The U.S. economy may be booming, but despite a recent uptick wage growth remains stubbornly flat. Kate & Luigi examine the effect of monopsonies in the labor market among concentrated industries like Big Tech. Are companies colluding against workers and driving down wages?

Academic articles

- Labor market concentration is pervasive and associated with lower wages:


News articles:

- On the decline of labor mobility:

- Personal emails between Steve Jobs and Eric Schmidt about poaching:

- Fast food no-poach agreements:

- Some statistics and opinion on non-competes:

Speaker 1: 200,000 jobs added last month. That’s a big number. The bigger headline though is that paychecks, wage growth, is way up, and it’s the fastest pace we’ve seen in years.

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

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

Luigi: And most importantly, what isn’t.

Speaker 4: I mean, if you’re somebody who is working in this American economy, you want your wages to go higher. So yes, we saw wages increase at the fastest pace as we’ve seen since the recession, since eight years ago.

Speaker 5: The wage growth number, it looks like we’re finally starting to see a tight labor market give workers more bargaining power.

Speaker 6: The wage growth jumped from 2.5 percent to 2.9 percent. That’s a huge jump, and you can attribute that for a couple of reasons. For one, the tax plan. We saw dozens of companies hand out raises and bonuses …

Kate: All right, I think we should slow down for a second. The fact that there has been a slight increase in wages over let’s say the past month or two has been encouraging for some of us. But for those of us who have been looking at long-term wage stagnation over the past couple of decades, I don’t think it’s time that we can celebrate yet.

Luigi: What is interesting, of all people, the ones who are concerned about wages not growing enough are central bankers: the head of the Federal Reserve, the head of the European Central Bank, the head of the Bank of Japan. Why are they concerned? Because they have some inflation target to reach, which is 2 percent per year. Without some wage pressure, they cannot reach that target. The irony is, you think about central bankers as always being on the side of trying to keep the wages down. But now, they are wondering themselves: what is keeping wages down?

Kate: I think also another part of this story is that low wage growth has been juxtaposed against pretty high corporate profits. This has been an issue for a lot of advanced economies, not just the United States.

Luigi: So the question we’re trying to understand is why that’s the case. We need to understand first how wages do rise in general. The idea is, when there is a booming economy and firms are looking for more employees, they start to bid up the wages of people who are employed in other places, or they are unemployed and they need to get in the labor force, to attract more people to work. This is the fundamental law of demand and supply. When demand for labor is increasing, as it is now in most parts of the world as a result of a continuing expansion, then you should see a rise in wages as well. The puzzle is that we don’t see that enough. Just to give you a sense, from 2009 to 2014, wages went up only by 8.7 percent, when inflation went up by 9.5 percent. So the real wage-

Kate: Is that in the US or globally?

Luigi: In the United States, yes. So the real wage of a US worker during those five years went down, rather than up, in a phase in which the economy was expanding.

Kate: What could be one reason for these wages going down? As you just mentioned Luigi, we have in mind this model of employers competing with one another. Maybe that’s not the case. In some markets, maybe there is only one employer. The fact that there’s only one, or only a couple employers not perfectly competing with one another, could mean that they have power over labor, or they have power over people that they’re employing, and therefore they can keep wages low.

Luigi: Let’s introduce this name that is not probably familiar to many listeners, the term of monopsony. Many people understand what a monopoly is. There is only one producer. Monopsony is when there is only one buyer. In particular, we’re interested about when it’s only one buyer of labor. In this extreme form, this is relatively rare. People have in mind the famous mines in West Virginia, company towns in West Virginia where the mine was the only source of employment. Or they might remember an old movie, maybe it’s too old for you Kate, It’s A Wonderful Life, where-

Kate: Oh, that’s a classic-

Luigi: ... in the little town ... It’s a classic, yeah, so even you know that.

Kate: Even I know that movie.

George Bailey: Just remember this, Mr. Potter, that this rabble you’re talking about, they do most of the working and paying and living and dying in this community. Well, is it too much to have …

Luigi: This guy Potter, who owns everything in the little town where the corporate bank of Bailey and Company is operated.

George Bailey: ... well, in my book he died a much richer man than you’ll ever be.

Mr. Potter: I’m not interested in your book. I’m talking about the Building and Loan.

George Bailey: I know very well what you’re talking about. You’re talking about something you can’t get your fingers on, and it’s galling you. That’s what you’re talking about, I know. Well, I’ve said too much. I ... You’re the Board here. You do what you want with this thing. There’s just one thing more, though. This town needs this measly one-horse institution, if only to have some place where people can come without crawling to Potter. Come on, Uncle Billy.

Luigi: So I think that this extreme form is rare. But in the last two decades, the concentration of industry in the United States has gone up. As a result, in many towns, especially rural towns, the potential employers are few.

Kate: Yeah. When we think about monopolies, we usually think about a global, or a countrywide marketplace for something. But when it comes to monopsonies, or companies that have buying power over labor, we also have to factor in people’s limited willingness to move around. The United States is not what economists would call a completely frictionless labor marketplace. If I’m working in New York, and a similar job opens up that pays a dollar more per hour in South Dakota, it’s not a very obvious decision that I’m going to pick up and move to South Dakota. People, for family reasons, for personal reasons, for issues of the fact that it just costs money to move, it’s hard to move around. Often times, people just want to stay in the same place.

This means that monopsonies can exist on a very local level. So even though within a particular industry there could be a few, or many firms that hire people, in small localities, let’s say a town or a county, you can still have companies that are the only employers in a particular market.

Luigi: The point you’re raising, Kate, is very important. Mobility in the United States has gone down. People are discussing what the causes are, but I think it’s a combination of factors. One is the fact that now there are more dual-career families, so if your spouse is employed, and well employed in a place, you are more reluctant to move, because you have to break up the family. The other is that in many places in rural America, people are stuck with houses that are worth much less than what they paid for them, and sometimes they can’t even sell them at a positive price. Moving to a different location might cost them a fortune.

We know that the market for buildings in cities like San Francisco or New York is not very competitive. There are restrictions to entry, and so on, and so forth. It costs so much to rent an apartment in New York that you might not want to actually move to New York, even if in New York you have a better job, and better pay.

Kate: All right, so we have set the stage, but what we are here to do is to figure out whether companies having market power over labor actually plays a role in keeping wages low. Before we move on, I think we should insert a quick caveat, that we’re not trying to answer the whole story about why wages have been stagnated. There’s a bunch of different variables that go into this. Part of the solution, or part of the reason could be globalization. Part of it could be the way that labor contracts are written. There’s a bunch of different explanations for this. We’re not going to try and address the whole picture. We’re just going to focus specifically on employer power.

Luigi: We know that concentration of industry in the United States has gone up. Unfortunately, we are discovering that in an increasing number of cases, the bidders do collude. The most egregious of these cases is actually the one that was brought out by litigation a few years back, the one that affected Google, Apple, and other tech firms in the Silicon Valley, that was filed in 2010. Now you don’t think about software engineers as employees that have particularly low wages, but it is important to look at this case, because we have some smoking gun emails about the existence of this no poaching list, in which you are not soliciting the employees of the other group.

Let’s read one of these exchanges, just to set the facts straight. In early March 2007, an employee of Google made what was considered a career-ending mistake. She cold contacted an Apple engineer by email, violating a secret, and by the way illegal, no-solicitation agreement between the two firms. Now let’s read what the exchange between Steve Jobs and Eric Schmidt, who at the time was the CEO of Google.

Kate: OK, so I’m going to read one. This is by Steve, to Eric, “Eric, I would be very pleased if your recruiting department would stop doing this. Thanks, Steve.”

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

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

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

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

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

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

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

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

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

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

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

Luigi: Please.

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

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

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

Kate: Oh yeah, that’s for sure.

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

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

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

Kate: I think they are considered high-skilled.

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

Kate: Yeah.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Main papers discussed during episode:
- Anne Case and Angus Deaton, 2015. “Rising morbidity and mortality in midlife among white non-Hispanic Americans in the 21st century.” Proceedings of the National Academy of Sciences, 1-6.
- Justin Pierce and Peter Schott, 2016. “Trade Liberalization and Mortality: Evidence from U.S. Counties.” NBER Working Paper 22849.
- Jessica Laird and Torben Nielsen, 2017. “The Effects of Physician Prescribing Behaviors on Prescription Drug Use and Labor Supply: Evidence from Movers in Denmark.” Working Paper.
- Kevin Boehnke, Evangelos Litinas, and Daniel Clauw, 2016. “Medical Cannabis Use Is Associated With Decreased Opiate Medication Use in a Retrospective Cross-Sectional Survey of Patients With Chronic Pain.” Journal of Pain, Vol. 17, Iss. 6.
- David Powell, Rosalie Liccardo Pacula, and Erin Taylor, 2015. “How Increasing Medical Access to Opioids Contributes to the Opioid Epidemic: Evidence from Medicare Part D.” NBER Working paper 21072.
- Jane Porter and Hershel Jick, 1980. “Letter to the Editor: Addiction Rare in Patients Treated with Narcotics.” The New England Journal of Medicine, 302(2).
- Anderson, Green, and Payne, 2009. “Racial and Ethnic Disparities in Pain: Causes and Consequences of Unequal Care.” The Journal of Pain, Vol. 10, No. 12
- Christopher Ruhm, 2018. “Deaths of Despair or Drug Problems?” NBER Working Paper 24188.

- New Yorker Article on Sackler Family:

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

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

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

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

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

Luigi: … and most importantly, what isn’t.

Speaker 1: The impact of the opioid epidemic is stunning, with 300,000 American deaths since the year 2000.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Show us. Show us the data.

Luigi: Yes. Exactly.

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

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

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

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

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

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

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

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

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

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

Luigi: What’s the difference?

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

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

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

Luigi: Why don’t we start with three?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: Market manipulation also.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

– Thomas Piketty, Capital in the Twenty-First Century (2014)
– A criticism of Piketty, including a discussion on depreciation: Matthew Rognlie, “Deciphering the Fall and Rise in the Net Capital Share: Accumulation or Scarcity?”, Brookings Papers on Economic Activity

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

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

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

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

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

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

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

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

Speaker 7: Piketty? How do you say it?

Thomas Piketty: Piketty.

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

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

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

Luigi: 1 percent of what?

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

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

Kate: Right.

Luigi: I’m sure you remember.

Kate: Definitely. I remember that all too well.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Capital isn’t.

Luigi: Exactly.

Kate: Sorry, too easy—

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

Kate: Bezos needs to start having babies—

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

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

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

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

Luigi: Wow.

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

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

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

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

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

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

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

Kate: It doesn’t.

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

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

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

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

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

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

Luigi: It’s certainly his main policy recommendation.

Kate: I disagree.

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

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

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

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

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

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

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

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

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

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

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

Kate: Why are those necessarily incompatible?

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

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

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

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

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

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

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

Kate: It’s more than three—

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

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

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

Kate: See, now the truth is coming out.

Luigi: Yeah, absolutely.

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

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

Fed transcript:
– Transcript from August 16th, 2007: (Page 13)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Luigi: It was released after five years.

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

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

Kate: I’ll be Lacker.

Luigi: OK.

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

Luigi: Yes.

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

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

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

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

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

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

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

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

Luigi: Can I suggest an idea?

Kate: What?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Absolutely.

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

Main papers discussed during episode:
– All the work by Raj Chetty and co-authors can be found at
– Hoxby C. and C. Avery (2013), “The Missing “One-Offs”: The Hidden Supply of High-Achieving, Low Income Students

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

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

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

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

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

Kate: We’re two economists who think that capitalism today is a sorry state of affairs.

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

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

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

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

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

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

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

Kate: Are you allowed to be talking about this?

Luigi: Yeah.

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

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

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

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

Kate: Yeah. OK. This is brilliant.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Yeah. That’s a good point.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: I think we benefit directly, too.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: I’m not a wealthy investor.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: No!

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

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

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

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

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

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

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


Policy Links:

– Corporate tax rates in the OECD

– Memo from CEA:

– Study of corporate inversions:

– Congressional Research Service study on possible corporate tax reforms:


Relevant academic papers:

– Albertus, James, Does Foreign Tax Arbitrage Promote Innovation? (December 2017). SSRN:

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

– Faulkender, Michael W. and Hankins, Kristine Watson and Petersen, Mitchell A., Understanding Precautionary Cash at Home and Abroad (September 2017). NBER Working Paper No. w23799.

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

– Petersen, Mitchell A. and Faulkender, Michael W., Investment and Capital Constraints: Repatriations Under the American Jobs Creation Act (April 29, 2012). SSRN:

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

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

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

Luigi: And most importantly, what isn’t.

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

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

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

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

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

Speaker 8: The big winners are clearly corporations.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: What did he say about fool me once?

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Yes.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

On the role of Facebook in the distribution of news:



Market Power in Data:

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


Possible solutions:

– Sokol, D. Daniel and Comerford, Roisin E., Does Antitrust Have a Role to Play in Regulating Big Data? (January 27, 2016). Cambridge Handbook of Antitrust, Intellectual Property and High Tech, Roger D. Blair & D. Daniel Sokol editors, Cambridge University Press, Forthcoming. –

– This idea is discussed in this online symposium


Other relevant news on the topic:



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

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

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

Luigi: You mean capitalism?

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

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

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

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

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

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

Kate: Actually my favorite social media platform is Instagram.

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

Kate: Yeah, Facebook owns all of them.

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

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

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

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

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

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

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

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

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

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

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

Luigi: But I’m a nice dad.

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

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

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

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

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

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

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

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

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

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

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

Kate: What?

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

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

Luigi: OK.

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

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

Kate: And-

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Kate: Houseparty.

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

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

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

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

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

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

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

Kate: of what?

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

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

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

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

Luigi: Actually-

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

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

Kate: OK-

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

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

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

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

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

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

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

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

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

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

Luigi: ... maybe a different podcast-

Kate: Yeah.

Luigi: ... but in addition-

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

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

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

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

Kate: Great, we’re starting a petition.

Luigi: And the petition should be [explicit]?

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

Luigi: You cut that out.

Kate: He’s not cutting it out.

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