funds that have long/short strategies, so they go long stocks and they go short stocks at the same time, or depending on market conditions.

But it’s tough to take a short-only strategy, because oftentimes, if you decide to buy stocks whose prices are falling, this is called trying to catch the falling knife, and that strategy, on average, is not going to make you money. And, as Luigi mentioned, for the most part, stock prices go up, so if you’re always just betting against the market, that’s not going to make you money.

To be a good short seller, you need to be able to identify companies whose stock prices are dropping, and they will be permanently dropping, and these tend to be companies that are either in industries that are just on the verge of death, or more likely, companies that are engaged in some sort of fraud, have some sort of scandal underlying them, or are right on the verge of failure.

Luigi: In a sense, this is an aspect of short selling I like, the idea of doing good and making money. If you are a good short seller, you expose fraud and you make money at the same time. It’s like a modern version of the bounty hunters that were going after criminals and making money.

Kate: To be fair, bounty hunters still exist. In fact, they make for very popular television.

Luigi: OK. Why don’t we meet a contemporary bounty hunter, Fahmi Quadir, who at the age of only 26 exposed Valeant, one famous pharmaceutical company, as an overhyped stock and made a fortune for the fund she was working for, and after that she walked away and created her own hedge fund, which is a short-only fund.

Kate: Unfortunately, I couldn’t make it to the interview because I was teaching all day, but I will chime in a little bit later, because I’ve got some thoughts about this interview.

Luigi: First of all, thank you for being on the show. This is a great opportunity for us to talk about a crucial aspect of capitalism that is not very much loved, which is shorting. Can you explain why this is such an important aspect of financial markets?

Fahmi Quadir: I think we live in a world where markets encourage companies to engage in varying levels of obfuscation, whether it’s at the corporate level or on their financial statements. So, short sellers are
. . . At least fundamental short sellers are really hoping to break through that obfuscation and provide some clarity as to what is really going on at a company, so there is ultimately true price discovery, and the stock price is more reflective of the true intrinsic value of that company.

Luigi: Can you explain to us what exactly is this dynamic between you and the companies?

Fahmi Quadir: One thing that we like to look for as short sellers are companies that complain about short sellers. Generally, if a company is focused on its operations and doing well and delivering to shareholders, then they will welcome short sellers, because it’s an opportunity for the share price to go higher, because at some point we have to buy those shares back.

But a company that has something to hide, they typically will act very negatively to the presence of short sellers. And it’s not just short sellers themselves. Sometimes, if there are skeptical Wall Street sell-side analysts—very rare I know, but they do exist—those analysts will be barred from asking questions on conference calls. They won’t be given access to management.

All of these behaviors . . . Even a toddler will tell you, it’s their attempts to hide something, to keep secrets and not be totally forthcoming. The only reason you can really ascribe to that is the fact they may be engaged in these same exact behaviors that short sellers are alleging.

Luigi: This is a little tip for a criminal CEO, don’t lose your temper and be nice with the short sellers, because otherwise you give away who you are.

Fahmi Quadir: Yeah. But fortunately for us, it seems that these guys can’t help themselves.

Luigi: Or they don’t listen to our podcast. That’s the problem. Most usually, I think that many people, in spite of the little explanation we gave now, see short selling as a bad activity. At some point a congressman said that short selling is un–American.

It seems like you are rooting for the other team. You are not only a contrarian, which is another side of that term, but you are antagonistic and hoping that things go badly. How can you respond to all this flurry of emotions?

Fahmi Quadir: If you are a believer in the free markets, then you should be a supporter of short sellers. We certainly play a role in keeping the markets efficient, as we discussed about price discovery.

But the way that I approach short selling, and the way we do at Safkhet, is we’re going after companies that are engaged in bad corporate practice, and that involves exploiting people, including exploiting Americans. Part of what we do is getting to the truth of what they’re doing and expose them so that they can at some point hopefully meet justice, so I don’t think there’s anything more American than that.

Luigi: So, you are making money by doing good?

Fahmi Quadir: I wouldn’t be doing it otherwise.

Luigi: Talking like a true millennial. Tell us a bit about probably the trade that made you most famous. Everybody has one high moment, and at least for the time being, your high moment is shorting Valeant. Can you tell our listeners how you first identified there was something wrong and what happened then?

Fahmi Quadir: Right. Valeant was the second short I ever put on in my entire life. I was first exposed to the company when I worked in pharmaceutical corporate intelligence. It was a company that there was an unspoken rule we’d never work with them, because they were known to be unethical. They were known to not pay their consultants, so they already had a bad reputation.

But the thing is, as a short seller, one thing we look for when a company is supposedly disrupting an industry, but it’s an established industry where there are certain norms that are adhered to, not just for purposes of convenience, but also for profitability.

With Valeant, we noticed that the business model was completely anomalous to the industry. The business model was to cut out R&D and to just raise prices. This didn’t really make sense, because the pharmaceutical industry itself is relatively profitable. It has better margins than most industries, so there wasn’t really much disrupting that needed to happen.

But what resonated so well with Wall Street was that it was very similar to a private-equity firm. It was all about managing costs and improving profits, and all the while taking on inordinate amounts of debt.

But I followed the progression of this, and it was only until I saw that the ability to access capital was basically cut off after they had acquired Salix that it became an attractive entry point for a short position, because the great thing about fraud is it can be incredibly profitable up to a point, and for me it seemed like that was the right point, because they couldn’t really keep the business model going with additional leverage.

So, I shorted it, and I continued pressing and building that short position on the way down as I investigated the company further and really tried to understand the nature of the fraud and how they were taking regulations that had been in place as far as reimbursement from private insurers and from the government and using that to enrich themselves.

All the while patients were getting hurt. The calls that we would get from whistleblowers and from patients who were taking these drugs still haunt me to this day. But, yes, it was, I guess, my first big short.

Luigi: Yes. But you are quite a character, because on the other side of the short, for people who don’t know, don’t remember, there was one of the most famous investors in Wall Street, Bill Ackman, who actually not only sort of invested in Valeant, but also defended the strategy of Valeant, so you kind of had a “high noon” moment and you won, so tell us about how.

Fahmi Quadir: Well, see, I’m not from the world of finance, so I didn’t really see it as so much of a duel against Bill. It was really, for me, with Valeant or with any other trade, I need to be right on the facts. I have to be able to justify to my investors why I’m taking on these positions.

Unlike Bill, on my side of the trade I have an infinite amount of risk. The stock price of Valeant or any other name that I’m short can go up forever, whereas on the other side, if I’m wrong it can only go to zero.

Luigi: This is an important point that most people don’t get, because they always think that shorters are very aggressive. In fact, in my view shorters are very timid and fearful, and they tend to only attack animals or companies that are really sort of close to death, because that makes it easier to actually profit.

Fahmi Quadir: I take issue with the word timid. I wouldn’t say we’re timid, we’re just very calculated.

Luigi: Prudent, I would say. They are prudent. OK.

Fahmi Quadir: Yes, prudent is a good word. To be a short seller, and because we’re up against those sorts of risks, you have to be right on the facts, so it’s about doing 10 times the work that the person on the other side of the trade is doing.

We saw the presentations that Bill had made. We saw that his justification for believing Valeant was not a fraud was because he asked Mike Pearson, the former CEO of Valeant, is Valeant a fraud? And Mike said no. So, that’s not a sufficient answer for me, so I had to go out and do proper due diligence and really investigate and prove my thesis.

That was compounded by the fact that this was my second trade of my career. I had no formal finance or accounting training, so I again had to prove myself, all the while proving my investment thesis. In the end, yes, I may have won, but it was never about Bill or anyone else on the other side of the trade. It was purely about the work that I had to do.

Luigi: What made you willing to take this bet that other people were not willing to take, and how is it possible . . . Maybe I’m talking too much like a Chicago professor here, but how is it possible that this information does not reach the market, that it needs you to reach the market?

Fahmi Quadir: Well, I think it starts with the questions that are asked of these companies. I think with something like Valeant, where the narrative was just that there was a lot of financial engineering, it was basically this private-equity type business model, and the stock was just . . . every year it was compounding and compounding and making lots of fund managers very wealthy, and the best performing funds all . . . what was their top holding? It was Valeant Pharmaceuticals.

It’s tough for an investment manager to take a stand against that. It’s not as tough for someone like me, who was an outsider and who really didn’t have to deal with those types of dynamics. I didn’t have any bridges that I potentially could burn. It was really just about asking the right questions and getting to the bottom of what was going on at the company.

Luigi: Generally, the first person saying that the emperor has no clothes gets shot, so how do you avoid getting shot in this situation?

Fahmi Quadir: Running a short-only fund, we’re taking bets against companies that are much larger than we are. They could go to any length to try to intimidate us out of our position. So, how do I keep this business model sustainable?

For us, part of that is just taking nonpublic positions, so we aren’t publishing research, we aren’t exposing ourselves to potential litigation damage, and we aren’t exposing ourselves to the attacks from these companies.

But even still, even though we aren’t making those public efforts, we have companies that are coming after us directly. Safkhet only started trading in January, but we’ve already faced very significant, orchestrated, sophisticated attacks on the cyber front as far as hacking, cyber surveillance, cyber intimidation. I even have to deal with physical surveillance, and it’s all because these companies don’t want us investigating their wrongdoing.

Luigi: You mentioned journalists earlier, and in order to make money, you not only need to make the right bet, you also need this right bet to be recognized by the marketplace. Basically, there are only two ways to do it. One is to have some journalist write about it, or to have the regulators go after the company. Which strategy do you prefer, and what are the plusses and minuses of the two strategies?

Fahmi Quadir: We try to keep all of those options in our toolkit. I think it really depends on the type of information that we’re trying to get out there. With every company that we do short, we will send our work to the regulators in due time, but that’s something that will take lots of time. Regulators require resources, and sometimes they won’t even direct any resources towards that particular company that we’ve been investigating.

With journalists, again, they’re also limited in resources, and even more so, I think, not enough support is going to our journalists. We live in a world where journalists are just killed for telling the truth, so it’s difficult for them to—

Luigi: Fortunately, not in this country yet.

Fahmi Quadir: I hope never. And it’s . . . From that point of view, journalists are also taking on very significant risks, and they are not getting the financial upside that short sellers get, but they play a crucial role in letting people know what goes on at these companies. But again, they have to be limited in the types of information that they get out there.

Luigi: You just said something a little bit earlier that was very interesting. You said that when you’re a shorter, you have to be doing your homework 10 times as hard as everybody else because it’s such hard work. Sometimes I hear this same expression, the same line vis-à-vis women, that in a man’s world they are forced to be 10 times as good in order to succeed. Is there a correlation within the two facts? How does your being a woman make you a short seller?

Fahmi Quadir: Well, being a woman and being in the fields that I’ve been in . . . I’ve never been in any sort of field where there have been a lot of women. It’s always been male-dominated, even when I went to college. At the time I went to Harvey Mudd, it was 70 percent men, and that wasn’t even that long ago.

For me, it’s more of, I won’t put up with BS. That’s why I’m here today, and I think women
generally . . . They have to put up with a lot of BS, but at some point, they shouldn’t.

Luigi: You have a nickname in your trade. What is it, and why?

Fahmi Quadir: So, I was named “The Assassin,” and just the backstory there, when I had started out, I would do my research and I would send it to other folks that were looking at these companies. Those folks would then ask, “Oh, who is this guy?” “Oh, it’s just The Assassin.” Then, eventually, people realized The Assassin was me, and I’m certainly not a dude.

Luigi: And you made the news with the fact that you shorted Tesla. Can you talk about this?

Fahmi Quadir: Well, yes. I can talk about Tesla. Again, we don’t really disclose positions, but journalists like the headline “Valeant Short Seller Now Shorts Tesla.” We’ve avoided shorting the company, because typically when there is mania and hype, mania and hype can continue for a significant period of time, and that means more losses and potentially business-ending losses if you’re a short-only fund, so we’ve avoided it. That being said, there’s so much that has been exposed—

Luigi: And we are looking forward to this “high noon” moment with Elon Musk. So, thank you very much for coming, and we look forward to seeing the next killing of The Assassin.

Fahmi Quadir: Thank you.

Luigi: Kate, now that you heard her interview, what do you think?

Kate: I think that Fahmi sounds like a smart and very capable and charismatic and well-spoken young woman. I think it’s great that she has made a name for herself in a male-dominated industry. But I take issue with the idea that we should be elevating hedge-fund managers, or anyone for that matter, who pursues a career of just making markets more efficient.

I don’t think that that’s something that we should be celebrating as a society. And I think that the reason for that is that there’s already so many young people flocking into the finance industry that it’s sucking up a lot of talent, and if we start celebrating these people as heroes, that’s only going to compound the problem.

People wouldn’t flock to finance if there weren’t money to be made, and I think that part of the reason that money is being made in the financial industry is because traders and hedge-fund managers make markets more efficient, so they take information and they incorporate that into prices.

I understand that that’s an important role that someone has to play in society, but I think that another reason, and maybe most of the reason why people make money in finance, has not so much to do with market efficiency, but to do with collusion between banks and local monopolies, or monopolies in certain types of securities, and the cozy relationship between Wall Street and DC, and all of these people justify their existence by saying, “Oh, yeah, we’re making markets more efficient.”

Luigi: Wow. What do you really think? Look, if you’re talking about a high-frequency trader who is making millions by quote-unquote making the market more efficient, I could be on your side. But in this case, I think it’s different. It’s not really just making the market more efficient. It is discovering fraud, preventing bad companies from wasting our money.

After all, you celebrate journalists when they write a piece like the Theranos piece exposing that the company was fake. What is wrong with celebrating somebody that exposes Valeant doing a strategy that is detrimental to American society, to people who are sick, and that without her work would be still there, doing that stuff?

I’m with you in saying we should not just celebrate finance people because they make money, but I think that we should not fall in the opposite direction and say we should criticize them all just because they make money.

Kate: I wasn’t criticizing them on the grounds of making money. And to your point about exposing fraud and exposing corruption, that’s not what her fund does. She explicitly said in the interview that they don’t disclose their positions publicly. They take a financial position, a short position, hoping that eventually later on people figure it out and the stock price falls.

But it’s not like they’re out there sounding the alarm. They’re just waiting privately for other people to discover that, for journalists to discover it and make that information public.

And also, Valeant in 2015 was being investigated by the SEC. It’s not like regulators were completely sleeping on the issue. And pretty soon thereafter, charges were brought and that led to the downfall of Valeant.

She talks about how regulators need more resources, and I totally agree. But if you’re on the side of exposing fraud, then go be one of those people who works for the SEC. Go work for one of the regulators. Don’t just work for a hedge fund where you take a short position and then keep your lips shut.

Luigi: I think you’re missing the fact that she diffuses the information, not under her name, not to be too much of a target. In fact, she was known as The Assassin during the Valeant case because her research was circulating, and as she said in the interview, she does pass information to the regulators and to the newspapers, and I bet money that the Valeant investigation in 2015 was caused by her research being given to the regulators.

Kate: It wasn’t.

Luigi: How do you know that?

Kate: Because they were aware of the situation before that.

Luigi: Look, I read in the paper about who blows the whistle on corporate fraud, and most of the time they are not the regulators. Most of the time, they are either employees talking to newspapers or short sellers. The regulators are late to the game, and very often even when they are told, they don’t act.

Like in Madoff, they went three times to the SEC saying that Madoff was a fraud, and nobody pursued that. If there was the ability to short sell Madoff, I think the Madoff scandal would have been discovered much earlier.

Kate: I agree with you that the SEC should act faster and that it needs more resources, but I don’t agree with you that just because the SEC acts slowly, that we should just rely on the short sellers as the heroes.

I thought your bounty hunter analogy was perfect, which is that bounty hunters from the perspective of society are not heroes. These are people who aren’t formally trained. They’re vigilantes. They don’t care about justice. They just care about making money.

If you actually cared about helping out the community and going after bad guys, you would be formally trained and you would work in formal law enforcement. It’s the people who don’t want to do that that are the bounty hunters.

Luigi: Wait a second. There are two things here that really get me the wrong way. The first one is, I don’t understand this “formally trained.” You can do a great job even without being formally trained. In fact, Bill Gates was not formally trained. He dropped out of Harvard, but I think he did a pretty good job. So, I don’t think that that’s the characteristic.

And second, I go back to Adam Smith. It’s not for the goodwill of the butcher and the baker that we get the meat and the fresh bread every morning. It is for their private interest.

I don’t see what the problem is in using private interests to reach the public good. That’s exactly what capitalism is about, good capitalism.

Kate: Sure. I agree with you, and we’re both in favor of a general capitalist society. But when I was in college, I hate to say it now, but I was in charge of two investment funds, these two student-run investment funds. Young college students, to them the idea of being able to make a ton of money just by being able to pick up on people’s personalities and having a good gut feeling about the market, that idea is like crack.

It’s worse than crack. It’s like fentanyl. It sucks them into the finance industry and it convinces them that they can make a ton of money without having to work hard or without actually having to have any experience or any specific knowledge, and I just think that it’s so dangerous to be disseminating ideas like that.

Luigi: But I think you are missing the bigger point here. I’m not saying that everybody should do what Fahmi does, and I don’t think in general that not having training is good. However, I recognize that training also brings distortions and brings some buy-in to a system that does not allow you to see the system from the outside.

I think that it is not a surprise that the biggest innovators tend to be outsiders who don’t fit into the system and see the system with a different pair of eyes. Do you want everybody to do that? Absolutely not. But do we need in society some people who do that? I think so, and Fahmi is one of those.

Kate: Sure. As I said initially, people need to make markets efficient, and if that means on the short side you need people with different perspectives, fine. I think that’s fine. I have no problem with the existence of short sellers, but I don’t think they’re any different than people who run long-only hedge funds, and they’re discovering positive information in order to make money. It’s all the same to me.

Luigi: Actually, I disagree here, because people who run long-only funds, they don’t get arrested, they don’t get hacked, they don’t get followed, they don’t get to be told they’re un–American and they are hated by people. I think it’s very hard to be a short seller, exactly like it’s very hard to bring bad news, and we need people who bring bad news.

The reason why there are stock market bubbles is there are not enough people who are willing to tell the bad news. I like to celebrate people who have the guts to do that, especially when they’re young, because you’re right that she only had one really big, successful short. But now we have a second test. Apparently she’s shorting Elon Musk and Tesla. Do you think she’s going to win on this one?

Kate: I mean, look, I’ll be the first person to make fun of Elon Musk. I actually dressed up as Elon Muskrat for Halloween. So, I have no problem with the position that she’s taking.

Luigi: What did your costume look like?

Kate: First, I wore a Tesla shirt, and then I got muskrat ears, or the closest I could find to it, and taped a rubber snake on top of it in the hopes that it would look like an eel, so, get it, eel on muskrat. And I had whiskers and claws and a tail, a rat tail and stuff. But then I also was carrying around a cigarillo that was meant to look like the blunt that he was smoking on that radio show.

Luigi: I think that people will flock to our Facebook page to see your picture impersonating Elon Musk.

Kate: I wish I hadn’t mentioned that.

In the second of a two-part look at global inequality Kate & Luigi talk about the downside of globalization. A listener's email sparks a conversation about what's driving the growing wage gap within the U.S. We survey the latest research on the lingering effects of the 'China Shock' and debate how to reverse the trend before the people revolt.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: We want to start out this episode with a note that we received from one of our listeners, Paul Driscoll, who wanted to hear us talk about globalization in technology. In his note, Paul described how he lost his IT job at HSBC Bank a couple of years ago, and it was under this internal slogan, “Moving IT to high-quality, low-cost locations,” which was just insulting. And after that, the next job he found was a pay cut from his prior job, and he said, “For me, this new liberalist viewpoint of most economists, treating people as mere widgets with none to little protection from the state, in my mind, no economics seems to have an answer.” And he blames a lot of this on globalization, automation and health care.

Luigi: Paul’s note is an excellent way to introduce our second episode on globalization. As our listeners remember, we started talking about populists, and then we moved to globalization because globalization is blamed for having created a lot of people who are disenfranchised—I suspect Paul is one of them—and who are very upset about what’s happening in the United States. And last episode, we looked at the positive aspects of globalization, the fact that billions of people were lifted out of poverty. Today, we’re going to look at the dark side of globalization, that is, an increase in income inequality in Western countries, and in particular, in the United States.

And, as Paul mentioned, it’s a bit difficult to separate globalization from automation or, generally, innovation. And the two, by the way, might combine to generate this phenomenon, but in today’s episode, we’re going to try to do our best to sort these things out.

Kate: Before we get into this, we should mention that what globalization means can be a complicated issue. So, it could refer to globalization of trade, to finance and capital markets, to immigration, to outsourcing of service jobs. Most economists focus on the trade element, and that’s what we’re going to talk about mostly today.

Luigi: And let’s start with the simplest example possible. Imagine that we have two countries, the United States and, let’s say, Cambodia, and those two countries don’t trade with each other in the beginning, and they both produce airplanes and T-shirts. And let’s assume that the United States is more technologically advanced, so they produce both T-shirts and planes better than Cambodia. But relatively, they are better at producing planes than T-shirts. Then, when the United States starts to trade with Cambodia, Cambodian T-shirts start to come into the United States, and they might be of slightly less quality, but they are much, much cheaper than the ones in the United States. And then, all of a sudden, the price of T-shirts in the United States drops, and as a result of this drop, the wages of low-skilled workers will go down, and the wage gap between high-skilled workers and low-skilled workers in the United States will most likely go up.

Now, let’s look at Cambodia. Cambodia, they probably are not going to import the T-shirts from the United States because they’re very expensive, but they love their US planes because they are much, much better than the Cambodian planes. And so, probably they even stop producing planes, but even if they do produce planes, the competition for planes would be quite harsh, and so prices of Cambodian planes will go down. And as a result, we should see, actually, a decrease in the wage gap in Cambodia, because the high-skilled workers working in the plane factory will get a wage cut, while the low-skilled workers working in textiles, because of the demand from the United States, will see prices go up, and so wages go up.

Now, what is interesting is if you look at the data, you do see the first phenomenon, you do see the fact that the wage gap in the United States goes up. You don’t see a similar phenomenon in Cambodia of the wage gap going down.

Kate: This is what’s known as the Stolper–Samuelson theorem. And the finding that Luigi just mentioned is part of why a lot of people in this literature, in this macro and international trade literature, they don’t think that globalization is what really is accounting for all of the increase in inequality within countries. Because, according to this theorem, we shouldn’t have seen inequality go up within countries like Cambodia. Instead, they think that automation and technology explain more of this increase in inequality, that machines and computers and robots are taking our jobs, and you don’t need as many people to make a T-shirt as you used to, because now we can automate that whole process.

Luigi: In general, it is very difficult to separate the impact of automation from the impact of globalization. And, in particular, from the impact of Chinese imports into the United States. And the interesting factoid is that until 2000, the number of jobs in manufacturing in the United States was fairly stable, and this was the result of two very different trends. On the one hand, the percentage of people working in manufacturing was dropping very fast. On the other hand, the quantity of manufacturing produced was going up, and the two things were conversating in a nice way, so that the total amount of workers was roughly the same. But then something happened dramatically in 2000, and between 2000 and 2007—so even before the financial crisis—we see a gigantic drop in the number of workers in manufacturing that goes from roughly 60 million to 12 million. And then, of course, with the financial crisis, there’s another drop from 12 million to 10 million.

Now, there is a paper, an economic paper that shows that the first drop, and maybe even the second, but certainly the first drop has been caused by a change in trade.

Kate: So, this change in trade was the result of what was called the permanent normal trade relations status. This is something that Bill Clinton pushed for a great deal towards the end of his presidency and was eventually passed in the late 1990s. And the whole idea behind this was that we wanted to normalize trade relations between the US and China. We wanted to give China this permanent status as a country that we could trade easily with. Eventually, he pressured Congress to pass this legislation, and it made it much easier for us to trade freely between the US and China, as well as move jobs over to China.

Luigi: Yeah. I think it’s useful to understand that before the passage of this law, China was considered a nonmarket economy, and so the possibility of trading freely between the United States and China was granted by Congress every year, at the beginning of the year. And while in the ‘80s, this was a no-brainer, after Tiananmen, there was a serious threat that the United States Congress would not renew this exemption. And so, the idea behind this paper is, up to 2000, when this law was passed, there was a lot of uncertainty about the long-term relationship between the United States and China, and so people were afraid, for example, to outsource a plant to China, because the next year you could stop trading. And in the same way, the Chinese were very much afraid to set up long-term relationships of exports to the United States for that reason.

And so, this paper looks at what happens to manufacturing, especially manufacturing that competes with China following that shock.

Kate: So, if you look at a chart that indicates the extent of imports and exports between China and the United States, what’s interesting is that you’ll see a gradual increase starting in the early 1990s, but this really takes off after 2000.

Luigi: The paper that we have been discussing has been written by Peter Schott at Yale and coauthors, and they have a follow-up paper that is pretty frightening, because they connect the increase in suicide rates at the country level with the decline in manufacturing caused by the opening of trade. And they find quite a remarkable effect, suggesting that the impact of globalization was not only a loss of income, but also some form of economic despair.

Kate: And in terms of the effects on inequality, there is a follow-up paper, a series of papers actually, by Autor, Dorn, and Hanson, and they pinned down the areas that were more exposed to trade with China, and the effect that that had on wages and labor force participation. And they found that in the counties exposed to the China shock, workers experienced lower lifetime income and had a really tough time readjusting their jobs and their skills. In some cases, it took more than a decade for people to transition into other industries.

Luigi: One aspect that is often forgotten is that in economics, it’s clear that trade improves overall welfare, but it’s not clear, in fact it’s clearly opposite, that trade increases the welfare of everybody. So, in economic theory, trade has winners and losers, and it does overall increase the size of the pie, but there are winners and losers, and these winners and losers need to be somewhat compensated in a political way, if we want trade to move ahead. And I think that part of what we have been seeing in the last 20 years is, we’ll push for more trade, ignoring the cost of the losers.

Kate: I think something that a lot of the macro literature on trade and inequality is missing is that for the most part they focus on the difference between low-skilled workers and high-skilled workers. So, people with no high school degree versus people with a college degree. That’s part of the inequality problem, but what’s really driving inequality at the high end isn’t all people with a college degree, it’s people in the top 1 percent. You could define that as income, but I think particularly wealth. And CEOs and top-paid executives are a big part of what’s driving within-country inequality.

There’s an interesting paper by Keller and Olney in 2016, and they showed this simple graph: if you look at exports from the 1950s to 2007, it’s a startling match for how much they went up versus how much executive compensation went up. Those two lines basically move in tandem. They don’t simply show one picture, they attempt to pin down the causal relationship between exports and CEO pay. But what they end up finding is, unsurprisingly, global trade did play a large role in increasing CEO salary, particularly for the top 50 companies.

Luigi: But I think this is a combination of expansion of markets, you can call it globalization, but the fact that now there is a global market, and technology. When I grew up, nobody was watching Italian soccer games except Italians. Today, there are people in China that regularly watch the Italian championship, because it’s better than the Chinese one. And I think that this expansion of the market, that is caused in part by technology, it is so much cheaper to transfer this information, and also by globalization, had an impact on wages and inequality that is independent of pure trade.

So, in my 2012 book, A Capitalism for the People, I used this example that I think is quite useful. Take golf tournaments, there’s no trade in golf tournaments. And take the best golf tournament in the United States, it’s the Masters, the Augusta Masters. Now, look at the prices that are paid for the winners. So, in 1948, the first prize was only $2,500. That, in 2008 numbers, is $22,000. In 2008, the first prize was $1,350,000. So, 60 times in real terms. Certainly, the wage of the people working at the field has not increased that much, but interestingly, even the second, third, or fifth prize did not increase that match.

So, even in prizes, there is an enormous increase in inequality, where the winner takes all. The winner is rewarded disproportionately, and why? Because people in Japan wake up in the morning to see Tiger Woods playing golf. They don’t want to see the number fifth or the number 20th.

My colleague Steve Kaplan and Josh Rauh from Stanford wrote an interesting paper trying to document how important are various categories in the famous top 1 percent, or top 0.5 percent, or even top 0.001 percent. And what you find is that, if you look at the 0.001 percent, the people that make at least $7 million, actually top celebrities are only 0.5 percent, professional athletes are 1.5 percent, and the Wall Street people are roughly 5 percent. So, there are a lot of other people who make it to that threshold, who don’t belong to the categories that we think normally are superstars.

And another colleague of mine, Eric Zwick with coauthors, is trying to identify who those guys are, and they tend to be doctors, dentists, and car dealers. Why car dealers? Apparently, car dealers are small entrepreneurs that make a lot of money.

Kate: Yeah, but you’re talking about the income distribution. And I don’t think that the same logic applies to the wealth distribution. To be in the top 1 percent of the income distribution on a household basis, you have to make over roughly $430,000 to $440,000 per year. That’s a lot. But to be in the top 1 percent of the wealth distribution in the United States, you have to have over $10.5 million of wealth. And I don’t think that there are that many doctors and car dealers who go from having nothing to having $10.5 million of wealth at the end of their lives. I think those people for the most part, to be fair, it’s harder to study the wealth distribution, and so we don’t have as good of a sense of who those people are with $10.5 million of wealth, but my hunch would be that they’re more ... People represented ... There’s more representation from the finance industry, and there’s just more inherited wealth in that top percent.

Luigi: Maybe we deal with different doctors. I think that there are quite a bit of doctors that at the end of their life have accumulated, at least at the end of their working life, have accumulated $10 million in total wealth.

Kate:Yeah. Maybe there’s a couple of brain surgeons and orthopedic surgeons out there, but also keep in mind that $10.5 million is the minimum cut-off. In terms of the average in that category, it’s much, much higher.

Luigi: The wealth has been tremendously affected by the internet, and now social media, and the stock market. I think that in order to make that kind of money, you need to basically succeed in the stock market.

The first artist who has become a billionaire is actually Jay-Z. And Jay-Z has an estimated wealth of north of a billion now, and most of it does not come from his phenomenal record deals. He had two deals. One in 2008, when he got $150 million, and another one recently for $210 million. So, he’s very good at dealing with this stuff, but where he made real money is that he created the Tidal streaming service in 2015. That now is valued close to a billion dollars. So, I think the real wealth is in the stock market.

Kate: And this goes back to Piketty’s point, it’s the owners of capital, who are able to have enough to save and put that in the stock market, whose wealth increases the most.

Luigi: That’s absolutely not true, because the capital that Piketty is talking about is land and housing, and neither Jay-Z nor any of the guys that made really a lot of money have made money from land and housing. I think that Zuckerberg is a billionaire, not because he’s saved a lot. Zuckerberg’s a billionaire because he had a clever idea and was able to appropriate a lot of future rents. And the same can be said for Bill Gates and for Jay-Z and for a lot of other people.

Kate: The reason that Piketty focused on land and housing was because most of the time series he was studying was in the 1700s and 1800s, but obviously, if you were to apply that same logic just to the past 20 years, he wouldn’t just be looking at land and housing, he would be looking at all capital, which, for the most part, what’s important is the stock market.

Luigi: Yeah. Little detail, he called his book, Capital in the Twenty-First Century, and he should have called it Capital in the 19th Century.

Kate: We’ve already been through this. If you want to hear more about this debate, you can go back and listen to our Piketty episode.

Should we talk about solutions?

Luigi: Please.

Kate: I think it’s a little disheartening to think about what the potential solutions are, because the solutions are things that we should have been thinking about in 2000, right? Coinciding with the permanent normal trade relations status of China in 2000, we should have also instituted labor retraining, labor mobility programs that would help out people who were working in manufacturing, and who lost their jobs because those jobs were exported to China. And we simply didn’t do that. We were assuming that everyone would be better off because we’d have cheaper goods, but we forgot about this huge swath of people who became unemployed.

And now, 20 years later, there’s the question of, is it too little, too late? Have those people permanently dropped out of the labor force? And what about the younger people in those areas, who are just entering the labor force? What can we do for them?

Luigi: Kate, you’re right, but I fear it’s even worse, because the issue should not have been thought of only in 2000. It should have been thought of even earlier. One reason why the American middle class is being so squeezed out by globalization is that it’s lost out in terms of relative education.

In 1950, high school graduates in the United States represented 35 percent of all the high school graduates in the world. And by 2000, they represented roughly only 5 percent. So, what this is saying is the world has caught up with the United States. The United States pioneered universal high school education in the early part of the 20th century, and since then, they have not pioneered universal college, but even worse, probably the quality of high school has gone down, while the rest of the world has understood the importance of education and has massively increased education, starting with the Asian tigers we were talking about last time, and most importantly, China.

Kate: And I think the answers are education, redistribution, and health care, but at this point I feel like, what’s the point of even talking about that, when we don’t have the political capital to really force through any of that legislation? Everyone knows that we need to solve these problems, but it’s depressing to talk about solutions.

Luigi: I think it’s important to explain to people that there was a negative effect of globalization, that this effect is not necessarily a reason to stop globalization, but it is a reason to join globalization with some other measures. And so, if you want to push for globalization, you need at the same time to think about some safety net to absorb some of the costs of globalization. If you want to go back, then you pay the cost of going back.

I think that, by and large, no one is proposing more globalization with better safety nets. You have people that say, more globalization, and people that say, no globalization, but the connection with the retraining, with the safety net, has been lost in many people’s view.

Kate: Sweden is a country that’s actually has done a pretty good job of that, though.

Luigi: Yeah. I think that they have a good safety net, and they are a very open economy. They’re just six million people. They can’t live just by themselves in a closed economy. So, they are very open. They favor markets. They also have some mechanism of a safety net that makes it difficult for people to fall behind.

Kate: The one thing I feel a little bit less depressed about is that I do think ... I mean, I’m sure there will be plenty of people on the right who would lobby hard against this, but I think one area where there’s probably some bipartisan consensus is that there needs to be less tax evasion, particularly on the part of the wealthy. And if we can do a better job of making sure that the wealthy pay their fair share of taxes, then that will help decrease the inequality problem.

Luigi: Except, though, the measures of inequality we look at are pretax. So, there’s no doubt that the after-tax measures can be improved with the redistribution, but at the moment, all the measures are pretax.

Kate: OK. That’s true. They probably won’t help the problem overnight, but over time, if there is more redistribution, then we should see wealth go up at the bottom.

Luigi: Yeah. But I fear that redistribution by itself is not the solution, because, of course, you need some safety net, but you can’t have people that live under it all their lives. I think there’s a human dignity aspect, which is at least as important as the income aspect. And I don’t want to demean the importance of support, but I think that people need to find a successful employment and meaning in life that is not just being paid off by the state.

Kate: So, going back to Paul, he said to us, “In my mind, no economics seems to have the answer.” And in a way, he’s sort of right. This goes back to the Rodrik dilemma, that you can’t have both economic globalization, and national sovereignty and democratic decision-making. And that’s kind of the point, that if you’re going to open up your country to globalization, then you’re going to end up having large swaths of the population who feel like they’ve been marginalized. And this inevitably, according to the Rodrik dilemma, will lead to trouble within our democratic system. And I think that that’s what we’ve been seeing with the rise of Trump and with the rise of populism.

Luigi: And it was easy for the United States to deride Latin American countries in the ‘60s, ‘70s, and ‘80s. They were very much affected by populism, but the reality is that those countries were much more exposed to global shocks than the United States was.

I remember as an undergrad student, I learned that whenever the United States sneezes, Canada catches a cold, because the United States was able to shock the rest of the world without being shocked. And today, the United States is shocked by the rest of the world. And if there is not a democratic response to that, people will revolt, and populism is a form of revolt.

Kate: So, Yascha Mounk was right. We’re all screwed.

Luigi: Join the worldwide movement against globalization. No, but the irony is, the worldwide movement against globalization.

Kate: The global movement against ... Yeah.

In the first of a two-part look at global inequality Kate & Luigi talk about the upside of globalization -- a decrease in income inequality between countries over the last few decades. How much of this can be attributed to China, and what was the secret to their success?

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: This is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

In the last two episodes, we discussed populists in Brazil with the victory of Bolsonaro, and with Yascha Mounk about populists all over the world. Yascha was one of the many people saying that the reason why we see this explosion of populists all over the world today is because of an increase in inequality.

What we want to do now is actually analyze how much truth there is in this allegation. In particular, what is the impact that globalization has on inequality?

Kate: There are many different ways in which you can think about globalization and inequality. One major distinction is between within-country inequality and across-country inequality. If a bunch of countries are converging to one another, poorer countries are being lifted out of poverty, you can think of that as a reduction in across-country inequality.

Luigi: The second thing we have to be aware of is that globalization is not necessarily a recent phenomenon. If we look at the last two centuries, there have been two major waves of globalization, one that took place between 1818 and World War I, and the second one that started in the 1980s and is continuing today. In both cases, we saw a similar pattern of increased inequality within the Western world. The difference is more what happens at the global level about inequality across countries.

What we’re going to do in these two episodes is focus on the recent wave of globalization, because, number one, it’s recent and more interesting, and, second, we have better data to analyze. But you have to keep in mind that some of the stuff that we say today has some historical background.

Kate: On today’s episode, we’re going to focus on the rosier side of the picture, which is how there’s some evidence that across countries, inequality has been improving, and, in particular, a lot of people have been lifted out of poverty as a result of globalization. But on the next episode, we’re going to focus on the darker side of the story, which is that within a lot of Western countries, there has been a big inequality problem.

I think part of the reason people are so mad about inequality is because of statistics like, just eight men in the world own the same amount of wealth as 3.6 billion people living in poverty, which is half the population of the planet.

Luigi: Are you angry because they’re men, or because there are only eight?

Kate: Both. A little bit more that there are only eight, but the fact that they’re men doesn’t thrill me either.

Luigi: This is not just a statistical issue. I think it is a philosophical issue. What do you care about? Why do we care about inequality?

I think that the reason why we care about inequality is because there is a tail of the distribution that is extremely poor. There is a tail that cannot arrive at the end of the month, cannot feed the kids, and so on, so forth. If that tail can improve dramatically, I think the world is a better place.

If the guy that used to buy a mansion can now buy two, that’s not a problem for me as long as more people can go to school, more people are not starving, more people are middle class. Definitely, we have seen that in the last 30 years.

Kate: Yeah, I do think there’s a distinction between talking about reductions in poverty and talking about changes in inequality. There have been reductions in poverty. I think at the global scale there’s no doubt about that.

But at the same time, there’s confounding factors there, too. Most of that is driven by China, for example. China’s poverty rate fell from 85 percent to 16 percent between 1980 and the mid-2000s. That was a huge driver of this reduction in poverty.

Also, another thing that confounds our measurement of global inequality is that rich people tend to not really report their incomes. If we’re not really counting how much richer rich people have gotten, then the numbers look rosier than, I think, the truth.

Luigi: Let’s put some structure to the discussion here. I think that the World Bank defines somebody as poor if the person can spend less than $1.90 a day and defines somebody as middle class if you can spend between $11 and $110 per day per person. Now, these dollars are adjusted for differences in what is called purchasing power, the ability to buy different goods in different places, and they are adjusted for time, so for inflation.

But, so, if you think about 2011 dollars that are not too different from 2018 dollars, in 1981, 42 percent of the world was poor. Now, it’s less than 10 percent.

You’re right, Kate, that much of this reduction took place in China. The number went from 660 million people to now 25 million, but, also, India, and part of the rest of the world. In addition, there has been an increase of people who consider themselves middle class.

I think that the other month there was a celebration that most of the world, slightly more than 50 percent of the world today, can be considered middle class by this standard. This is a remarkable success, and I think that globalization and capitalists are responsible for this success.

Kate: How do you measure inequality? If everyone’s wealth doubles, then, according to the Gini coefficient, inequality didn’t change. Also, if you’re looking at a poor person’s wealth doubling versus a rich person’s wealth doubling, I think that the rich person got better off, and, so, actually, inequality increased.

Luigi: I think this brings us to, why do we care about inequality? If the concern about inequality is envy, that you are jealous that some people make more than you and can buy more mansions than you can, I think that measuring on an absolute basis might be relevant.

But if we are concerned about people who are left behind, people who cannot afford a decent living, people who cannot send their kids to a decent school, I think what we care about is the fact that the lower tail of distribution is improving dramatically its standard of living. In that sense, a relative basis is fine and captures that very well.

Kate: I don’t think that the concern with rich people getting richer at the same time that poor people are getting poorer is just poor people being jealous of rich people. I think that the concern is that if rich people double their income at the same time that poor people double their income, that makes rich people relatively more able to influence the political system. It makes rich people relatively more able to distort the playing field in favor of their own children.

Yeah, I think the jealousy thing matters, too. It foments political unrest. I think there are reasons to be concerned about inequality on an absolute basis.

Luigi: I think that the point you’re raising about the influence in the political system is very important and should be taken very seriously. But if you keep that aside for a moment, and I’m not saying you should always keep it aside, but if you keep it aside for a moment, what we care mostly about is inequality of consumption. Inequality, if you want, of utility, of welfare.

We know that marginal utility of money is decreasing. If I go from making $1 a day to making $3 a day, my utility goes up tremendously. If I go from making $1 million a year to making $3 million a year, of course, my utility goes up, but not in any possible form or shape in the same degree.

I think that the standard measures that look at the relative distribution of income are useful measures, and, by those measures, the last 30 years have been very good years in terms of decreased inequality.

Kate: I don’t even agree with that. Even if we’re just looking at relative measures, one of the most popular studies of the decrease in global income inequality is by these two guys named Lakner and Milanovic, where Lakner is at the World Bank, Milanovic is at CUNY. They find that the global income Gini coefficient has fallen from 0.722 in 1988 to 0.705 in 2008.

First of all, 0.722 to 0.705 is not a massive decrease, and that still indicates a pretty high level of inequality. Then, also, here I think it’s important to talk about how much that increase in global income is attributable to just one country, China.

According to those same World Bank statistics, between 1981 and 2005, if we look at the number of people who are living below $2.50 per day, and we exclude China, then the number only dropped from 50 percent to 49 percent. Yeah, I’m bumping the number or the definition of poverty up by a little bit, you said $1.90, I’m saying $2.50. But really, I don’t think there’s a huge difference there. If we exclude China, there’s barely been any change.

It’s not to say that we should be sad about that, because there’s a huge number of people living in China, and they’ve become much better off. But I also don’t think that this necessarily tells us anything about global trends.

Luigi: First of all, it is not just China. Also, India did remarkably well—not as well as China, but I think it’s important. It is true that China is the big outlier. I think it’s worth understanding why China was able to make it.

I think that the turning point in China was the Deng Xiaoping reforms in the early ‘80s, when China de facto abandoned a communist regime, where even the land was in common, and started to recognize private property and allow some form of private enterprise. It was not initially very diffused. It was only in some economic areas. But then, this spread in a larger and larger part of the country.

The other major turning point is when China joined the World Trade Organization at the turn of the new century. This is really a turning point, because China accepted many rules of the economy, the world economy, and entered full term into the global economy in global trade. I think that it benefited tremendously from the transfer of technology and money coming in and being invested in China, foreign money coming in.

Kate: There’s this open question as to why did manufacturing jobs go to China and not South Africa or Indonesia. I think the answer to that is a difficult one, because there’s a couple of different potential solutions. One is that it has to do with government institutions. There’s a single party in China. Maybe there’s cooperation problems if you’re working with a democracy, where there’s changes in party control, and you’re not really sure what the next regime will be. For Western countries moving plants, for example, to other countries, it was easier for them to work within a single-party system. That’s one of the explanations.

Here, Amartya Sen, a Nobel Prize-winning economist, has weighed in on the issue, and he believes that it has much more to do with education and health. If you look at the educational statistics between China and India, for example, in 1990, only 45 percent of the adult Indian population was literate, whereas it was 80 percent for China. Life expectancy was also significantly higher in 1990.

This is why American manufacturing companies would want to relocate their factories to a place like China, where they knew that it was easier to train the population, because so many people were literate, and, also, they didn’t have to worry as much about low life expectancy, about having to deal with issues like disease and famine.

Luigi: But I think that I will divide the problem into two. There are the first 20 years of Chinese expansion from 1980 to 2000, and, then, there are the next 20 years, from 2000 to today.

In the first 20 years, I think that the secret is very simple. It is starting low. China was completely mismanaged. Agriculture was very, very low productivity, in part because there was no private ownership of land.

We have seen many countries having a very high level of growth succeeding in getting the agriculture from the Middle Ages to the 20th century. Even Italy after World War II had 20 years of 7 percent growth, which is hard to believe today, but it is a combination of a rapid movement from agriculture to industry.

Now, the more interesting question is, what happened in the next 20 years? Because, while it’s easy to go from a low-level agriculture to productive agriculture, it’s much more complicated to move from being a middle-income country to being a more-sophisticated country.

Here, I have to say, it’s not just China that did it. If you look at Korea, Taiwan, Singapore, Hong Kong, what we used to call the Asian Tigers, they all succeeded in this in a remarkable way.

They all share some common features. One is an emphasis on education, as you mentioned. The second was a pretty good rule of law, even if in China certainly much less than Hong Kong. I think that those two things are quite crucial to the success of the economy.

Kate: I think there’s an interesting debate to be had here about what we mean by good rule of law. There’s good rule of law for the people. That means democracy. That means voting rights. That means liberalism in the sense that there are civil liberties and people have free speech. But there’s also good institutions for business and capitalism.

I think the latter is really what united what you call the Asian Tigers. Even though China’s a communist country, at least de jure, it had a lot of the similar business-friendly institutions that Singapore and South Korea did.

Luigi: Yeah, I think it’s quite important especially to motivate foreign investments that if you set up a plant, this plant is not expropriated by the local authorities, or even if it’s not expropriated, if the working conditions, the regulation is changed ad hoc to make your life worse, or if they try to extract gigantic bribes for you to work there.

While Korea, China, and Taiwan are not in any way perfect from the corruption point of view, they are certainly better than Latin American countries or African countries or even India, for that matter.

Kate: I think that’s a huge point. I think it’s really the corruption problem at the local level and the everyday level that impedes business formation and growth.

Luigi: I think a point I would like to get across, because it’s often forgotten, is many economists or even policymakers think that if you just have markets, they will do wonders. But markets need infrastructure, legal infrastructure to work. The legal infrastructure must be supported by a competent state.

China has a long tradition of a competent state. I think that even Korea, et cetera, they do. I think in my view that helps forming a competent state to run a modern economy. In a lot of other countries, this tradition does not exist, and that makes it much more difficult.

What makes a country rich is not how much gold is there. It’s not how many buildings are there. It is the ability of the people working there to be very productive, to produce a lot per hour of work.

Labor productivity is what drives the wealth of nations in the long term. The fact that China increased tremendously the number of people out of poverty meant that China had a tremendous increase in labor productivity over this period.

Kate: I really hate to have to talk about this, because I don’t want to have to nerd out on this show, but it’s a little bit hard to talk about global growth without introducing this model called the Solow growth model, which is pretty important to understanding economic development. It’s named after Bob Solow, who won a Nobel Prize for this idea.

The two ideas behind the Solow growth model are that if you go from having just a little bit of capital—by capital I mean machines and plants and stuff—if you go from having just a little bit to more than just a little bit, that actually leads to a big increase in output, or a proportional increase in output. Whereas if you have a ton of machines and a ton of plants already, and then you increase them by that same amount, the relative increase in output is lower.

What I’m trying to explain is this idea of the declining marginal product of capital. Going from a low level to an intermediate level, you gain more than going from a high level to an even higher level.

One thing that’s a little bleak about the classical view of country growth is that once you reach what’s called a steady-state equilibrium, that’s just a point at which countries are basically stuck, the idea is that if you’re rich enough as you invest more in capital, you don’t actually get that much more output. In fact, you reach this point where the rate at which your factories and your tractors are depreciating is the same amount that you reinvest in them, and your output isn’t increasing at all. According to the classical model, once you’re a developed country, you just stop growing.

Luigi: You’re right, but this is in the classical model that ignores the importance of idea innovation. In fact, this year’s Nobel Prize winner, Paul Romer, got his prize precisely because he emphasized the importance that the spillover of ideas has increased the productivity of everybody.

This bleak view that we converge to a steady state, and we don’t grow from a steady state, is too negative a view and too old-fashioned a view. I think that innovation is important in increasing the famous Solow’s residual and in guaranteeing an increasing standard of living to everybody.

But this is the interesting part. China improved its productivity, not just importing capital or accumulating capital, but also importing technology and new ideas from the West. Globalization actually allowed China to do that and to do that very successfully.

Kate: Yeah, so you had mentioned this point earlier about how we allow other countries to experience the same sort of growth. I think it’s relevant to mention that if you look at the reduction in extreme poverty in some of the worst parts of the world, so, sub-Saharan Africa, and you look at the number of people living on less than $1.25 per day, that’s barely changed between 1990 and 2013.

Why is it that a country like China was increasing rapidly, whereas countries like those in sub-Saharan Africa didn’t benefit at all? The answer is mostly that it has to do with institutions. That you’ve got to give people property rights. You’ve got to create courts, and you’ve got to educate them at the elementary level and things like that. You have to have those basic institutions in order to really reap the benefits of technological improvements.

Luigi: This is where Africa starts at a major disadvantage, because it’s still affected by major fights and wars that are mostly a leftover of colonialists that divided Africa into countries that have very little to do with their ethnic origin, but more to do with which European power was grabbing what part of Africa.

War is the biggest enemy of development. The second biggest enemy is the lack of property rights. Africa is behind in creating these property rights, partly because, during wars, it’s difficult to maintain them.

But second, because you need a certain level of diffused education to do that. A friend of mine told me that when Tanzania became independent in 1961, there were 12 or 13 people with a college degree, 12 or 13 people in a country of 60 million people.

I think that the amount of human capital to start with was low, and, as a result, the ability to create courts and reliable systems is behind. But I think that, at least in parts of Africa, this is changing today.

Kate: Absolutely, I used to copy my math homework off of my Tanzanian roommate. She was brilliant. Thanks, Gloria.

Luigi: That’s not what I meant with the human capital, because, unfortunately, probably, your roommate will stay in the United States and will not help Tanzania develop, wouldn’t change—

Kate: Yeah, she actually lives in D.C., so, yup.

Luigi: Which is actually … a very important point that we’re raising is the level of brain drain that the United States is doing with respect to the rest of the world, and I am a case in point, is a problem for the rest of the world, because it is depriving the rest of the world of a lot of resources and making it more difficult for those countries to develop.

But now, Uganda, Rwanda, and Burundi are actually developing fast with a much better ruling class, much more educated ruling class, and I think the hopes of a turnaround of Africa are pretty significant.

Kate: I think another thing that’s good news for Africa is that Trump is making it harder and harder for people with high levels of human capital from other countries to stay in the United States. That’s good news for other countries, not great news for the US.

Luigi: In our podcast, we discuss so often what does not work in capitalism, but I think that in this episode, we can celebrate what does work. The success of China is a success of globalization and capitalism.

Remember that historically Western nations colonized other places, and this increased the poverty of those countries. Lenin famously said that colonialism was a way to exploit the monopoly power of Western nations over the rest of the world.

The globalization starting in the 1980s is the other way around. It is, in fact, the Western nations transferring technology to mostly China, but also India and some other countries were able to catch up, and this brought an enormous increase in the standard of living in a large part of the world. I think that we can celebrate a big success for capitalism in this episode.

Kate: Usually, I’m the one who’s positive about capitalism. I’m always the one who says, “What’s working in capitalism today.” But this time, I might feel a little bit more negative.

The huge success of China in the past couple of decades has led to an increase in the standard of living in China. But on the other side of it, there has been a lot of pain felt by Western democracies and, in particular, the United States. Many think that that was the flip side of the globalization that helped China out. This may have been what generated populist movements across Western democracies.

Luigi: I think you are absolutely right on the last point. But we have to remind ourselves that the failure of capitalism in this case is to be too egalitarian, because capitalism made it easier for the Chinese to catch up to the American standard of living and brought the standard of living of some Americans, at least, down in the process.

This is not something that capitalism is generally accused of. It’s accused of favoring inequalities, and, at least at the international level, it didn’t.

But you are right that it did create some losers. Globalization, in particular, created some losers in the United States. The big problem is that we vote on a national level, not on a global level, and so this legitimate concern was not addressed in any way politically, and that brought, too, a lot of disenfranchisement of a large part of the American population. I think that this is something that we need to analyze more.

Kate: On our next episode, we’re going to talk about how wealth inequality has changed over the past couple of decades within the United States, what the potential negative repercussions of that are, and we’re going to try to do it without sounding too much like nationalists or protectionists. I’m a little worried about that.

Yascha Mounk talks with Kate & Luigi about his new book "The People Vs. Democracy: Why Our Freedom Is in Danger and How to Save It." Recorded in front of a live audience, the conversation touches on recent populist uprisings and the extent to which they threaten liberal democracy.

Kate: Hi. I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales from the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: We are thrilled to have on our podcast today Yascha Mounk, who is a lecturer at Harvard, a senior fellow at New America, an executive director at the Tony Blair Institute for Global Change, and the host of The Good Fightpodcast, which I highly recommend. Welcome, Yascha.

Yascha Mounk: Thank you very much.

Kate: This is also our first live podcast episode. I am personally terrified. You can’t feel my palms right now, but they are just dripping with sweat. Luigi, you’re probably used to this. Are you terrified?

Luigi: I’m not terrified, no.

Kate: That’s what I thought.

Yascha Mounk: What about me? Nobody’s asking me if I’m terrified.

Kate: I just assumed that you’re good at this.

Yascha Mounk: I don’t know. We’ll see, we’ll see.

Kate: All right. So, we’re here to talk about your book entitled The People vs. Democracy, maybe more aptly titled Saving Liberal Democracy. So, to make sure we’re all on the same page, can you start out by telling us about what exactly is liberal democracy, and why is it worth saving?

Yascha Mounk: Sure. So, you know, we usually just talk about democracy. And so, we try to associate everything we like with democracy. But I think the problem is that when you expand one word so much that all of the good things sort of fall under it, you can’t draw careful, conceptual distinctions anymore. You can’t actually understand what’s going on in the world anymore.

So, I think it’s worth remembering with our political system is twofold. It’s a liberal democracy, which doesn’t have anything to do, obviously, with the sort of more political way in which we use the word liberal. So, in the way in which I’m talking about it, George W. Bush and Ronald Reagan are about as liberal as Bill Clinton or Barack Obama, right? This is not liberal/conservative. But what it means is that there’s two basic values which our political system tries to instantiate.

The first is individual freedom. That we ourselves decide what to say or not say. That we ourselves decide which gods to worship or whether to worship at all. That we decide how to lead our lives. And in order to have that, we don’t just need protections for various unpopular minorities. We also need the rule of law and the separation of powers, because if the president or prime minister can say, “Hey, I don’t like what you just said, I’m going to throw you in prison,” you’re not going to be free. That is the liberal element of our political system.

And then the second is the democratic element. That we want to collectively make our decisions together. That there isn’t a monarch or a military general or a priest who tells us what kind of laws we should have and where we should take our party. It’s all of us deciding those things together. So, to me, liberal democracy simply means a political system that strives and, to some extent, succeeds in instantiating these two basic values.

Luigi: Your book is also called The People vs. Democracy, as if there is an opposition between the two. Maybe it’s because I wasted five years of my young life in learning ancient Greek, but democracycomes from demos, people, so what is this tension? And you said that the notion of a democracy expands to everything that is good, but you seem to dump into populisteverything that is bad. If I may say, there is a bit of a populistic interpretation of the word populist.

Yascha Mounk: I have no idea what that means, but explain it to me down the line. Yes, why is it the people versus democracy? What does that mean? Well, I mean two things by that. One is relatively straightforward, one is a little bit deeper, perhaps. So, the straightforward bit is that back in the years in which everybody thought that democracies in places like Italy and the United States were obviously consolidated and obviously safe and obviously there wasn’t any particular reason to worry about it, I was a little skeptical of that narrative, because I saw lots of data points out there in the world point to various forms of trouble.

The fact that people have very low trust in institutions, that governments were really unpopular, that participation in elections kept going down, that especially in Europe, membership in political parties kept falling. And so, taking all of those things together, I thought that seems like reason to worry.

But most social scientists at the time, and at the time meaning three years ago, didn’t agree with me. And they drew this basic distinction between what we call government legitimacy and what we call regime legitimacy. So, they said, “Yeah, yeah, yeah. People are getting more critical of particular governments, but that’s a good thing. That’s healthy. That just means they’re becoming more ambitious when they demand more from the political system. That’s actually healthy. They’re becoming critical citizens. Regime legitimacy, the actual attachment to a political system, is as deep as it has always been.”

And so, I started to look at questions in surveys that actually got specifically at regime legitimacy. And what I found is that that regime legitimacy has been going down, in very worrying ways, quite rapidly. So, in the United States, for example, when you ask older people born in the 1930s and 1940s how important it is to them to live in a democracy, over two-thirds say absolutely important, 10 out of 10. Once you get to younger Americans born since 1980, relatively young Americans, less than ... Thanks for that slight chuckle.

Kate: When were you born?

Yascha Mounk: 1982. Exactly, that’s ... Yeah. Less than one-third of those say that it is absolutely essential to live in a democracy. So, that’s one thing. But there’s lots of other data points, right? So, even when you asked about as extreme an alternative to democracy like army rule, 20 years ago, one in 16 Americans said that was a good idea, and now it’s one in six. Among young and affluent Americans, it’s actually gone from 6 percent to 35 percent.

So, that’s one of the senses of the people versus democracy. The people, it turns out, are sort of turning against democracy. A majority still likes it in some kind of general way, but they don’t have a commitment to it that they once did.

There’s also a deeper sense which is important to understand, I think. So, you know, if you have these two core elements of our political system, liberalism and democracy, my fear is that these two things have been starting to come apart. And that on the one hand, for a long time, we’ve had what I call rights without democracy, undemocratic liberalism. So, a political system that’s reasonably good, not perfect, but reasonably good at ensuring individual rights, the rule of law, but that doesn’t do a great job of actually translating popular views into public policies.

And then on the other hand, you have the rise of what I would call illiberal democracy or democracy without rights. A bunch of populists ... We’ll get to that. A bunch of populists who come in and basically say, “The only reason why we have political problems is that this corrupt elite that wants to serve itself was in cahoots with those sort of minorities and outsiders and so on. And what we’ve got to do is for somebody like me who really speaks for ordinary people to come in. I alone am the true voice of the people. So, just give me a little bit more power, trust me a little bit, and I’m going to fix everything.” And what happens over the long run, as we’ve seen in countries like Hungary over the last eight or nine years, is that this person, first of all, establishes an illiberal democracy, which is to say that they scapegoat various minorities and restrict their rights and so on.

But once they have also attacked liberal institutions, once they have also put their own loyalists on the Supreme Court, once they have replaced the independence of law enforcement communities, once they have taken over state broadcasters and made it very difficult for private media outlets to do their job, once they control the electoral commission, it no longer is possible to replace a democratically elected government through democratic means. So, at that point, the champion of the people, the populist who claims to speak for the people, who initially might have been very popular, actually turns against democracy. And illiberal democracy slides into straight-out dictatorship.

But since he claims to represent the people, that’s the idea of a populist, and since people have actually voted him into office, there’s this sort of deeper sense in which the people turn against democracy.

Kate: OK. Let me try and reformulate Luigi’s question then. I wasn’t clear in your book what exactly populism meant. And in particular, the examples that you gave were, for the most part, far-right populists. What about people on the far left? So for example, Jeremy Corbyn, Bernie Sanders. Would you consider them populists?

Yascha Mounk: So, there are absolutely left-wing populists. I want to say two meanings of populist, right? So, sometimes in America, we just mean the sort of 19th-century agrarian populist and so on. That’s not the way in which I used the term. Right? The way in which, internationally, people use populist is a kind of style of politics, a kind of rhetoric of politics, and it’s precisely the claim to an exclusive representation of the people. That I stand for the real people and, by definition, everybody who disagrees with me does not. Everybody who disagrees with me is illegitimate.

And once you do that, you’re not going to accept the kinds of independent institutions we need to preserve liberal democracy over time. You’re not going to accept that you pass some law and the Supreme Court decides that it’s unconstitutional. That you commit a crime and the police might investigate you for it. That seems illegitimate to those kinds of populists. So that means that it’s not defined by public policy. If you just look at public policy, then populists seem not to have very much in common with each other. You may have noticed, for example, that our dear president, Donald Trump, does not appear to be, let’s say, overly fond of Muslims. When you look at someone like Recep Erdogan, the president of Turkey, he does not appear to be overly fond of anybody who’s not a Muslim.

There’s some populists like Donald Trump, actually in certain ways, who at least in the actions are readily right wing on the economy. Right? Giving tax cuts to billionaires and actually cutting some of the welfare state. There’s others, like Hugo Chavez, who are very left wing on the economy. So that’s not what defines somebody as a populist. What defines them as a populist is a rhetoric in which they say the whole political system is broken, it needs to be replaced. I alone truly represent the people and there’s no real legitimate limits on my power.

Absolutely, people like Hugo Chavez, who are left wing because of economic policies, left wing, fall into that and that’s why I call them populists.

Luigi: But when somebody says, “I’m the 99 percent. I am the people.” So, Bernie Sanders said, “I represent the 99 percent.” Why is he not a populist?

Yascha Mounk: Well, what he’s saying is that he is standing for the economic interests of 99 percent of the US population. I don’t particularly like that slogan for a number of reasons. For one, because if you actually want to do something about economic inequality in this country, it’s not just against the 1 percent that you have to go, but actually it’s the top 10, 20, 25 percent who have huge advantages over the rest of the population. So, as an actual prescription to the kind of policies you need, if you’re serious about remedying economic inequality in this country, I find that slogan quite unhelpful.

But I don’t see anything in Bernie Sanders’s rhetoric which goes beyond that, which actually says, I’m going to shut down media outlets. I think it’s unacceptable for people in the media to criticize me. I think that anyone who disagrees with me isn’t a true American. Those are all things that Donald Trump does all of the time. And those are all things that Hugo Chavez did all of the time. I haven’t seen Bernie Sanders do those things and so, that’s why I wouldn’t call him a populist on my terms.

But let’s talk about your country for a moment, Luigi. You know, how can you explain why in Greece, Cyprus is managing to rule with ANEL, a far-right populist party, and how can we explain that in Italy, the Five Star Movement, which very much has its roots on the political left, even if now it’s more politically amorphous, is able so far to be in a relatively stable government with the League, which is a far-right party? If you just look at the policy proposals, if you just look at where they come from on a left-right spectrum, this doesn’t make any sense.

But when you look at the fact that they’re both populists, that the main driving force behind them is precisely this deep opposition to the existing political system, and this claim that you’re either with us or you’re against us, then I think it starts to make sense. It’s the only way we can explain how these forces have ended up in coalitions and have ended up making it work.

Luigi: Actually, in Italy, it is very simple. It is because the only other alternative was to have a coalition with the Democratic Party. And the Democratic Party, run by Renzi, said, never ever. They preferred to be in bed with Berlusconi than to run with the Five Star. So, the Five Star had no alternative except this one. So, it was really, I think, the contempt of the traditional left that forced the Five Star into the hands of the League—

Yascha Mounk: But that might explain how they wound up in bed together. It doesn’t explain why they’re still in bed together and why—

Luigi: After two months?

Yascha Mounk: Seem to be going rather well and ... Well, that’s a long time for an Italian government—

Luigi: That’s true.

Yascha Mounk: By the way, it’s been half a year. So, I’m about to publish a study with a colleague, Jordan Kyle, which shows that, contrary to some expectations, it’s not true that populist governments tend to be less stable or in government for less long than “ordinary governments.” In fact, they’re in government for about twice as long as others on average, which is really striking and shocking.

Luigi: But let’s go back to the term populist. Again, you see everything negative, but even in the history of the United States, of course, Andrew Jackson had a lot of defects, but he did represent some change. For the first time, somebody not from the landed gentry became president, and the existing elite was indeed very corrupt. The people who were supporting the Second Bank of the United States were on the payroll of the Second Bank of the United States. And the United States survived after Andrew Jackson.

So, you have this view that if you have a populist president, necessarily you drift into disaster, but at least, if you look at the US history … and Italian and German history is very different. But if you look at the US history, it seems to be pretty positive.

Yascha Mounk: Look, I mean, the best way of looking at that is comparatively. And obviously, you know, it’s not easy to destroy democracy. And there’s plenty of cases where populists failed to do that. But on average, they do tremendous damage to democracies. Less than 50 percent of the time … A populist who is elected in democratic elections is removed from office through free and fair elections less than 50 percent of the time.

We see that if you want to look at times in which democracy is damaged by a democratically elected government, rather than foreign invasion or something like that, it is 14 times more likely to happen because you’ve elected a populist into office than any other kind of government. And when you look at many countries around the world, you see that economically, at the beginning, it can work relatively well, because the populists tend to be a little bit more immune from the ordinary sort of constraints of politics. And that can lead them to have effective management in the short run.

But in the long run, they tend to fail to modernize their economies. They tend to rely very strongly on short-term economic performance through fossil-fuel sales and so on. And they tend to hugely overspend. And so, in very many cases, 10 or so years into the rule, you get an economic disaster, as we’re seeing at the moment everywhere from Venezuela to Turkey, and so on.

So, sure, you can cherry-pick one particular example and say, “Well, there’s plenty of bad there, but perhaps there were some good things, too.” When you look at it systematically, it becomes very obvious that these governments do real damage.

Kate: Well, I’ll add in another example, which, to be fair, was not the president of the United States. But I think that the McCarthy era was also a period of populism in the sense that McCarthy was bringing to trials people who were considered outsiders and Communists. People who worked in the entertainment industry, people who were homosexual, and doing serious damage to their reputations and to their careers.

But that movement to some extent was diminished, if not completely eradicated, by due process and the rule of law. There were a number of Supreme Court cases that ruled against their unfair methods that pushed people back in the direction of the established rule of order. And I think that there are positive and optimistic lessons to be learned there, in the sense that we can do the same thing now.

For example, Trump was at his lowest point of popularity when the Supreme Court, or not necessarily the Supreme Court, but a number of courts were ruling against his travel ban. And now I think we’re making progress in terms of going after his emoluments or his financial interests. And there’s the case, I think, DC and Maryland have sued him for emoluments and that’s progressing. And I think a few months before that, the same case was dismissed.

And so, I guess what I’m trying to say is that I thought you were a little overly pessimistic about the use of the rule of law to overturn populism when there have been examples, including here in the US, of cases in which due process has made headway in overcoming populism.

Yascha Mounk: So, first of all, I just want to note that the line of attack on me has now shifted, which is good. I want all the lines of attack. So, it’s no longer—

Kate: Did you think we were going to play good cop, bad cop, because that’s not how—

Yascha Mounk: No, it’s bad cop, bad cop. But that’s fine. I’m, you know. Welcome to Chicago.

Kate: I’m not from Chicago.

Yascha Mounk: So, the sort of first line of attack was that populism might actually be good. Now, apparently at least for the moment, we’ve conceded that populism is bad. And the question is, but can’t we beat it in the end?

And look, I mean, you know, three years ago, I was going around to people trying to persuade them that our democracy may be under some amount of real threat because of the rise of populism around the world and various things that worried me in the United States. And people, to put it politely, looked at me like I was crazy. They kept calling me Cassandra, by the way, and I always wanted to say, “But Cassandra was right, dammit.”

And so, you know, my argument is not that we’re doomed. My argument is not that there is nothing we can do to defend our institutions, or that I’m swearing to you that two years from now, we’ll all be living under Generalissimo Donald Trump. My argument is that there’s a serious danger. And that when you look at the best historical analyses we have available, they’re imperfect, but the best we have, there’s very real reason to be concerned that often populists prove to be more effective at government, to do much more damage to the institutions, than elites tend to think. We think, that guy? He’s not going to beat us? What on Earth are you talking about?

So, to get to the question, I think some American institutions have been holding up, others have not. It’s striking to me to what extent the Republican Party has become a willing tool of Donald Trump’s latest whim. Whenever he says, “Jump,” and whichever hoop he holds out to them, they try to not to jump through, but jump above and do a little pirouette whilst they’re at it. That’s very concerning to me. People did not predict that two, three years ago. When you look at the extent to which he’s already managed to bring the FBI to heel, that’s very concerning. He has at this moment managed to fire the director of the FBI, the deputy director of the FBI, and three really leading instructing agents and so on.

When you look at the investigation of Brett Kavanaugh, I think there were real questions about whether that political context helped to limit what the FBI actually investigated. And I don’t think it is any longer impossible to believe that Rod Rosenstein will be removed and that the last sort of checks on how the FBI does its work are gone. And that in 2020, for example, you might have a politically motivated prosecution of a Democratic presidential candidate. I’m not saying that’s sure to happen, but I don’t think it’s unimaginable anymore.

When you look at the Supreme Court, I’m starting to worry as well that there is a deeper rot there than I would have anticipated two or three years ago. That’s partially because of the decisions we’ve seen over the course of the past year in which Congressional maps, where there’s evidence on email that they were used to weaken the Democratic Party and discriminate against African-Americans, were ruled to be constitutional. Where a highly dubious voter purge in Ohio was ruled to be constitutional. So that was business as usual though.

Now we have a stronger conservative majority on the court, and the circumstances where the pretense of nonpartisanship has gone out of a window in a really striking way during the Kavanaugh hearings. And in which the nature of conservative partisanship has ceased being a commitment to a set of values and has started to be loyalty to one person. So, you take all of that together and it worries me.

At the same time, you’re right, but certainly the media continue to be very active and that, in part, because we have such a decentralized country, elections for now remain, not entirely fair because of all of the problems of gerrymandering, and so on and so forth, but certainly robustly free.

And so, if the midterms go as some of the polls at least predict, and Democrats manage to regain control of at least one of the branches of government, and if Democrats run a sensible candidate in 2020 and manage to remove Donald Trump from office ... But yes, I think there’s a very good chance that we survive this kind of populist moment, at least in the short run. But we are in danger and we need to recognize that, because otherwise, we’re blind to mistakes we face.

Kate: So, can we briefly talk about some of the solutions that you propose in your book?

Yascha Mounk: Sure. So, look, I mean, I think the first thing to say is that wherever I go, people tell me these very local stories about what went wrong in their particular countries. And since we see the rise of populism across lots of different countries, I think we have to look for causes which are shared. Now I don’t think there’s any one cause that’s exactly the case and the same shape everywhere, but there’s a cluster of four or five causes. And a subsection of them, I think, is jointly sufficient to see the rise of populism.

So, anywhere we see three or four of those five or six causes, you wind up with strong populist movements. The three most important ones that I focus on the book is the stagnation of living standards for ordinary citizens. You know, in United States, from 1945 to 1960, the living standard of an average American doubles. From 1960 to 1985, it doubles again. Since 1985, it’s been roughly stagnant. The same in Europe, you had the Trente Gloriousesin France, the Wirtschaftswunderin Germany. These 20-, 30-year periods at the inception of democracy in many countries in which the living standard of people just fundamentally transformed. And now, for the last 30 or so years, people don’t feel like they’re getting something out of the local system. That fundamentally transforms what they think about politics, how they trust the political system.

The second big topic is culture, immigration, race. So, most democracies in the world upon their founding had a sort of mono-ethnic, monocultural conception of themselves. They said somebody who truly belongs in our country is somebody whose ancestors also came from this place. And we certainly are not from any ethnic minorities. We certainly do not come from other continents and so on and so forth. That has started to change over the last 40 or 50 years, there’s some real change in those self-conceptions. But there’s a big part of the population that isn’t on board with those changes and then rebels against it.

And the United States and Canada on that are both sort of similar and different. They’re similar in the sense that they, too ... They’re different in the sense that they’ve always been countries of immigration. They’ve always been multiethnic societies in a certain kind of way. They’re similar in the sense that they had a very clear racial and religious hierarchy, which gave a lot of advances to one group over others. Here, too, they’ve actually come a long way of overcoming that, but we certainly haven’t overcome it completely. And there’s a lot of people who are rebelling against the relative amount of equality that we’ve managed to achieve.

And then the third thing to me is the rise of digital technology, of the internet and of social media, which makes it harder for political and financial elites to control the Overton window, to control what can be said in politics. And that can be a positive thing. It can allow important formerly marginal voices to enter the political fray. But it can also be quite dangerous when it allows people who want to spread racial hatred, people who want to spread straightforward false information, to have a much bigger voice now in political discourse, particularly at a moment when people are already economically frustrated and a part of the population already is fearful of demographic and cultural change.

So, I think we need to confront those basic drivers. So, I think we need to have an economy that ensures that the fruits of economic growth and globalization actually go to ordinary citizens in a way that they currently don’t, but that also tries to accelerate productivity and economic growth, because we’ve seen that that’s one of the big reasons why living standards have stagnated. I think on the cultural piece, we should resist the temptation that a lot of people on the left have, and that I had for a long time in my life, of trying to leave patriotism and nationalism behind in the 20th century, which it so cruelly shaped.

If we do that, we ignore the fact that nationalism has tremendous force in the world, as the last 20 years have shown, remains the most powerful political motivator in most of our societies. And allow the political right and the worst part of the political right to dominate and exploit that motivating power. And so, instead, advocating fighting for an inclusive notion of patriotism in which we don’t leave that camp to the Steves, Bannon and Miller and so on, but fight to appropriate for it for ourselves. Arguing that, actually, nationalism historically has been a way of expanding the circle of human sympathy beyond our own village, our own family, our own ethnicity, our own religion, so we can feel real solidarity with people who might be 1,000 miles away from us, who might have a different skin color, who might have a different religion, but who we recognize as our fellow citizens.

And finally, on social media and the internet, I don’t think the solution is to censor, as some European governments are now doing. I think the solution is actually in a serious way to fight for our political values. From Plato to Aristotle, from Rousseau to the founding fathers, each set of political thinkers who have thought seriously about how to make a self-governing republic work emphasized the importance of passing our values on from one generation to the next.

I don’t think we take that seriously in the way we educate our children. I don’t think we take that seriously in primary and middle schools and high schools around the country. And I certainly don’t think we take that seriously as one of the core tasks that university professors and academics like us here on the stage have to do every day. And I think if we change that, hopefully it’ll make a little bit of a difference.

Luigi: Is the failure of the elite missing from here? Generally, populism arises, and we see now in Brazil with Bolsonaro, part of it is the economic failure. But part of it is the elite was deeply corrupt. And in the West, with a major failure like a war in Iraq that was fought for no reason, for misleading ... Leaders that misled the American and British people into a war that was a disaster, and I don’t use swear words, but you understand what kind of disaster.

You had a financial crisis. We had no executive going to jail in spite of the massive fraud of that financial crisis. We have an opioid crisis in the United States that is pushed very much by an industry that wants to make money on the face of people and is protected throughout the way and I can keep going.

Yascha Mounk: I mean, one of the things that I say is that when you look at the 2016 election, I think there was a choice between a moderate politics of the status quo and an extremist politics of change. And so, if people voted for Donald Trump, it’s not necessarily that all Americans are extremists, or even, you know, 46 percent or whatever voted for him are extremists, it’s that they really wanted change.

And the best way to fight against that is to create a plausible vision of how we can have quite radical change, of how we can actually shake up our political system and reform some of the ways in which it’s not delivering for people. But without being ideologically extreme, without giving up on the basic founding values of our country and the basic founding ideals of liberal democracy. So that’s the project I try to pursue.

Luigi: And with this, thank you very much. And thank you all for coming.

Kate: Thank you so much.

Populism strikes again as the world's 4th largest democracy is set to elect controversial right-wing politician Jair Bolsonaro as its next leader. Writer and lawyer Glenn Greenwald (now living in Brazil) tells Kate & Luigi how rampant corruption, violent crime and a struggling economy have given rise to yet another populist movement.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: For the past few months, we’ve been seeing populist movements pop up around the world, and the latest iteration of this is happening in Brazil, as we speak. This coming Sunday, the Brazilians are about to vote in the second round of a presidential election, which will almost certainly elect Jair Bolsonaro, who is a far-right-wing candidate.

Luigi: And some listeners might say, “What does this have to do with capitalists?” But, in fact, the interactions between capitalists and democracy are very important, and the degeneration that democracy is taking in many, many countries is problematic, not only from a political point of view, but also from an economic point of view.

Kate: So, on today’s episode, we’ve decided to invite Glenn Greenwald, who is a lawyer and journalist in the United States but has also been living in Brazil, and so he has a unique insight into what’s been going on with their political system and their institutions.

Luigi: In preparing this episode, we tried to reach out to both sides of the debate, and we tried to contact both Paulo Guedes, who is the economic advisor of Bolsonaro, and Greenwald, who, in spite of being a famous US journalist, actually lives in Brazil. We’re lucky to get Greenwald. Unfortunately, Guedes did not reply.

Kate: All right, so before we get to Glenn, we want to give you a little bit of context and background for what’s been going on in Brazil’s political history over the course past half-century. Brazil is no stranger to having its political parties overturned, the most salient of which took place in the 1960s, when the military took power and held onto power for 21 years. It was only relatively recently, in 1985, that democracy was restored. During that period, I think it’s important to note that Brazil actually experienced a great deal of economic growth, what some people call the Brazilian miracle.

Brazil’s a large exporter of natural resources, including oil, soybeans, agriculture, and its political cycle is very closely tied to what happens to commodities. So, in periods when commodities prices have been booming, Brazil’s political system has been more stable, but whenever there’s a downturn in commodity prices, it has tended to lead to overturning whoever was in power at the time.

Luigi: In 2002, Brazil elected the first left-wing president, Lula, a leader of the Workers’ Party, called PT in Brazil, and it was the beginning of this commodity cycle. So, at the early part of the Lula government Brazil did very well, and Lula left government after eight years with an 86 percent approval rating. Unfortunately, after that, the economic cycle turned south and Dilma, who was the first woman president elected after Lula, faced the difficulties of that downturn and eventually was even impeached, and Temer became president.

Now, the first thing we need to know about Brazil is the extent of political corruption. In the United States, we complain about campaign financing and how much money’s in campaign financing, but if you adjust for GDP in Brazil, just the legal donations are five times as much as the ones in the United States. That doesn’t count bribes and illegal donations. There is now an investigation going on where more than 16 large companies are involved. These are the best companies in the country. They all paid bribes in a systematic way to everybody who was in power. We’re talking about billions and billions of dollars of contracts and bribes paid.

Kate: The second thing that’s worth noting is that Brazil has been experiencing a serious recession for the past few years. Even though here in the US the economy has recovered ever since the financial crisis, from 2014 to 2017, Brazil has been going through one of the worst economic downturns in recent history. It’s been experiencing stagflation, so the economy, the GDP, was falling while inflation was high and also very high levels of unemployment, particularly among the young.

Luigi: This recession is actually a combination of the bad part of the commodity cycle and, actually, the result of the investigation by being so aggressive in a country that lives off corruption. If you are very harsh against corruption, you might freeze a lot of public work and a lot of work in general. The combination of the two has put Brazil in a very difficult situation.

Kate: All right, so now that you’ve heard a little history, let’s hear from Glenn Greenwald. Glenn is a lawyer, a Pulitzer Prize-winning journalist, and a best-selling author. He’s also a co-editor and co-founder of The Intercept. Glenn is also married to David Miranda, who is a city councilman for Rio de Janeiro. He is a member of the Socialism and Liberty Party, which is a left-wing party in Brazil. Glenn and his husband also have a program whereby they adopt dogs, and so, over the course of this interview, if you hear some dogs barking in the background, that’s why. Glenn, thank you for joining the show.

Glenn Greenwald: Thank you for having me. Happy to talk to you.

Kate: Let’s jump right into the Brazilian election that’s about to take place this Sunday. It’s almost certain that Jair Bolsonaro is going to win, and he is well known for speaking his mind about a number of pretty thorny social issues. Can we go through some of your favorites of the best-worst things that Bolsonaro has said, or what I like to call Bolson-uh-ohs?

Glenn Greenwald: Yeah, I mean, so I generally think of Bolsonaro in two different categories. One are the kinds of comments that he’s made that are inflammatory and offensive by design, similar to the ones that Trump has made, although they’re grounded in a much more serious ideology than Trump’s are. Secondly, the policies that Bolsonaro endorses that show that he really means the things he says. But kind of the highlight, or lowlight, reel of his comments begins with things like explicitly praising the torturers, the most notorious torturers of the military dictatorship. When he stood up on the floor to announce his vote to impeach Dilma, who herself was detained as a dissident under the military dictatorship and was tortured, he went out of his way to explicitly praise the military colonel who oversaw her torture.

He said they should’ve killed probably another 30,000 people. He said in 1989 that he didn’t think elections would ever fix any of the problems, that we needed to use … unfortunately, he said killing people who are a threat to the country, and at the time he even named the elected president, Fernando Henrique Cardoso, who was kind of a center-right figure, as somebody who should be killed. In 2014, he told a female colleague in Congress who had pointed out that he had a history of defending not just torture but rape that was used as a weapon by the military dictatorship. He told her, “Oh, you don’t need to worry. You’re too ugly to deserve my rape.”

Kate: Lovely.

Glenn Greenwald: When he was asked in an interview just about a year and a half ago about his history of anti-gay comments and how he would react if it turned out that his son was gay, he said that, “I couldn’t love a gay son. In fact, I’d rather learn that my son died in a car accident than learn that he was gay.” There’s a lot of racist comments as well. Things of those—

Kate: That’s disgusting.

Glenn Greenwald: Along those lines. He has not just a distant history, but a very recent history of saying all kinds of the most horrific things you could possibly think of.

Luigi: But the shocking thing is not only that people like this exist. Unfortunately, they do exist, but that the vast majority of Brazilians are ready to vote for somebody who explicitly says those things. How can you explain that?

Glenn Greenwald: I think that is the key question given that Brazil is a country, as we should recall, that in the last four national elections has voted for what is widely regarded as a left-wing party but is really more of a center-left-wing party, which is the Workers’ Party, founded by Lula da Silva, and also elected Dilma Rousseff, the first woman president. Why is there this radical shift in ideology all of a sudden?

I think the answer is the same one that explains the election of Donald Trump in the US, and Brexit in the UK, and the rise of extremist parties in places where we thought that it was previously unthinkable to see them in Western Europe, which is that once people conclude that the political establishment or the ruling class has so fundamentally failed them, they will run into the arms of anybody that they perceive is an enemy of that ruling class and is somebody who promises to burn it all down and destroy it. No matter what their own flaws are or their own faults are, the idea becomes, “Well, we have nothing else to lose. It can’t get any worse, and this person is hated by the very people that we blame for our plight.” That makes us think that he’s somebody we ought to dispatch as our agent or weapon against those who have spent the last two or three decades making our lives miserable. That’s a big part of the appeal of Bolsonaro.

Luigi: One of the potential causes of such an outrage is corruption. As people living in America, we are no stranger to corruption, but Brazil is at a different level. You have lived in both places. Can you explain to us how Brazil is so different?

Glenn Greenwald: Yeah, it’s an important point, because it is true that people in Western democracies, when they think about corruption, think about isolated cases of particular politicians who accept bribes in exchange for votes or contracts. Maybe even think about it now a little bit more systemically in terms of, say, corporations who donate large amounts of money to political campaigns or PACs in exchange for their agendas being served, but Brazil is in a completely different universe when we talk about corruption.

Every party in power, far more than ideology or political allegiance, essentially serves the interest of oligarchs who pour money not just into their party but into their secret Swiss bank accounts in exchange for contracts of enormous magnitude. This has been going on for a long time with total impunity, and it was just sort of the way that things worked in Brazil and have always worked in Brazil. It was just assumed that’s how Brazil was governed, and the only thing that changed is that there was this sort of young team of prosecutors who kind of stumbled by accident into a narrow corruption case that opened up this much broader window into this sweeping corruption scandal that has now exposed every major political party, the nation’s leading plutocrats, and exactly how they have engaged in corruption. A lot of them have been hauled off into prison. A lot of them are on the verge of going to jail, and that has obviously destroyed public faith and confidence in all Brazilian institutions except for its military.

Kate: What does it feel like to be a Brazilian on a day-to-day basis? Do you encounter corruption in your regular life? When you come across the police, for example, do you have to pay them off or is it something that’s more removed?

Glenn Greenwald: Corruption is definitely ingrained into every fabric of Brazilian life. It’s just accepted that if you want bureaucracies to move quickly you need to bribe bureaucrats. If you get stopped for a speeding ticket or a traffic infraction, almost every police officer encourages you to pay them some bribe in order to let you go without a ticket or without points on your license. That’s definitely just a natural part of all aspects of Brazilian culture that date back to the dictatorship and the way that it ran. Because bureaucracy is something that dictatorships use to control populations, and there is a massive residual bureaucracy that’s extremely slow moving and almost impossible to get anything done. Yeah, it’s well known that even petty corruption and bribery is just a daily part of Brazilian life no matter who you are.

Kate: Taking a step back and taking a broader look at Brazilian politics, if corruption is so deeply ingrained, how is anyone ever going to root it out and still maintain democracy?

Glenn Greenwald: Well, that’s an open question whether or not that can really happen. The reality is that, although, as I’ve indicated, this corruption scandal has exposed essentially every political party and every major corporation, in a very fundamental way, only a small fraction of the people who have been implicated have actually gone to prison. In large part because the members of Brazil’s Congress, both the lower house and the Senate, enjoy this kind of legal privilege where they’re immunized from being prosecuted for any crimes while they’re in office, except for prosecutions that are conducted by the Supreme Court, the highest court of the country. You could imagine what that would mean in the US, for example, where the Supreme Court is nine judges and has a very full docket. They can’t really oversee criminal cases, and so that immunity means that they’re essentially fully immunized.

Recently, just to give you a sense for how corrupt this mechanism is protecting people, the right-wing candidate who ran against Dilma Rousseff in 2014 for president, Aécio Neves, with the center-right, establishment-backed party called PSDB, was a senator, and he has now been exposed as not just a corrupt politician who accepts bribes, but he got caught on tape talking about murdering witnesses, including his own cousin, to hide evidence of his corruption. Yet he is still in Congress, and just this year the polls showed that he had no chance of being re-elected to the Senate, so he decided instead to humiliate himself and run for a seat in the lower house just in order to keep his legal privilege and stay out of jail, and just through name recognition he ended up winning.

There is a real question about whether or not the systemic corruption is actually going to really be dented by what had looked like this really monumental investigation. Of course, a big part of Bolsonaro’s appeal is that he hasn’t been implicated by this scandal and intends to clean out all of Brasilia. A dubious promise, but one that definitely has a lot of political appeal.

Luigi: What is funny for me as an Italian is that this Operation Car Wash is almost identical to Operation Clean Hands that took place in Italy in 1992, ‘93. The irony of this is that in Italy, Berlusconi, but all the center-right, was blaming the prosecutors for being communist and claiming that all the investigations of Operation Clean Hands were, in fact, a political agenda to get rid of the center-right and put in a leftist government. In Brazil, it seems sort of the other way around, that all the allegations are that the judges are right-wing. Is there some sort of truth to that claim or not?

Glenn Greenwald: There is some truth to that claim, but I think we have to be a little bit careful about it. It is definitely true that the results of the investigation have disproportionately punished left-wing politicians while right-wing politicians have gone largely unscathed. If you speak to the prosecutors and confront them with that allegation, as I’ve done, what they will say is that, “Well, of course that’s the case, because it’s the left that has been in power for the last 16 years.” Since 2002, the Workers’ Party was occupying the presidency through two terms of Lula and then one-and-a-half terms of Dilma. Dilma herself was chairman of the board of Petrobras, where a lot of the corruption was centered, and so their argument is, “Of course, the politicians who are actually in power are more likely to be involved in corruption, because they’re the ones who can get things done.”

There’s a little bit of truth to that, but the much bigger truth is that even though the Workers’ Party occupied the presidency for those 14 years, they relied on parties in the center and the center-right as coalitions in Congress in order to get things done, and those parties wielded great influence. As I indicated earlier, Dilma’s right-wing partner, Aécio Neves, has been caught on tape ordering bribes and murdering witnesses. The president that they installed once they impeached Dilma, Michel Temer, who is part of this kind of centrist transactional party, PMDB, also got caught on tape that the whole country heard, ordering bribes to silence witnesses, and none of them have gone to prison.

There is this very valid left-wing critique of the prosecutors that they seem to be much more interested in going after left-wing politicians. If you think about Brazilian society, that’s not surprising because the society is so stratified that the people who become prosecutors, who become lawyers, who become judges, come from rich families, and there’s lots of things that these judges have done that, we can go into detail if you want and I can give you examples, but that do suggest a very politicized bias where they’re far more interested in punishing politicians and others on the left than they have been on the right.

Kate: When we think about moneyed interests in the United States, most people are concerned about Wall Street and the big banks, to some extent there is concern about pharma and big oil. Who are the moneyed interests in Brazil? I mean, in the case of the Workers’ Party it seems like a lot of the corruption scandals revolve around Petrobras, the state-owned oil company. Are there different interests backing Bolsonaro, or is it the same set of oligarchs as you mentioned earlier?

Glenn Greenwald: Well, obviously, oil is a major industry, and Petrobras is one of the world’s major oil companies and is a state-owned oil company that has funded a lot of other social programs and has lifted people out of poverty under Lula’s presidency. But they have a lot of construction companies that are adjacent to Petrobras that do a lot of the building of the infrastructure that Petrobras uses but also that the country uses.

Then, there’s a very large financial and banking industry that’s linked to hedge funds and international capital. For a long time, those interests were very skeptical and wary of Bolsonaro. Much like the kind of classic Wall Street, Silicon Valley billionaires and plutocratic class in the US supported Jeb Bush or Marco Rubio and most certainly not Donald Trump, because they perceived Trump as this kind of anti-establishment outsider who was going to bring instability. Eventually, what Bolsonaro did that was actually quite shrewd was he hired as his kind of economic guru Paulo Guedes, who is kind of one of the classical neoliberal privatizing economists.

Kate: He was trained at the University of Chicago.

Glenn Greenwald: Out of the University of Chicago school. Exactly. In the most notorious sense, the kind that ran Chile under Pinochet, and Bolsonaro just came out and said, “I know nothing about economic policy. That’s not my interest. I’m an army captain. I’m going to focus on cleaning Brazil up and getting rid of its criminal elements and getting rid of its left-wing communists, and I’m going to turn over economic policy to Paulo Guedes.”

Kate: Can you compare and contrast the economic plans of Bolsonaro and his rival Haddad?

Glenn Greenwald: One of the really interesting things about Bolsonaro’s economic policy is that he, in his 30 years in office, has never really demonstrated any real interest in economic policy, and to the extent that he ever opined on it, it was as an interventionist, as somebody who believed that the state should play a significant role in regulating the economy. In order to kind of lure Brazil’s oligarchical class and financiers that wield a great amount of power, Bolsonaro has basically said, “I’m going to have very little to do with the economy and economic policy. I’m going to just simply turn it over to Paulo Guedes, who’s going to implement this kind of libertarian, right-wing, highly privatized, focused economic approach that will eliminate state-owned industry, sell off all of our assets, and make certain that businesses are freed of regulation.”

On the other hand, you have Haddad that comes from ... He actually got his PhD in Marxist economics, although he’s now regarded as a kind of technocrat and moderate. He governed as mayor of São Paulo for four years, the largest city in Latin America, and really was not even a left-wing figure. He was just sort of this kind of Hillary Clinton-type centrist. Probably not nearly as moderate as she. I mean, he was definitely still a Workers’ Party candidate, but definitely in the Workers’ Party universe, he’s kind of a moderate. But the Workers’ Party has always had its origins, as its name indicates, as shifting resources away from the richest to the poorest. There is a very stark contrast in economic policy between the two, but because Bolsonaro is just such a kind of singular, aberrational figure in Brazilian politics, much like Donald Trump was, the election really hasn’t focused very much on things like economic policy and instead has been very Bolsonaro-centric. Just like the 2016 election was all about Donald Trump.

But the economic programs and ideologies that they would usher in really couldn’t be more starkly different. I mean, I should say that the Workers’ Party, despite how it likes to market itself, actually was very closely aligned with the nation’s oligarchical class during the rule of Lula and Dilma. They did very, very well and got very comfortable with the Workers’ Party. That was part of their strategy for staying in power. They definitely moderated their economic ideology, but compared to the ideology of Paulo Guedes, the difference is quite vast.

Kate: They both want to invest in infrastructure. That’s the one thing they have in common.

Glenn Greenwald: Yeah, sort of like Bernie Sanders and Donald Trump both had that in common, but other than that it’s very difficult to find commonalities.

Luigi: Whether we like it or not, we are all part of the elite and in some way of the establishment. What can we do to avoid this deterioration in Brazil, in the United States, around the world?

Glenn Greenwald: I think that there’s one very important requirement to prevent more Marine Le Pens, or Brexits, or Bolsonaros, which is that people who have been a part of the ruling class for the last 20 to 30 years need to engage in a serious self-critique and self-reckoning about what the effects of things like globalization and other free-trade policies have been or the cultural rift that has emerged in Western democracies that has made a huge portion of the country feel as though they have zero investment in what happens in distant capitals that rule their lives. Because until that happens, until there’s some sense of responsibility assumed by the establishment of the world’s leading democracies, the resentment and the anger, a lot of which is valid, that is now bubbling to the surface and being exploited by demagogues is only going to intensify. That will only result in the empowerment of exactly the people who are best able to exploit our worst human instincts, because once people conclude that their futures are grim and that they have no hope, they’re willing to roll the dice on anything that is new and different.

Kate: Bringing this back to the United States, where are we in this process of recognition and soul searching, looking for a candidate who will fix everything? Is Brazil trailing the US or is the US trailing Brazil at this point?

Glenn Greenwald: I think there’s been this attempt by Western media to understand Brazil with reference to the US, because that’s the way that Western journalists can think about things and call Bolsonaro Brazil’s Trump. As we’ve discussed, I think that Bolsonaro is a far more extremist figure and his election is far more dangerous, in part because Brazil’s democracy is so much younger and its institutions much more fragile. But I do think there are similarities in the dynamic.

In particular, just as is true of Bolsonaro, there are some elements of Trump’s electorate that voted for him because of the racism, and the misogyny, and the xenophobia that he spewed, but a large number of people voted for him despite all of that, because they watched their manufacturing jobs and their opportunities to stay in the middle class disappear over the last 20 to 30 years, as both parties presided over policies that destroyed the economic security and the future of a huge portion of the country with utter and seemingly aggressive indifference towards their plight. That’s why there are a lot of people, despite the media narrative, who voted first for Obama when he promised the ideology of change, to go and change who Washington works for, and then who also voted for Trump because they were just looking for anyone who seemed like an outsider figure, somebody who was going to go and be an enemy of Washington and the factions that rule it.

I think the same dynamic that’s driving Bolsonaro largely, which isn’t his racism and homophobia and misogyny ... That’s a big part of it but not the biggest part. The biggest part is this anti-establishment anger that has a lot of legitimacy and validity to it is also driving a lot of the political currents in the US. What you’re seeing actually, what you saw in Brazil in this last election, is the disappearance of the center.

Kate: I have a personal question for you. We started out the episode talking about Bolsonaro’s support of torture and his praise of the use of murder extrajudicially. This is a man who is nostalgic of a time when there was military rule, has hearkened back to it, wants to reinstate it, and this military rule was extremely oppressive of free speech. As a lawyer and a journalist, when Bolsonaro is elected president, as he is almost certainly going to be in a few days, are you thinking about leaving?

Glenn Greenwald: Well, I mean, I guess I would add to that the fact that obviously given my work as a journalist and my husband’s work as an elected official in the same left-wing party that Bolsonaro blames for his near-fatal stabbing a month ago ... Bolsonaro attacked me personally on Twitter about six months ago when he used an epithet for gay people against me on Twitter. My husband is currently demanding the removal of Bolsonaro’s son from the city council, where they serve together, because he posted some pictures that were intended to glorify torture and threaten protestors with murder. We’re definitely a pretty high-profile target for Bolsonaro and his movement.

I’d be lying if I said that we didn’t actively think about the risk that we might face, but at the same time, we’ve adopted two children here who are Brazilian. We consider Brazil our country. No, I don’t intend to just run away the minute that things get a little bit difficult, or risky, or dangerous. I don’t intend to engage in pointless self-sacrifice, but I think there’s going to be a substantial resistance because even though the democracy is young, there is a whole generation of people who have spent the last 30 years inculcated with the idea that democratic values matter. I think there’s going to be a lot of resistance to any steps that he intends to take to reinstitute the kinds of oppressive measures that were seen during military rule, and I intend to participate to the best extent that I can using my public platform as best I can as part of that effort.

Kate: Glenn Greenwald, I wish you the best of luck. I hope for your safety and the safety of your family, and thank you for joining us on the show.

Glenn Greenwald: Thank you for having me. I really enjoyed the conversation.

In our third and final episode on the 2008 financial crisis, Kate & Luigi look at recent volatility in the markets and try to predict the cause of the next financial crash with help from prominent economists Robert Shiller and Lawrence Summers.

Speaker 1: Do you worry about another crisis?

Speaker 2: Well, there will be one some time.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On today’s episode, we’re going to be doing economists’ favorite thing, which is to predict when the next crisis is going to hit.

Luigi: The running joke about economists is that predicting is hard, especially about the future.

Kate: Yeah. In order to minimize the amount of opining that Luigi and I would have to do in this episode, we went out, and we made a couple of calls to prominent scholars who perhaps are better equipped—or at least more willing to talk about—this issue of where the next crisis will come from.

Luigi: We reached out to Bob Shiller, who not only has a Nobel Prize but also has the privilege of having called the recent real-estate bubble before it burst, so he has some claim to fame in terms of predictive ability.

Kate: We also called Larry Summers, who is the former secretary of the treasury of the US, also president emeritus of Harvard, and who’s also spent a lot of time working in the policy world, particularly as a key advisor to Obama during the financial crisis.

Robert Shiller: “Where the Next Crisis Will Come from and Why,” by Robert Shiller. It’s hard enough to answer where previous crises came from, let alone do that for the next crisis. Part of the problem is that the big crises are the result of a confluence of factors. Little fluctuations in the economy become big if 10 or 12 small factors become big and important all at once. So, there is not a good tellable story of the cause. The explanation of the crisis has to take the form of a list of factors.

Many of these factors typically involve new narratives that become contagious and go viral. The concept of a housing bubble went viral starting around 2005, and this eventually crashed the housing market. Nicola Gennaioli and Andrei Shleifer have a brand-new book, A Crisis of Beliefs, that attributes the financial crisis to a change in fundamental beliefs. I would say they are right, but would add that the change in beliefs is mediated by newly viral narratives.

The next crisis is inherently difficult to describe, since there are so many new directions future narratives could take. Combinatorics, working with lists of relevant subjects and words—bubble, bank run, oil crisis, trade war, and on and on—suggest an astronomical number of possible mutations of our existing narratives. These will be experimented with by countless people, and something new and different will emerge as contagious.

Kate: Can I just say that Bob Shiller has the warmest voice of anyone that I’ve ever heard?

Luigi: Can I say that he punted the question a bit?

Kate: I mean, yeah. He didn’t give the most direct answer to the question, but whenever I hear Bob Shiller’s voice, I want him to be my grandpa. I want to make gingerbread for him at Thanksgiving and just listen to him talk around the fireplace. He’s just got such a nice voice. I don’t even know how to make gingerbread. All right.

Luigi: More seriously, there are two, I think, powerful insights here. The first one, which is maybe kind of obvious but important, is that you don’t know where the next crisis is going to come from, because if you knew, you could to some extent avoid it. So, there is this element of unpredictability that’s inherent to a crisis. And—

Kate: Can I just step in there?

Luigi: Sure.

Kate: I mean, yes, obviously, that’s true for markets. The market can’t predict a market crisis, because then the crisis would have happened already, but individuals can predict crises just as long as enough people don’t listen to them.

Luigi: Yeah, so it’s possible that somebody might sort of spot it, but it’s hard for the system overall to spot it, because if it does, it does not unfold as a crisis.

Kate: OK, sure.

Luigi: The second important point is that there is an element of irrational beliefs in crises. I think that one of, in my view, limitations that classical economics and the dominant paradigm, until the crisis, are responsible for is to have eliminated completely what in jargon goes as a Hyman Minsky moment, from an economist who died in 1996 who was very much into the history of crises and what causes crises. He was emphasizing the rational component of crises, and, as a result, became a sort of non-grata basically in mainstream economics.

If you go and look at the textbooks of macro until the crisis, nobody was citing Minsky, and today everybody does cite him because of that.

Kate: Yeah. I would characterize it . . . I agree with him, but I think most of the irrationality comes before the crisis. It’s that people get irrationally exuberant about things and then it’s only when they wake up because the system has become so bloated that, actually, that’s when they become rational, and that’s what sets off the crisis. I think it’s two sides of the same coin.

Luigi: I actually disagree here. I think that there is a moment of rationalizing the crisis itself. Kindleberger, who cites Minsky, was an economics professor at MIT and wrote a famous book about manias, panics, and crashes. Actually, he uses a German term, which is Tür schlosspanic, which means “door shut” panic. Basically, what happens in a . . .

Kate: I love the German terms.

Luigi: In a room when you try to get out, and you fear that the door is going to close, and then everybody panics. I think that represents very well what happens at the peak of a crisis. Another description I heard, which I think is very funny, is the Minsky moment. It’s like Wile E. Coyote and the Road Runner when they chase each other, and at some point they go off the cliff, and they keep going for a little while off the cliff, until they realize they are off the cliff. Then, they start to precipitate. I think that crises have this element that you are . . . Of the euphoria before, the euphoria that pushes you off the cliff, and then there is the moment you realize you’re off the cliff. That’s what is called in jargon the Minsky moment, and that is when you have the opposite, which is the panic.

Kate: All right, next up let’s hear from Larry Summers.

Larry Summers: I’m Larry Summers. I’m the president emeritus of Harvard, and the former secretary of the treasury. I think a main lesson of history is that important aspects of the next crisis are likely to be things that we don’t anticipate, and that we don’t foresee right now, because if we foresaw a crisis there’d be selling pressures, there’d be various mechanisms that would be either accelerating the crisis or forestalling it.

As I think about the risks in the current global environment, I would highlight the risk that central banks overtighten, because they’re not fully internalizing the lags between tighter monetary policies and its impact on the economy, and that that leads to an economic downturn with important financial consequences.

The second risk would be the risk that we saw too often with the internet bubble, with the housing bubble, that complacency becomes a self-denying prophecy, that after a period of tranquility, after a period of rising markets, people come to think that it’s safe to borrow in order to invest. They come to invest less in reliance on the fundamentals of an asset, and more in reliance on their ability to sell it to someone else at a higher price. At some point, the music stops and matters unwind.

A third risk is what will happen in China and in emerging markets, which have accumulated, in some cases, very substantial quantities of leverage. In the case of some emerging markets, very substantial quantities of dollar debt, and therefore are at risk of an economic downturn.

The last risk, which I think is very real, is the geopolitical risk at a time when we’re seeing substantial emergence of what used to be called great-power rivalry between the United States, Russia, and China. A time of substantial, potential instability in the Middle East, on the Korean peninsula, and so, political and security developments could also be a source of uncertainty and risk to financial stability.

Kate: Maybe I’m a little biased, but I agree with everything that Larry said. I think he actually pinpointed certain areas of the economy that we should be worried about. In particular, I completely agree with him about his concern about overtightening.

I want to share a little bit of the history of recessions in the US. The recession in 1949 followed monetary tightening. The one in ‘53 followed monetary tightening. The recession in 1957 followed monetary tightening. In ‘60 it followed monetary tightening, and in 1969 it followed fiscal and monetary tightening. Then there was the recession in 1973. It partially followed monetary tightening, but it was mostly about the oil shock. There was a brief recession in 1980 that was really followed by monetary tightening. The one in ‘81 was a mixture of the oil crisis and monetary tightening. 1990, there was an oil shock, we had accumulated a lot of debt, but it also followed monetary tightening.

And then, the more recent ones have been a little bit different. The 2001 recession was the bursting of the dot-com bubble combined with 9/11, and then, obviously, the more recent financial crisis had more to do with the subprime mortgage market, but I think there is enough of a history there that we should be a little concerned about actions of the Fed, and whether Jerome Powell is going to raise interest rates too quickly when the fundamentals of our economy actually aren’t strong enough to support that.

Luigi: But I would like to distinguish between the normal business cycle and real crises. For instance, the one you describe . . . Most of the ones you describe are recessions in the post-World War II period that did not really have the aspect of a major economic and financial crisis. They were just business-cycle fluctuations, which, I agree, most of them were caused by a tightening of the Fed, which was trying to prevent a rise in inflation. But when we look at big crises, the 1929 crisis, the financial crisis in Japan in 1990, and in east Asia in 1997 and ‘98, then we look at the last financial crisis in 2007, 2008, these are kind of different in nature from your normal business-cycle recessions.

Kate: Yeah. I totally agree. I think what I had in mind for this episode is where the next recession is going to come from, not necessarily the next major crisis.

Luigi: I think that it’s more interesting to try to speculate what the major crisis is going to come from, because here, even if we are unable to tell exactly where it’s coming from, I think using some of the insights that Larry Summers gave us, which are very much in line with what Hyman Minsky gave us, we can trace some characteristics that will help us spot the beginning of the next crisis.

Hyman Minsky has this view that everything starts with what’s called displacement. A moment where you create some enormous profit opportunities that change the way people invest normally. That tends to generate a lot of excitement and a lot of lending in that direction. Think about the dot-com bubble, where a lot of people lent for new telecommunications, or the real-estate bubble, where there was a lot of lending related to real estate. This is the moment where you start by lending on fundamentals, as Larry Summers said, and then you start to stop lending just on fundamentals and lend against expectations of future increases in prices.

This is where the Wile E. Coyote moment comes, because you lend against future increases, and as long as those future increases come and everybody expects them, you can keep going. But then, there is the moment in which you start to doubt that they’re going to come, and once you doubt, you don’t want to lend, and that makes those doubts reality.

Kate: So, do you think there’s evidence that we should be worried about this right now?

Luigi: Not necessarily yet, but I think that we need to watch out for this kind of phenomenon. Certainly, there was this phenomenon in the bitcoin market until recently, but I don’t think it’s big enough to create a major crisis.

Kate: I think that this is something we should be worried about right now, particularly in the leveraged loan market. The term leveraged loan, or leveraged lending, refers to loans that are made by banks or groups of financial institutions, to borrowers that have pretty bad credit ratings, particularly below double B. This market has been taking off ever since the financial crisis. According to CVC Credit Partners, it’s doubled since 2011 globally. I think it’s worth over a trillion dollars, and that’s in terms of loans that have been made to already very highly levered, risky borrowers.

I think that part of what’s been driving this is, well, at least in the past couple years, is the Trump tax cut. I think, if anything, that should make us really worried, because what you would expect from the tax cut is sort of the opposite of what happened. Part of the reason that debt is attractive relative to equity is that there’s a tax benefit from it, and so, if the marginal tax rate is really high for corporations, then relative to equity, debt seems pretty attractive.

When Trump cut the marginal tax rate for corporations from 36 percent to 21 percent, it should have made debt relatively less attractive. But what it did was that it infused companies with a ton of cash. Some of that they paid out to investors, so it infused investors with some cash, and some of that they held on for themselves. I don’t think that the investment opportunities were as plentiful as Trump made it sound like they would be.

Instead, all that cash rushed into the buyout market, where companies were trying to acquire one another, or make deals with one another, and they’re just sitting on all this, what they call, dry powder. I think that that has been ramping up deal activity, I think it’s been pushing down yields, I think it’s been leading to an influx of money lent to a pretty dangerous sector, and I think that we should absolutely be worried about this.

Luigi: You’re right, Kate, but the big question in my view is to what extent a crash in the leveraged loan markets becomes a major financial crisis. I think this is the aspect that neither Larry nor Bob analyzed. To be fair, we didn’t ask them to analyze it, but what they didn’t stress are the mechanics through which a relatively small hit becomes a major source of instability. After all, ironically, if you look at the real-estate market, particularly the subprime real-estate market, in 2008, it was a relatively small sector. We’re talking about $1.5 trillion, which, of course, is a lot of money, but even a major loss in that market shouldn’t, in a normal situation, lead to a financial crisis.

After all, when the dot-com bubble exploded, there were a lot of people who lost money, but there wasn’t really a major financial crisis afterward. I think the loss was bigger in terms of magnitude than the loss in the real-estate market in 2008. So, the mechanics that lead from a small loss to a big financial crisis is actually debt, and, in particular, short-term debt. There is a colleague of mine, Doug Diamond, who stated that financial crises are everywhere and always the problem of short-term debt. This, of course, is a bit of playing with a famous sentence by Milton Friedman that said, “Inflation is always and everywhere a monetary phenomenon,” and I think that he’s by and large right. Short-term debt plays a crucial role, because in the moment in which . . . In the Wile E. Coyote moment in which you are panicking, if you are locked in with long-term debt, or with equity, there’s nothing you can do. But if you have the chance of having some short-term debt, what you do is try to get out, to get to the famous door, as fast as possible. That’s where the crisis starts, because everybody tries to get through the door, and not everybody can.

Kate: Yeah, and to reiterate the role of short-term debt in the past crises, the past major crises we’ve seen of this century. During the Great Depression, it was bank deposits. You and me having our money in a bank and being able to pull it out right away. As we discussed on the first episode of this series, the nature of short-term debt for the most recent financial crisis was a little bit different. It was more about banks lending on a short-term basis to one another in what’s called the wholesale funding market, which is a little bit more opaque than a typical bank deposit, but, in a way, it was just as risky and susceptible to runs as the typical deposit was in the 1920s.

Luigi: And, in most international financial crises, actually international creditors, short-term international creditors, try to pull out of the country, and when they all try to pull out of the country at the same time, what you generally have is a major devaluation of the currency and a financial crisis. That’s what Argentina is going through as we speak.

Kate: Yeah, I have to admit in terms of the short-term funding perspective, I don’t think that we have any serious problems. I think that a lot of the issues with wholesale funding that were present in 2006, 2007, have been remedied since the crisis. I think that banks are fundamentally safer. I don’t think that we have a major crisis or depression looming. I do think that there are elements of our economy that could trigger a recession in the next year or two, but I don’t think that it will be anywhere near as bad as the financial crisis.

Luigi: I’m not an expert of China, but as Larry said, I think that the Chinese financial system is a system that is probably likely to experience a major financial crisis in the near future. Part of the reason is because there’s a lot of short-term funding, and the other reason is because there is a huge amount of opacity.

The other aspect of a crisis, the Wile E. Coyote moment, is also when you realize that the system is not as safe, or is not following the rules you expected the system to follow. In the 2008 financial crisis in the United States, I think people realized that, actually, mortgages were not made as they thought they were made, and that led to a panic—what else is there? In Wall Street, there is this famous story of the cockroach theory. For people who live in high-rises in New York, they know when you see a cockroach, there are many more to come. So, when you see something problematic, then you start wondering what is the next shoe to drop.

Kate: What’s tough to predict about China is that the state has its hands in everything in China. They might not exactly know what’s going on in the shadows, but they have the power to step in and bail anyone, or anything, out if they wanted. I don’t think the concern about moral hazard that existed here in the US during the financial crisis is as strong in China, because, by definition, they are supposed to be involved in everything. They’re supposed to own everything. I do think that if there were a short-term funding panic in China, then the government would step in, it would bail out whoever needed bailing out, and then it would probably engage in the slow and lengthy process of trying to reform the system, which I do think that it has been trying to do. They’ve at least been working on reforming the bankruptcy system to get rid of some of the zombie state-owned enterprises that are basically defunct, but are still on banks’ balance sheets. It’s hard to predict how much of a panic could ensue in China, because the government could prevent the panic from happening.

Luigi: You raise an excellent point that I would like to return toward the end of this episode, because I think we need to think about not just where the next crisis is going to come from, but also what can be done to prevent the next crisis to unfold. I think that you suggest that if you have a very capable and very powerful government that intervenes very massively, it might be able to stop a crisis, with some other consequences. I’m not saying that this necessarily is a panacea, but I think it’s—

Kate: I was going to say, Luigi, are you calling for a very capable government to intervene in all financial situations? All distressed situations?

Luigi: Not necessarily, but I think that in the situation of panics, having a government that is capable, and with deep pockets and credibility, I think is a big issue. I speak as an Italian who has a government who is not very powerful from that point of view, because there’s not a deep pocket, it cannot even issue its own currency, because only the European Central Bank can. So, it is potentially subject to a run, in terms of the banking system could be subject to a run. I think that if I have to predict the next financial crisis, I think that the euro system seems like the most likely one, and Italy probably the culprit.

Kate: OK, but going back to the United States, something that has captured a lot of attention in the past few years is that student-loan debt has skyrocketed in the past decade. In particular, since 2004, it’s more than tripled in the US. Do you think that this a potential source of concern?

Luigi: Yes and no. I think that there is indeed an overlending in this direction. I think that, to some extent, an overlending that is very similar to what happened in the real-estate crisis, because at the time you had very aggressive lenders that didn’t particularly care about the ability of the borrower to repay. In a sense, that’s exactly what student debt is about, because the lenders know that the debt cannot be restructured in bankruptcy, so they push this onto the students as much as possible. For many students, the cost really exceeds the benefits they receive, especially in a world that is becoming more and more unequal.

The median student does not get enough from the future income after college to pay for the debt. Is there a possibility of major losses in that market? Absolutely. Whether this will transform itself into a financial crisis, I think that’s less likely to be the case.

Kate: I basically agree with you on this one. I think that student-loan debt is certainly concerning, and I think that it may lead to issues in the future. I don’t think that those issues will necessarily turn into crises, because student loan debt isn’t as systemically risky as, let’s say, subprime mortgage debt. I do think, though, that student loan debt will have adverse consequences on the economy from an aggregate demand perspective. 2004 was really the inflection point when we saw the total amount of student-loan debt really start to balloon. If you think about it, if you were starting college in 2004, you are just turning 32 right around now. Thirty-two is the average age of the first-time homebuyer. I don’t think we’ve really seen the effects of student-loan debt yet, I think that we’re just starting.

Luigi: I think you’re right. I think, in part, we’re already observing this as we speak. People are getting married less, and home ownership is down, and I think that the demand for some durables is down. Some of the effects are already in place today, and, as you said, they might have macroeconomic consequences that slow down growth. Whether this is transforming itself into a major crisis, I don’t see it coming, but it certainly will impact the economy in a negative way for a long time to come.

Can I try something quite different in terms of potential risk?

Kate: Sure.

Luigi: If you wake up in the morning and you realize that a major bank, or a major securities house, etc., has been hacked, and you’re not sure that you can get your money back, I think that everybody will try to reach out to their online account and try to get their money in some safe place. The question is, what is safe at that point? That could be indeed a major financial panic.

Kate: All right. What about the trade war? This has also been discussed widely in the news. Do you think that that’s going to have a significant drain on our economy?

Luigi: I think that it potentially could, if it really is pushed to the limit. I think it has the appearance of being a lot of noise, with very little substance, in the sense that, after denouncing NAFTA as the worst deal on the face of American history, the history of America, President Trump seems to have agreed to the renewal of NAFTA. That, of course, cannot be called a renewal, but is a completely new agreement, that is not that far off, with some marginal improvement, by the way. I think that there were some marginal improvements, but . . . I think he barks more than he bites. That’s my impression. I’m much more concerned about a political deterioration in terms of a military confrontation or a cyberwar than I am about a trade war.

Kate: I agree with you on this one, too. Particularly that Trump’s bark is worse than his bite, but I also think that trade between the US and China is not as big as people make it out to be. It’s only 3.2 percent of world exports. Yeah, the trade war will lead to slight increases in prices for the US consumer. I don’t think it’s necessarily going to trigger a recession.

Luigi: So, Kate, I think that everybody says that a financial crisis is hard to spot in advance. So, what can be done at a government level, or even at the individual level, or the corporate level, to prepare, to make sure that the next shock that inevitably will come, will not transform itself into a major financial crisis like the one we experienced 10 years ago?

Kate: I think in terms of preventing a financial crisis, it’s incumbent on the government to make sure that it knows what’s going on, and that deposits or short-term funding are relatively stable. In that regard, I think that we’ve made improvements since the financial crisis. We’ve got the Financial Stability Oversight Council, and a lot of the provisions of Basel III, which are new provisions that regulate banks and investment banks, have made the funding and liquidity of investment banks more stable.

Having said that, I think another thing we should have learned from the financial crisis is that new types of engineering, or new types of financial securities, that we didn’t even know existed maybe five, 10 years ago, are something that the government should be worried about. I think there is some of this going on in the corporate loan market. I think that we should be careful to make sure that the financial sector can’t just dodge the regulations we have in place by coming up with new types of vehicles that exist in the shadows.

What about you?

Luigi: I think that central bankers have been trying to develop tools to face new crises that go under the name of macroprudential regulation. The idea is all these major crises started with an explosion of debt, so if we monitor what leads to this explosion of debt, and we have instruments to prevent that explosion, or moderate that explosion, then we can prevent or deal with the new financial crisis.

I think there is some element of truth in that. However, as we discussed in a previous episode with Paul Tucker, there are also some dangers, because if the macroprudential regulation leads to determine who can borrow and who cannot, it becomes, really, a centrally planned economy. So, to what extent can you change the requirement for lending against . . . For a house, for example, and can you change the down payment based on the cycle and based on the location? So, if I say that in your neighborhood of Washington, all houses should be purchased with a 60 percent down payment, that’s quite intrusive. This is what, actually, has been going on in New Zealand, they’ve started to put some requirements first on the country overall, then on just the capital, Auckland. They didn’t go down to the quarter level, but you can imagine they might. I think that that’s a serious concern.

Kate: So, just out of curiosity, have you changed the composition of your wealth, or your investments, in any way to reflect your views on whether there will be a crisis or a recession coming in the next couple years?

Luigi: No. I have not, but I don’t want to give advice. I am a terrible investor and I don’t think people should learn from it. You know the expression that the children of cobblers don’t have shoes, that’s exactly my model of investing, so I don’t think that I want to give listeners any investment advice.

The second in a 3-part series on the 2008 financial crisis. In the weeks after the crash Luigi remembers petitioning the government for a better bank bailout. Looking back, he and Kate review everything from TARP to Dodd-Frank to see how we averted a worse recession. But did some CEOs get away with fraud?

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, the podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On the last episode, we discussed the lead-up to the financial crisis, and I shared some of my maybe sort of embarrassing stories about how I worked for Lehman, lost all my summer internship money, and then ended up dropping out of school and hitchhiking around. Luigi, I’m assuming that you were making a more productive use of time around the end of 2008.

Luigi: I’m not so sure that it was more productive, but I do remember I was in my office looking at the news. I was outraged when I heard that the secretary of the treasury, Hank Paulson, wanted to ask Congress for $700 billion to be used to buy assets from the failing banks. I remember that I was sitting in my office. I said, “That can’t be. That is really the end of capitalism as I know it, because this is the fact that when a business fails, it fails. When small banks fail, they fail. But when big banks fail, or are about to fail, the government comes in and socializes the losses.”

A system where you prioritize profits and socialize losses is the worst possible system on Earth. Actually, I remember at the time, and I already mentioned in the last episode about Allan Meltzer, Allan Meltzer was saying that capitalism without bankruptcy is like religion without sin, it doesn’t work.

I didn’t know about that sentence at the time, but I wrote a little piece with the very subtle title of “Why Paulson is Wrong,” and I started circulating it, and I got a lot of attention on that. Then, the next week, early in the week, I was so outraged that I started … At the time, Paola Sapienza was visiting Chicago. I was discussing with her, “We need to do something.” So, with her and then John Cochrane, who was my colleague at the time, we started a collection of signatures of economists against that version of TARP.

We quickly reached 300 signatures of major economists, including a few Nobel Prize winners, and I remember that during the debate Senator Shelby actually showed on camera the list of economists against TARP.

Kate: Is this something you frequently refer to as a mechanism to combat the government, is that you start petitions?

Luigi: Maybe this is my Italian background. In Italy, you petition all the time. I don’t believe in abusing those, but I thought that, in that particular case, that was important, because this was a topic that was pretty obscure to most people. I think that this reverse socialism where you socialize the losses is the worst kind of socialism.

Kate: So, did it work at all? Did your petition actually have any influence on what the government did?

Luigi: Actually, I think I would be a bit too full of myself saying that that was the fact, that made things change. But I have to say that there was enough opposition that, number one, the version of TARP that later was approved by Congress was modified. Now, it was still a bit of a gift to the major banks, in particular Citigroup. But the investment by the government came with a restriction, a restriction on executive pay. Surprise, surprise, when you restrict the executive pay, the executives really wanted to buy back those stocks as fast as possible. They did in June of 2009. So, I think in that sense, it was very successful.

Kate: TARP wasn’t just for the banks, though. TARP also involved the big automakers, and it also had a component to help support homeowners who may have gone through foreclosure. To put some numbers on the magnitude of the crisis that unfolded, the GDP shortfall ... So, in terms of the path that US GDP was on prior to the financial crisis and the amount that we lost by not staying on that path, is estimated to be about five or six trillion dollars. That’s relative to the roughly one trillion that was spent in stimulus. The unemployment rate went up to 10 percent in 2009. Then, finally, the median family experienced a household drop in income of about 8 percent. That’s on real terms, so in terms of how much they could buy.

Luigi: One of the things that was particularly scary at that time is the speed at which companies fired workers. It’s normal in a recession to have a reduction in employment. But the reduction in employment that came at the time of the Great Recession was abnormal by any standard, even by the standard of the large drop in GDP.

Economists are still wondering why that was the case. But the results were pretty dramatic, because unemployment, as you said, Kate, reached 10 percent. The possibility of finding a job for many people became a distant prospect. That was pretty devastating in a large part of the country.

The other thing that was very devastating is it took a long time for this unemployment to be reabsorbed. In a typical recession, you have that the sharpest is the downturn, the fastest is the recovery. However, when there is a recession due to a financial crisis, the recovery is actually quite slow.

What was very painful for the US economy overall is that the recovery, in spite of TARP, in spite of the stimulus package, in spite of the other monetary interventions we’re going to discuss in a second, was much slower than we’ve seen historically. So, a lot of people remained unemployed for a long period of time.

One thing that we know as economists is that long terms of unemployment tend to have permanent effects. People lose their skills, lose their willingness to go and look for a job, lose even their ability to work on a regular job at a regular time. So, it’s not that easy to reabsorb those people in the labor force after them being unemployed for six, nine months, or even a year.

Kate: Unemployment benefits and their extension were a component of the stimulus act, but it was a relatively small fraction of the funds dedicated. It was much smaller than the outright tax assistance. I think that there should have been, given the fact that unemployment rose to 10 percent, I think that some of that tax assistance should have been shifted over to the increase in unemployment benefits.

Luigi: But, to be fair, if you compare the United States to the euro area, they both were hit by a crisis in 2008. The United States recovered faster than the European Union. So, the other factor, and I think this is the right time to bring it into the picture, the other factor that delayed the recovery in Europe is the European Central Bank was slower in doing any form of quantitative easing. Kate, can you explain to our listeners what quantitative easing is, because everybody talks about it, but what actually is it?

Kate: Sure, so I think before we explain quantitative easing, we have to explain that the Fed cut interest rates to virtually zero, shortly after the panic ensued of the financial crisis. Cutting interest rates to zero is the Fed’s main lever of monetary policy. Those interest rates that I’m referring to, by the way, are pretty short-term interest rates.

Now, how much can the Fed actually do to help stimulate the economy once interest rates are already zero? In the traditional sense, the answer is not that much. So, this is where quantitative easing comes in. It’s sort of a form of the Fed also trying to push down interest rates. But not just in short-term securities, but in long-term securities. So, they purchase assets, typically longer-term government bonds. This purchasing is being done by the government. When there’s more demand for long-term bonds, the yields on those bonds go down, and that typically boosts the stock market. So, it’s another way of central banks trying to keep down yields and bonds.

Another thing that it does is that it helps prevent deflation. Deflation is really dangerous, potentially, because if prices are going down, and if interest rates are already zero, then people are incentivized to just hoard cash, right, because they’re not going to put it in the bank, because they’re not going to earn any interest on it. They’re also not going to spend it, because prices are going to keep going down.

Even though we haven’t actually experienced much of this sort of deflationary trap in the United States, there was a concern that it might happen shortly after the financial crisis. So, by buying longer-term bonds, the government through quantitative easing was trying to boost asset prices and prevent us from entering into this deflationary trap.

Luigi: Now, many people thought that quantitative easing was an extraordinary measure of monetary policy that was unprecedented, and even some people attacked the Fed as being kind of revolutionary and unjustified. In reality, as Kate said, this is just a continuation of ordinary monetary policy in a different way.

When you choose to keep inflation only at 2 percent, you find it hard to bring the level of real interest rates negative, because basically what happens is there is a demand and a supply of savings. The demand and supply of savings should lead to an equilibrium price of interest rates. However, if the demand of savings, i.e., the investments, are very low, it might be that the clearing price for this market is a negative real interest rate. How do you get negative real interest rates when you have low inflation? You have to have negative nominal interest rates.

The negative nominal interest rate is difficult to administer, because, as Kate said, people have an easy arbitrage. They can hold onto the cash and get the benefit of that.

Kate: Then, finally, we come to Dodd-Frank, which was the legislative branch’s approach to changing regulation after the financial crisis, and preventing a similar crisis from taking place in the future. The component of Dodd-Frank that people are most familiar with is the Volcker Rule, which prohibited investment banks from proprietary trading, or trying to make money on their own behalf, rather than on behalf of their clients.

The Volcker Rule effectively made most investment banks have to spin off or eliminate the proprietary trading components of their operations. There was also an entirely new government agency created, the Financial Stability Oversight Council, with a research arm that was part of it, which is dedicated to just making sure that huge crises, whether in the form of subprime mortgages or anything else, financially engineered products, didn’t happen again. It’s like a group of people who are just keeping their finger on the pulse of the economy, making sure there aren’t big systemic risks building up in ways that regulators don’t see.

Luigi: Two things. First of all, the Dodd-Frank Act is extremely large and has so many provisions that we can’t possibly do justice to them all. There are some that are definitely very beneficial, like, for example, the movement of most derivatives onto organized exchanges to make the system more stable. There are others that are more controversial. In particular, what I find very controversial is the Volcker Rule. The Volcker Rule is an attempt of the Obama administration to please the popular demand for the separation between investment banking and commercial banking. What goes under the name of an old law passed during the Great Depression, the Glass-Steagall Act, and the demand of banks to keep doing the same.

My interpretation of it, and you might disagree, Kate, but my interpretation is Geithner was very clever, trying to have the cake and eat it, too. He had a rule that was named after an impeccable person like Volcker, that in some sense gives the impression of catering to the people who want the separation between the two, but de facto does not do much, because it’s very hard to implement, because you’re right in saying that the Volcker Rule prohibits proprietary trading. The question is, what is proprietary trading? If I trade with my clients in mind, even if my clients did not give me an order, is that proprietary trading? The Volcker Rule will say no. So, in order to implement the rule, we really need to look at the intent of the trader, something very hard to do.

Kate: I think there’s two points to discuss about the Volcker Rule. One, whether it was actually effective. Two, whether it had anything to do with the financial crisis. In terms of effectiveness, I do think that the outright prop desks, the outright groups within investment banks whose sole purpose was to just make money for the investment banks, for the most part those disappeared, or they were no longer part of the investment bank. To your point about whether an individual trader can actually make any money for his or her own desk, even if trading on behalf of a client, yeah, sure. I do think that there are ways for them to make money. But I still think that compliance departments within investment banks were pretty careful to make sure that they weren’t at least explicitly violating the Volcker Rule.

I do think that the Volcker Rule was pretty effective in mitigating how much banks were trading on their own behalf, even if not completely effective. But I think the bigger question is, did it have anything to do with the financial crisis? The parts within investment banks that were responsible for financial engineering and subprime securitization weren’t really the proprietary desks of these banks. They were the desks that were devoted to purchasing these bad mortgages, bundling them together, and then selling them off to investors. Those weren’t necessarily those groups that were later eliminated. So, I don’t think that the design of the Volcker Rule necessarily had that much to do with preventing future similar crises.

Luigi: One of the causes of the crisis, according to many economists, was lack of regulation, or at least lax regulation, and regulation that was not apt to stand up with a change in the economy. However, the Financial Crisis Inquiry Commission came up with seven names of people that, in their view, had committed fraud. Two of these people were indicted, or potentially indictable, on two grounds. Those two people are Robert Rubin and Chuck Prince, both from Citigroup. The attorney general under Obama, Eric Holder, did not proceed against any of them, but in particular did not proceed against any of these two.

Kate: I think the question of whether fraud occurred at the level of the mortgage originators is much easier to handle. It’s sort of like with a drug ring. The guys on the ground who are selling the illicit drugs, it’s easier to prove that they are directly doing something wrong. In the case of the mortgage originators, I think that the fraud is easier to prove. There are some people involved in the process who absolutely should have been convicted and put in jail. At the higher level, at the financial institutions, it’s … in some sense they bore a bigger burden.

But it’s also harder to prove that they necessarily violated any particular law, because I think that their actions that were detrimental to the entire system were, in some sense, not explicitly illegal. They were creating these financially engineered securities that were dangerous and amplified risks. But everyone was doing it, and there was no ... I think there was also large fault on the part of the regulators who allowed this to happen. So, how can we really say, “Oh, it’s really their fault”?

Now, in the case of a couple people, Rubin and Prince, I’m not sure exactly what the Financial Crisis Inquiry Commission pinpointed as their exact fault. I mean, I get the sense that it was that they had a feeling that the market was about to turn. They still continued in their financially engineered securitization process. In some cases, they even took positions betting against what they were creating. That is immoral. But how can we necessarily throw someone in jail for doing something immoral that’s still legal?

Luigi: I think you’re too generous. I think that what the Financial Crisis Inquiry Commission found were violations of the law. If you refer somebody to a prosecutor for indictment, it means that you have a strong suspicion that there is ground for indictment. The fact the attorney general dropped the case without even trying, I think is worrisome. Just to make sure that we’re not picking only on those, there are a lot of other cases. For example, a whistleblower came out saying that Jamie Dimon, at the time and even today CEO of JP Morgan, knew perfectly well that some of the packages of securities that were done contained a lot of fraudulent mortgages. This was settled with a large fine to JP Morgan, but no particular indictment against Jamie Dimon.

I think there was a concerted effort of letting these things go. At the beginning, you can even understand that, because you are afraid that this might create more panic. But the fact that this was done even later I think was a disaster. I think that there is a big difference between the way Roosevelt dealt with the problem led by the financial crisis in 1929, and the way Obama dealt with the leftovers of the financial crisis 10 years ago. I think that the backlash that we have observed, the lack of trust in institutions, the lack of trust that justice applies equally to everybody, is a consequence, a direct consequence, of the fact that homeowners were forced out of their houses. Some of them even paid for the fraud they did when they had the application for their mortgage. Nobody else did.

By the way, I remember that in the fall of 2008, the beginning of 2009, I wrote an explicit piece to Geithner saying, “Look, we have saved the banks. Why don’t we try to do the same thing with homeowners?” After all, if I am a guy in Las Vegas who bought a house, and because I’m getting married, and because I have a new kid, because of whatever, and all of a sudden prices drop 50 or 60 percent, am I really a bad guy because I don’t pay the mortgage anymore? Or is it that I got hit by a tsunami, and honestly, I am not responsible for that tsunami? I should be helped in the same way, or even more, than the banks were helped.

The asymmetry that you help the banks but you don’t help people who generally ... not speculators who are buying five houses, but ordinary Americans who are buying the place where they’re living, and found themselves hit by a tsunami, the lack of support for them is what, in my view, created all this resentment.

Kate: I think that there should have been, and this is maybe an unpopular opinion, but I think that there should have been some foreclosures, to the extent that there was overheating in the housing market. There was too much subprime lending. People who bought McMansions with no jobs, no income and no family, for that matter, I mean, I think that there is some natural adjustment that should have taken place.

Now, for people who really needed homes, for people who were using those subprime mortgages to buy a primary residence, and for people who had jobs and a family, I think that there should have been assistance that went directly to them, and there was. I mean, there were programs that were designed for that. I just don’t think that they were designed well enough. I don’t think that there was enough funding set aside for them. But I do think that there was some political will for it.

Luigi: Yeah, at the end there was a little bit of help. It was, as you said, little, designed in a way not to make it easy, and did not work very well. I am the first one to say you need bankruptcy. You need bankruptcy for big banks. You need bankruptcy for individuals when they make a mistake. However, I don’t understand why, when it comes to banks, you say, “Oh, it’s better to intervene when there is a big crisis, because bankruptcy is so inefficient than we can benefit by fixing it.” The same is true for individuals. Bankruptcy isn’t efficient. When you foreclose on a house, you lose a lot of value in the process. When the fault, if you want, I know I use a moral term, but when the fault is not of the individual, when the individual has bought a house in Las Vegas and that house now is worth half what was owned before, and he has a mortgage that will basically waste his money for the rest of his life, why don’t you want to help getting this person out of it in a decent way?

Kate: I think we agree that they should have, and the government should have. I mean, I think we’re on the same page here. But I want to go back to an earlier point that you made about the Financial Crisis Inquiry Commission actually finding that people like Rubin and Prince had violated laws. What were the laws that they violated? What law says that Jamie Dimon is committing a crime if he knew that some of the loans that were going into the securitized products that he was issuing to investors, some of those loans had faulty documentation?

Luigi: That’s called fraud. If you know that you’re selling something that is sort of defective, and you don’t tell people, that’s called fraud.

Kate: But the people who were committing the fraud were the ones that were writing the faulty documentation. Right? They were committing fraud. Then, they were selling bad products to the investment banks. The investment banks were just the intermediaries who sold those bad products onto other people. So, if the investment banks had a vague notion that there was some fraud going on at a lower level of the chain, is that also fraud? I mean, I’m sort of playing the devil’s advocate here, but I think it’s a hard question. I think that we can’t just throw people in jail based on vague definitions of the law.

Luigi: If you know that you’re selling crap, even if you’re not the one producing it, but if you are repackaging fraudulent mortgages and you don’t tell people that these are fraudulent mortgages, you are committing fraud. Whether you are an intermediary, you are still an intermediary of fraud. Or when you mislead investors, you don’t reveal stuff to investors, that’s a fraud. I think that there are laws against that.

I’m not a lawyer. I did not do the investigation. But what I read is that there was enough evidence that in normal cases, you would have proceeded. But they did not want to proceed, in order to protect the stability of the financial system.

Kate: My position is that we should amend the laws to make them stricter.

Luigi: Yeah, but that’s a different question, because if you change the law, you cannot prosecute people after you changed the law, because you cannot prosecute for a law that was not in place at the time.

Kate: Exactly. I think that it was primarily the fault of our regulators and the legal system that existed earlier. I don’t think that we can look back on that and be like, “Oh, well, shoot, we should have had those laws in place that would have protected investors, and protected consumers, and we didn’t. So now, let’s just throw people in jail, even though it was really our fault for not putting those investor protections in place.” But there’s the deeper question of whether Dodd-Frank was effective in preventing another crisis.

Luigi: Yeah, I think that this is indeed the bigger question. Even more importantly, do we fear another financial crisis? Is any bubble leading to a financial crisis of the type we experienced 10 years ago? Or do we have a more resilient financial system that can withstand some shocks? Because the only thing that we can be sure of is there will be other shocks. As we said in the first episode, at the end of the day, these shocks were not that big to begin with. But they were amplified by a number of factors. So, the question is whether these factors are still in place, and whether there is a risk that a relatively small shock might lead to a big crisis like the one we experienced 10 years ago.

Kate: I think we haven’t yet talked about what’s potentially the biggest result of the crisis, or the biggest response to the crisis, which is that despite lack of regulation in this area, a lot of the products that led to the crisis completely ceased to exist. In terms of subprime mortgage origination, for example, I mean, it still exists, because some borrowers who have low FICO scores still should be able to get houses if they have an income. But the market fell from about $600 billion in 2005, to around $60 billion now.

I think that the order of magnitude shrinkage in the subprime mortgage origination market is something that I’m comfortable with. Maybe more importantly, the types of mortgage-backed securities that were being created by non-GSE, or non-Fannie-Freddie institutions, fell from over a trillion dollars to only $14 billion now. That market completely disappeared. So did these financially engineered products like the crap CDO-Squared and synthetic products that we talked about in the first episode. For the most part, they’ll all gone.

Those were not due to government intervention, but they were just because investors realized that those products were not fundamentally sound, and so the demand for them disappeared. But I don’t think that we’ve put in place sufficient regulation to prevent banks from engaging in similar, even though not identical, types of financial engineering in the future.

Luigi: I agree, and that’s the reason why, in the next episode, we’re going to try to explore where the next crisis is going to come from.

The first in a 3-part series on the 2008 financial crisis. Kate tells Luigi about being an intern at Lehman Brothers when it collapsed and then we debate the causes including subprime mortgages, investor fraud and an ill-advised speech from former President George W. Bush.

Speaker 1: Mark your calendars, because this is the 10-year anniversary of Lehman Brothers’ collapse.

Kate: Hi. I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Speaking about what isn’t working in capitalism, today is the 10th anniversary of the last day in which Lehman was trading as an independent company.

Kate: It’s a death day.

Luigi: Yeah, it is a death day. And where were you, Kate, at the time?

Kate: I think that I was in my dorm room. I was back from my junior internship, which was at Lehman, that summer, the summer of 2008. By September, I was out of my internship for two weeks, back at school, watching the stock price fall.

Luigi: Now I understand why you have so much interest in bankruptcy, because you started experiencing bankruptcy from day one.

Kate: Yeah, it’s weird. When I started my PhD, I was like, I’m interested in shadow banking and bankruptcy, but I don’t know why.

Luigi: So, Kate, you had unique insight. You were in Lehman just before the collapse. How was life on the verge of death?

Kate: I guess I have to say that I don’t have a tremendous amount of insight into what was frantically going on in the background, because I was just an intern. I was only there at the very end. But I will say that I was on the fixed-income trading floor, and they had ... at the top of the floor, the center of the room, Lehman’s stock price with the LEH sticker in front of it. It had been blinking green for the most part for the past 10 years, and that summer it was just blinking red, every day. I mean, that weighed pretty heavily on people’s moods.

Even though my desk was reasonably secure—I was on the government bonds desk, so everyone always needs that sort of trading desk in an investment bank—moods were high, tensions were high. I think the managing director threw the phone against the wall once.

Luigi: And did you lose any money?

Kate: OK. I don’t know if this qualifies as insider trading. I don’t think it does, because I didn’t have any special information, but everyone on my desk was convinced that Lehman would be OK. They were convinced that either they would survive through the weekend, or they would be purchased, like acquired by another bank for a reasonable amount, and that their jobs would remain.

Just based on that vague information alone, based on everyone’s optimism, the weekend before Lehman failed, I used all my summer internship money to buy Lehman’s stock. And then on Monday morning—

Luigi: Wow. That was a good trade.

Kate: Yeah, it was a great trade. On Monday morning, I woke up right after my summer internship and had no money left.

Luigi: So that’s the reason why you became a professor.

Kate: Exactly. Extremely risk averse now.

Luigi: Let’s now try to go back to what led to the Lehman weekend and to that disaster. I think that your position is interesting, because a lot of people back then, and a lot of people even today, are wondering, should Lehman have failed? But, before entering this discussion, let’s give our listeners a short recap of how we arrived at that dramatic weekend of 10 years ago.

Kate: In celebration of the 10-year death day of Lehman, we’re going to be doing a three-part series. This first episode we’re going to talk mostly about the causes of the financial crisis. On the next episode, we’re going to talk about the aftermath, and then, on our last episode, we’re going to talk about whether there’s a crisis brewing in the future.

Luigi: Yes, but let’s start with history, which is easier, and let’s go to ... In your view, what caused the crisis? How did it start?

Kate: All right. So, we’re standing in 2007. There had been a real-estate bubble in the United States. So, to give you some sense of that, house prices had risen 91 percent between 1995 and 2003. And then, between 2004 and mid-2006, they rose another 36 percent.

Luigi: But not just in the United States, they went up everywhere. They went up in the UK, went up in Spain, went up in Australia. In all these places, by a bigger factor than in the United States. So, yes, there was a dramatic rise in real estate, but it’s not like there was a gigantic real-estate bubble. I think that the problem was that a lot of people bought in very highly levered positions, and the second is there was a lot, in my view, a lot of fraud, but this is something that we can discuss later.

Kate: Yeah, absolutely. So, to your point about household debt, between 2001 and 2007, US mortgage debt basically doubled, and so households had a lot more debt than they did in the beginning of the century.

Luigi: Yes, but this can explain why, in 2008 and 2009, we see families cutting down consumption because of the high leverage. However, what generated, really, the financial crisis was not so much the leverage of their households, it is the fact that many households started to default, and many financial institutions were heavily exposed to the risk of this default.

Kate: Right, so when you talk about risk, a lot of that was coming about through this popular word, “subprime,” that entered everyone’s vernacular around 2007. Subprime mortgage origination had always been about 10 percent of all mortgage origination in the late ‘90s, and by 2006 it was almost a quarter of all mortgage originations. The types of housing loans that were being made had gotten a lot worse in quality throughout the early 2000s, and that was a big part of why, at least in the United States, the bubble started to deflate around 2006.

Luigi: Yes, because traditionally mortgages were issued by banks and then were sold by two government-sponsored entities, Fannie and Freddie, that were repackaging these mortgages into what are called mortgage-backed securities, and selling them to the financial markets. So, historically, these repackaged mortgages were relatively safe because they were issued under strict guidelines, but in the early 2000s, the playbook was thrown out, and many mortgages were issued without strict guidelines and with the understanding that the market will take the risk.

Not only were there so many of these mortgages being sold, but these mortgages were further repackaged and sliced in different tranches, giving different degrees of priority to investors. The frenziedness was such that this operation took place many, many times and, in fact, some investment banks started to bet on those mortgages even if those mortgages were not issued—what is called, in jargon, synthetic mortgages.

Kate: Yeah, so around mid-2007, people started to get really worried about this. In particular, in between April and June, Bear Stearns had a bunch of hedge funds that it sponsored. One, in particular, had been doing gangbusters. In 2004, it earned 17 percent for investors, in 2005, it earned 10 percent, and so they started another, similar fund, both of these heavily exposed to these risky mortgages, and there was $18 billion of capital invested in these hedge funds by 2006. And yet, by June of 2007, these hedge funds failed and Bear Stearns had to bail them out.

After this, it set off a bit of a panic in financial markets. People typically say that the financial crisis started around August or late summer of 2007, when financial markets really started to react to the fact that these two large mortgage-exposed hedge funds had failed.

Luigi: However, to be fair, the stock market peaked in the fall of 2007, so, in spite of the early warnings in 2007, the market as a whole was going up, and the first really big wakeup call was in March 2008, when Bear Stearns, which was an investment bank, basically was rescued at the last minute in an operation joined by the Fed and JPMorgan.

Kate: So, why did they need rescuing? This has to do with the fragile nature of the way that investment banks are set up. If you’re an investment bank, you probably have a portfolio of securities called a security inventory, and, oddly enough, these securities are financed on a very short-term basis. If Bear Stearns held, for example, a bunch of mortgage-backed securities in its inventory, it was financing those mortgage-backed securities not by owning them outright, but by borrowing money to buy them and then having to reborrow that money every single day.

It was essentially borrowing on a very short-term basis where each loan was due the next day, and it was just expecting these loans to be rolled over every single day. In March of 2008, that stopped. It couldn’t borrow anymore against these securities that it held in its inventory, and so that’s why it needed a bailout.

Luigi: What is interesting is that, number one, in a matter of a week they lost tens of billions of dollars of liquidity. So, at the beginning of the week, they still had plenty of liquidity in their portfolio, and by the end of the week, actually by Thursday, they had to get special loans from the Fed in order to be able to operate on Friday. And then they were rescued during the weekend. One thing that surprised the market is that not only did they find it difficult to borrow against these mortgage-backed securities, they found it difficult to borrow even against Treasurys.

This is the stuff that surprised everybody, because Treasurys are super safe, and you expect that everybody is willing to lend you money against Treasurys as collateral. However, when people perceive you might not be around tomorrow, they don’t want to take the risk, even to have the inconvenience to be stuck with some Treasurys or some securities they don’t want to hold.

Kate: To highlight how exposed Bear Stearns was to this really short-term repo financing, I like an example that was provided by the Financial Crisis Inquiry Commission in a special report that they did, which is to say that Bear Stearns’ leverage and their exposure to short-term financing was about the equivalent of a small business with $50,000 in equity borrowing $1.6 million overall and having about $300,000 of that due every single day. So, having to rely on refinancing your loan, your $300,000 loan, every single day, even if you only have $50,000 in equity. That’s how much Bear Stearns was exposed, and one day that liquidity just dried up and they had to be bailed out.

Luigi: Let’s actually discuss for a second how it was bailed out, because it’s interesting. So, normally, in normal times, the Federal Reserve makes loans only to depository institutions, normal commercial banks. However, in the Fed statute, there was an article that has been modified slightly in 2010, but there was an article called 13(3) that says that under unusual and exigent circumstances, then the Fed can lend to other institutions that are not depository institutions. What is interesting is Bear Stearns asked for this possibility and this possibility was denied, but then, immediately after the failure, or the quasi-failure, of Bear Stearns, the Federal Reserve opened a particular kind of facility called the primary dealer facility that extended the access to loans to primary dealers including Bear Stearns and Lehman.

Kate: But it was kind of too little, too late, because I think it was either on the same day that the Fed announced this, or the next day, Bear Stearns was downgraded way below junk status by Moody’s. That was enough to scare the market, so even though Bear Stearns had access to this financing, its liquidity dried up anyway, because its credit rating was downgraded.

Luigi: And the result for Bear Stearns was that the Fed made a loan to JPMorgan, and JPMorgan bought out Bear Stearns at a very low price and, by doing so, also guaranteed the liabilities of Bear Stearns. Nobody lost money except the shareholders of Bear Stearns, so the market got spooked a bit afterward, and people started to worry about who was going to be next after Bear Stearns, but the market continued operating rather normally until, basically, the summer.

Kate: Yeah, so then, six months later, a similar type of panic happens for Lehman Brothers. Lehman was highly exposed to real estate. At that point, it was clear that the US was experiencing a full-fledged mortgage-backed-security, subprime-mortgage-backed-security crisis. Because of Lehman’s exposure to these types of securities, there was a similar liquidity run on Lehman. They also used a lot of short-term financing that was really susceptible to drying up overnight.

Luigi: Now, what is interesting is that Lehman, at the beginning of the week that ends with September 13, they had $41 billion in liquidity. By the end of the week they had $1.4 billion. This is literally a bank run of the type that we have seen in movies like “It’s a Wonderful Life,” but a bank run where the runners are not the depositors, but are the institutions that lend to Lehman in this repo transaction.

Kate: So, this time, Lehman was not bailed out, and some people argue that this is part of why the financial crisis was so bad, because there was a little bit of inconsistency in terms of what the government was doing. It brokered a deal so that Bear Stearns could be acquired by JPMorgan, it brokered a deal so that Merrill Lynch could be acquired by Bank of America, but it didn’t really facilitate a deal for Lehman to be acquired by another bank. Even though there—

Luigi: A little bit of inconsistency? I think you might be … There was a gigantic inconsistency.

Kate: OK, I don’t want to be too harsh on Geithner or Bernanke—

Luigi: Let me quote David Swensen, a legendary investor who runs the portfolio of the Yale endowment. He said that you have to try hard to have the kind of inconsistency that was shown in the 2008 approach to the problem. Every time there was a new approach that was designed ex novoand then caught the investors by surprise.

Kate: To be fair, though, I think the reasoning on the part of the federal government was that they didn’t want to just bail out every single bank, because that would send a message to markets that banks could take a lot of risk and then be reasonably assured that they would be bailed out later on, so that would create a moral hazard problem.

Luigi: It’s true, but remember, the reason why the Federal Reserve was created was to intervene in situations of panics. The Fed was created in 1913 in response to the 1907 panic, where the financial markets were cornered by the only provider of liquidity at the time, that was JP Morgan. Not just the bank, but the person.

Kate: The individual.

Luigi: And so, what is a bit strange is, over the years, this notion of the Fed has kind of gone by the wayside. If you look in macroeconomic textbooks, between the late ‘80s and the financial crisis, they only talk about inflation as the main job of the Fed. The Fed was not created to control inflation, the Fed was created to control panics in financial crises. The article I mentioned, the 13(3), of unusual and exigent circumstances, is precisely the article that says, in those situations, the Fed should intervene by lending, against good collateral but lending freely against, or generously against, good collateral. That’s the part that, in my view, but we can come back later, the Fed did not do.

Kate: Look, I’m not trying to say that I’m defending Tim Geithner, I’m defending Ben Bernanke, but part of the reason why they didn’t necessarily want to bail out all the banks was because of this moral hazard issue.

Luigi: I, at the time, was against a bailout, too. But part of the problem, in my view, is part of the way economics thinks about this issue. To what extent you have panics, to what extent you have a liquidity crisis, to what extend you have a solvency crisis. One of the big issues, and we’re going to return to that, but one of the big issues is, was Lehman insolvent at the time, and could the Fed have lent to Lehman or not? Ben Bernanke came out saying that he could not have lent to Lehman, because it was too risky. A macroeconomist, Larry Ball, came out with a book recently showing, in excruciating detail, that is actually false. That the Fed could, and, in his view, should have lent to Lehman.

Kate: Well, I think another part of why the Fed was reluctant was because they simply didn’t know how exposed Lehman was to the global markets. The way that banks were structured then, and still are now, except there’s more transparency now, is that they finance a lot of their inventory on a very short-term basis, and it’s not just like a mortgage-backed security is being financed overnight by one company. It’s that that company that provides the overnight financing then also gets a loan to be able to do that, and whoever they got the loan from is also getting a loan to be able to provide the loan provider with the financing.

So, there were these long chains of interconnectedness, some of which had to do with derivative exposure that was all very opaque. It was not all reported to the government, and so, it was hard for the government to know exactly how systemically risky Lehman Brothers was.

Luigi: To be fair, until March 2008, the Fed was not supervising Lehman at all, because Lehman was an investment bank, like Bear Stearns, and they should have been supervised. They were supervised by the Securities and Exchange Commission, who wasn’t particularly aggressive in doing so. However, when they opened the primary dealer facility, the Fed started to have some people at Lehman overseeing what Lehman was doing. So, there was a team from the New York Fed inside Lehman during the summer you were working there and at the time Lehman fell.

Kate: I didn’t see them. Yeah, but again, it was sort of too little, too late. In Lehman’s bankruptcy, it took years to unravel and at least figure out who owed who what. Having six months over the summer in the middle of a panic just wasn’t enough time for the government to really get up to speed on what was going on within Lehman.

Luigi: OK, but the day after Lehman fell, the Fed got another phone call saying that AIG was in trouble. Now, full disclosure, I testified on behalf of AIG in a case that involved an AIG owner against the US government, but the only thing I testified was that there was a taking by the US government, which was proven in court.

Kate: And, full disclosure, I did some research on the other side, on the side of the US government arguing against Luigi’s position.

Luigi: Good. So, I think that overall, we are not biased.

Kate: We’re balanced.

Luigi: AIG found itself in a major liquidity crisis due to the fact that it was insuring a lot of those mortgage-backed securities that were failing. It was insuring them not in a traditional insurance form, but through this instrument that goes under the name of credit default swap, which is the factor in insurance that repays you in full in case a bond defaults.

Kate: So, credit default swaps written by AIG, I think, covered over $440 billion in bonds that day that it needed to be bailed out. The government decided in the case of AIG, it was too risky to just let it collapse, because all this insurance that it had provided to other financial institutions, it would have disappeared. And then, those bonds failing would have meant that those financial institutions would have then collapsed, and so, it would have been a huge house of cards. The government decided to rescue AIG by essentially purchasing it outright.

Luigi: They were in the process of dropping in value. The cash needs of AIG were not to pay for defaulted bonds but were as collateral, because they were providing this insurance as collateral for people that were insured with AIG that, in case things went badly, they would be able to pay. Interestingly, among the institutions that were asking very aggressively for more and more collateral was, on the other side, Goldman Sachs. Goldman Sachs was valuing the insurance that was provided by AIG at a very low price and was demanding from AIG a lot of collateral, and, as a result, AIG needed some liquidity. It went to the Fed and asked to be accepted in the primary dealer facility or some form of facility like that facility.

The Fed denied that but made a very special loan at a very high rate with also some warrant that would allow the Fed, basically, to control AIG. In fact, the CEO of AIG resigned, and who did they put as CEO of AIG? They put a board member of Goldman Sachs, who was actually on the risk committee of Goldman Sachs. The weekend of the 19th and 20th of September, he was both participating in the meetings of the risk committee of Goldman Sachs and deciding what to do for AIG, which was a counterparty to Goldman Sachs.

Kate: That’s a little bit shady. I didn’t know about that.

Luigi: But anyway, the important part for our listeners is that the Fed did rescue AIG, issuing very large loans, but financial markets got even worse because the default of Lehman caused major losses in money market funds, and money market funds have, or used to have, this promise to redeem the investors always at par, 100 cents on the dollar. Some of these funds, in particular one fund, the Reserve Primary Fund, had invested so much in Lehman bonds, and that caused, basically, a run on the money market funds that created a panic in the entire money market industry.

However, big crises, of course, are not caused by one factor alone, but if you were to go retrospectively, in your view, Kate, what is the main cause, or the main causes, of the crisis?

Kate: In my mind, I like to frame this as a supply and demand issue. On the demand side, there was global demand for very safe assets that could be a sure store of wealth. This is coming from emerging markets, it was coming from China, it was coming from countries where there was a lot of saving. It was also coming from government institutions. Fannie and Freddie, which we’ve talked about as these safe, government-sponsored entities, were investing heavily in these subprime mortgages that were being securitized by the private sector.

So, there was this significant demand coming from all over the world for these very safe securities that had to be created through this bundling and securitization process that made it very lucrative for investment banks to put whatever they could possibly find in these pools of mortgages and that, in turn, spread down to mortgage originators who were willing to push basically junk, crap mortgages, on whoever was willing to take them out and buy a new house. Even if they couldn’t afford it. Even if they didn’t have a job.

I think there was kind of this pull coming from a lot of different participants, international and domestic, but there was also the supply of terrible mortgages that was aggravated by the fact that ... As you mentioned earlier, there was fraud going on, the incentives of the investment banks and the mortgage originators were so perverse that people who absolutely had no business buying mansions were buying multiple mansions. On top of that, there was very lax oversight of this whole system, and, sitting in the middle, were the ratings agencies that said everything was OK.

So, I think I just listed 50 different causes, but—

Luigi: You put it very nicely. I will be more rough. And I would say that, in my view, the real problem was the pervasiveness of fraud and the inability of institutions to weed out that fraud. In fact, they probably wanted to encourage and push that fraud throughout the system. It’s true that there is demand for stuff, but if you cannot supply that stuff and you fake it, I don’t call it demand and supply. I call that fraud. I think institutions who were supposed to lend with the prospect of repayment in mind violated those conditions simply because there were some willing buyers on the other side, and they faked much of the documentation. Now, there are papers documenting that there were double liens that were not reported, the fact that you were an investor rather than a homeowner, so that you had multiple properties, was not reported properly, and so on and so forth.

There was a laissez-faire attitude that really cultivated, in a moment of market euphoria, the possibility for vast fraud. Once the market stopped going up, the US stock market stopped going up, people started to realize that the mortgages were much, much worse than they expected. There was a gigantic uncertainty of who would bear the losses and how big those losses were. I think that that is what created a situation of frozen markets. In this difficult situation, the Fed behaved in a very inconsistent way. A great economist, Allan Meltzer, who studied the history of the Federal Reserve, wrote extensively about the fact that the Fed never developed a policy of lender of last resort.

Kate: I completely agree with you that there was rampant fraud in the mortgage market in the early 2000s, particularly in subprime mortgages. I completely agree with you that the inconsistency of the government’s actions was part of what amplified the crisis, but I belabor this point about the demand side, the global capital being invested in safe US securities, because there were housing bubbles as well in France, Australia, Italy, Spain, and they also, at least some of them, experienced significant housing drops around the same time.

A lot of European banks failed as well, and this happened in countries that didn’t have the same sort of securitization process that we have here. They didn’t have investment banks going out and pooling together subprime loans, and yet they also experienced significant drops in housing prices and bank failures. So even though I completely agree with you that what happened in the United States, the rampant fraud that we experienced, was a big part of the crisis here, I think that the story about global capital being invested in Europe and the US, therefore pushing down long-term interest rates, therefore increasing housing prices, I don’t think that that gets enough attention.

Luigi: Certainly, there were enabling conditions, and these conditions can be different. So, for example, in Europe, there wasn’t a huge influx of foreign money, but in some parts of Europe, there was a huge influx of German money coming down. So, in Ireland and Spain, there was a huge amount of loans made by German banks to Spanish banks, and the influx of easy money is what made ... what enabled, I think, a lot of bad loans. There is a fundamental difference between Spain, Ireland, and the United States, and it is that in Spain and Ireland, the number of actual people who defaulted was relatively limited because all the mortgages there are full recourse.

If you abandon your house, the banks will come after you for the difference between the value of the house and the value of the mortgage. In the United States, some states are fully nonrecourse, some are more ambiguous, but there is a greater tolerance toward other people who walk away from the house and don’t pay the mortgage. And so, in situations like this, it’s a much greater responsibility of the lender to be very careful on the way they lend. Financial institutions not only gave up that carefulness, but also lied about the objective characteristics of the mortgages.

This created not only large defaults, but also an enormous amount of uncertainty. At some point during the crisis, there was even the possibility that all the mortgages would be considered not valid. Why? Because they were not properly transferred according to some legal rules. If fact, some borrowers got away paying nothing, because they could prove that their mortgages were not properly endorsed. Later, Congress fixed the problem with the law, because otherwise the entire mortgage market in the United States would have collapsed.

Kate: One thing we haven’t mentioned, or at least explicitly discussed, is who ends up holding the risk, and why was it that these banks were engaging in so much fraud and pushing these no-documentation or no-income mortgages on people who couldn’t afford them. I think part of the reason is that there was this huge separation between who was ultimately holding onto the risk and who was issuing the mortgages. So, there were mortgage originators, like Countrywide, on the ground knocking on doors, trying to convince people to take out these terrible term mortgages.

Those mortgages were then sold to investment banks like Goldman Sachs, Morgan Stanley, Lehman Brothers, who then put them in the big pools, securitized them, and then sold them off in pieces either to domestic investors, foreign investors, or, for riskier parts of the pool of mortgages, to hedge funds. The people who ultimately bore the risk were pretty separated in this long chain from the people who were on the ground making the loans. If you were making a fraudulent loan, it didn’t really matter, because you were so far removed from the consequences of it that, basically, you were just being incentivized by the fee that you were making on the loan. All you cared about was maximizing volume, the quality didn’t matter to you.

Luigi: Yeah, but, Kate, you’re forgetting an important part. You describe, perfectly, this chain and the fact that this chain somehow did not work properly. However, if I am Countrywide and I make loans and then I sell them to you, let’s say Lehman, so that you repackage and you resell them, I attach to these loans what is called rep and warranty. I make some statements about the way those loans are made and the reliability of the parameters under which those loans were made. If any of this is false, I need to pay for damages. Number one.

Number two, most of the time, those portfolios are audited by the Big Four audit firms. How do they audit? Do they look at every single mortgage? Of course not. But they have some system of random checking that should enable them to catch the problems. And here, both of these things fail. Number one, the audit firms were not able to identify them early, and with a single exception of PricewaterhouseCoopers, PWC, that was held liable in the Colonial Bank trial for not doing that properly, we have not seen the Big Four paying for these mistakes.

And, number two, many firms got away with not paying their responsibility of reps and warrants, because, actually, once the Fed got control of AIG, it waived the ability to sue the banks for having violated these reps and warrants. I think that there was a major failure in compliance, a major failure in audit, a major amount of fraud in the system. One thing that offends me is the fact that, while there were a lot of fines paid by banks in the aftermath of the financial crisis, basically no financial executives went to jail, or was even prosecuted for those frauds. In fact, many of the same financial executives who committed those frauds are back in business like nothing happened.

Kate: The fraud that you’ve been talking about was, for the most part, on the part of the mortgage originators, the people on the ground making loans face to face. But I think the real failure of the investment banks was in the way that they turned these mortgages into actual securities. Banks were basically making securities out of thin air, even though there was no underlying pool of mortgages to back them up. And they did this using bets on the original pool. That way, you could take a pool of mortgages and the securities that stem from them and replicate them as many times over as you possibly wanted. This, I think, led to a lot of the amplification of the crisis that these synthetic instruments really had no underlying securities to back them up.

I think another issue was in the way that tranches of mortgage-backed securities that were not considered super safe were then repackaged together to create what was deemed by the rating agency as super safe, even though it was just kind of a mixture of crap from the lower tranches of other mortgage-backed securities.

I guess the point that I’m trying to make is that there was a lot of risk amplified many times over by the type of engineering that these investment banks were doing, and I think that was maybe not explicitly fraud, but that was where investment banks contributed to a huge amplification of the crisis.

Luigi: By the end of that week ... So, the week that starts with the bankruptcy of Lehman is September the 15th, by that Friday, which is the 19th, the situation is really tense, and it’s pretty clear … Both Goldman and Morgan tell the Fed that they’re not sure they’re going to open on Monday morning. That’s when two things happened. Number one is the Fed intervenes by allowing Morgan and Goldman to transform into bank holding companies, and, two, the first proposal by Paulson to intervene with some government help that will try to stabilize the situation—what eventually became the Troubled Asset Purchase Program, better known as TARP, floated on the 19th of September.

And then, on the 23rd, George W. Bush goes on TV in front of the nation.

George W. Bush: Good evening. This is an extraordinary period for America’s economy. Over the past few weeks, many Americans have felt anxiety about their finances and their future…

Luigi: So, listen to George W. Bush, president at the time, reassure the country that everything is fine, he says.

George W. Bush: …collapse. The government’s top economic experts warn that without immediate action by Congress, America could slip into a financial panic and a distressing scenario would unfold. More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet…

Luigi: And people heard their president saying that we are about to face a new Great Depression. They stop spending, they stop investing. They stop consuming. I think that that is, at least in part, what brought the economy into a tailspin.

George W. Bush: …and, ultimately, our country could experience a long and painful recession.

Kate: Yeah, I can relate to that, because as I was sitting in my dorm room watching Lehman collapse and seeing all my summer money disappear, a couple of weeks later I thought to myself, you’re screwed. There’s no way you’re getting a job. There’s no way you’re going to have anything to do after you graduate, because the economy is just going to be completely tanked. At that point, I decided to quit school. I used the couple of hundred dollars that I had recovered from selling my Lehman stock for pennies on the dollar to buy a one-way ticket to California and just kind of hiked around hoping that I could wait out the crisis and hoping that the economy would recover a year later.

I consider myself one of the lucky ones. At least I had that option. At least I knew that I would be able to return to school the next year, unlike many millions of Americans, who just completely lost their jobs and didn’t have many other options.

Luigi: In the next episodes, we’re going to discuss what we have learned and how we’ve made the system better, or to what extent we’ve made the system better. And, finally, we’re going to discuss, in the third episode, what holes are still there and face the very difficult question of where the next financial crisis will come from.

Economists experience their first major #MeToo moment. Kate and Luigi explore the larger implications of a recent case involving a Columbia University professor who was found liable for retaliation against a female junior faculty member.

Kate: Just a quick disclaimer. Our descriptions of the case and events in this episode are based on media reports and allegations in court documents.

Hi, I’m Kate Waldock from Georgetown University.

Luigi: I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: We are here at the University of Chicago recording together for the first time in a really long time.

Luigi: In a really long time, indeed.

Kate: We’re here for a podcast retreat, which took place yesterday. It was a really lovely time. We did trust falls, we built a log cabin. We did an escape the room. It was a lot of fun.

Luigi: No, we didn’t. We should thank a lot of our listeners who sent us feedback. Very useful.

Kate: Yeah, that’s true. We’ve had a survey up on our website, and you can still go there and let us know what you think about the podcast. On today’s episode, “Sex, Power, and the Ivory Tower,” economists experience their first major Me Too movement. What does it mean for women broadly, and what can we do to prevent situations like this in the future?

This situation revolves around an assistant professor of finance, Enrichetta Ravina. She was formerly at Columbia. Now, she’s visiting Northwestern. Luigi, do you know Enrichetta?

Luigi: Yes, I do.

Kate: How do you know her?

Luigi: I met her several times, because she was an advisee of Paola Sapienza, who is a coauthor of mine. I met her through her, and I met her on the job market. I think she had a very interesting paper on the job market.

Kate: All right, so for some background, Enrichetta is an assistant professor of finance. She does research on how individuals make investment decisions, particularly those that pertain to retirement savings. She started out at NYU for a couple of years. She was poached by their uptown neighbors, Columbia. When she started at Columbia, she was given the opportunity to work with a tenured, senior professor, Geert Bekaert, who offered her access to some proprietary data on four million people and their retirement decisions.

As they began to work together, and as she spent more and more time cleaning this data to make it usable for research, she alleged in court that Geert became increasingly sexually aggressive towards her. His behavior ranged from either talking about his sexual exploits to touching her inappropriately.

At this point, she filed some complaints against him to Columbia’s higher-ups. She alleged that she was allowed to take a paid leave, but that that paid leave was later revoked. Columbia accelerated her tenure process, even though there were letters written by other faculty members at Columbia stating that junior faculty needed to be protected, and that at the rate that her tenure review was going, her work couldn’t be properly evaluated. So, there was a trial in the Southern District of New York, which resulted in a finding that Geert was liable for retaliating against Enrichetta, and ordered to pay $1.25 million in damages. Although, it should be noted that he wasn’t liable for damages related to gender discrimination.

Luigi, you wrote an article on 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 wou