As ad revenue continues to decline more and more news organizations are turning to paid and sponsored content. Luigi and Kate revisit the decades-old music payola scandal and debate how to ensure proper disclosure in the digital age.

Speakers: The sharing of biased and false news has become all too common on social media.

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

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

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

Luigi: And most importantly, what isn’t.

Kate: A media organization called Sinclair has been in the news recently because it was making its anchors read the same statement, and everyone across a bunch of stations was sounding like zombies just reading the same thing over and over again, which was something like:

Speakers: Unfortunately, some members of the media are using their platforms to push their own personal bias and agenda to control exactly what people think, and this is extremely dangerous to our democracy.

Speaker 4: This is extremely dangerous to our democracy.

Speaker 5: This is extremely dangerous to our democracy.

Kate: To back up for a sec, Sinclair is both a TV and a radio broadcasting company. They own something like 193 just television stations, but there’s also talk about them acquiring even more from Tribune Media soon. What’s ironic is Sinclair was actually fined by the FCC a few months ago in what was basically the largest fine in history because they were found guilty of accepting money in exchange for endorsements.

Speaker 6: More and more patients at Huntsman Cancer Institute are recording their life stories.

Speaker 7: My grandfather’s family all died, usually in their late 20s, early 30s, because they were not diagnosed back then.

Speaker 8: It’s taking too many lives, and my husband at 54, he had a lot to offer the world.

Kate: But they were reporting news tied to cancer organizations as if it were news without disclosing that they had accepted payments for what they were claiming was news.

Luigi: So we’re going to try to unpack today these practices, starting from payola to go to advertising to sponsored content, but we want to start with actually the music industry.

Kate: Yeah, can I talk really quickly about the word payola?

Luigi: Please.

Kate: I just, I hate the word payola. It makes me think of 1950s naming conventions, like Crayola and Victrola. They just added ola. Terms that you may be more familiar with now are pay for play, #sponcon, which stands for sponsored content. But anyway, it’s all the same idea.

Luigi: And this is a practice that has been going on in the music industry since probably the beginning of the music industry. What really shook the industry is that in 1955, four traditional companies were controlling 78 percent of record sales. By 1958, the same four companies dropped to 34 percent, and the reason was the explosion of rock ’n’ roll that was done by other record companies. Many senators got concerned about the spreading of this evil music, and of course, the evil music could only spread because of corrupt practices. As a result, there was an investigation in Congress about the use of payola to promote the new music, which was rock ’n’ roll.

Kate: So anyway, Ronald Coase, who’s a Nobel Prize winner, he wrote this paper describing everything that happened, and his opinion, payola in the music industry was really not that bad of a thing.

Luigi: Yeah, and his argument, I think, is quite clear. Number one, he says it’s not a bribe, because in legal terms, a commercial bribe is when you pay somebody to use his discretionary power in a way in which his boss does not want him to. In this particular case, the radio stations were perfectly happy to have the DJ take that money, and they knew this money was taken, so it’s a little bit like a waiter in a restaurant. You give him or her a big tip to get the corner table. This is not a bribe by any measure of the word.

Kate: Yeah, and another argument that he makes is that from the DJ’s perspective, it doesn’t really make sense to accept money to play bad music, because you still want people listening to your station, and so you’ve got this sort of joint optimization problem, where on one hand, you want to make money by being paid some amounts by these record labels, but you also want to make money through your salary from the music station, which means that you want to have a lot of listeners. So it’s not necessarily the case that bad music was being pushed on a lot of people. Maybe once in a while there was the occasional record that people wouldn’t have normally wanted to listen to that they had to listen to, but for the most part, people were still listening to music that they enjoyed because that was consistent with the incentives of the DJ.

Luigi: Actually, I don’t like that argument too much, because as we will discuss hopefully later, this leads to being too sort of accepting of other practices I have more quarrels with. I’m more intrigued by two points that he makes that are quite clever. The first one, it says, look, it’s not like the rating or the combination of music that you receive on the radio is not distorted without the payola. In a world without the payola, the way that radio supports itself is through commercial ads, and as we know, if you want to maximize audience, you’re trying to play the music that is more enjoyed by people who buy more products, and so you make yourself more valuable to the commercial ads.

So to some extent, the payola was useful in getting the music that actually listeners wanted, independently of the kind of commercial power they had. That’s the reason why they started to play the rock ’n’ roll, because the rock ’n’ roll was appealing to teenagers, but it was not appealing to old farts with a lot of money in their pockets.

Kate: Yeah, so I think Coase’s most compelling argument is that the groups who were really anti-payola were the big band music stations or the music labels of the 1930s, and they were pitted against these new, up-and-coming rock ’n’ roll artists, who they considered obscene. If you think about it, big band was already being played on the radio, and so the marginal dollar spent on payola by someone who was already super popular was not really that valuable, whereas if you were a new rock ’n’ roll artist, then maybe you would want to spend a little bit of money, you want to give a little bit of money to DJs asking them to play your stuff so it would be introduced into the mainstream. So it was really the old incumbents who were trying to fight against the new upcomers and prevent them from breaking onto the scene.

Luigi: And many of the actions to ban payola were actually conceived as a way to restrict this payment and maximize the revenues of the music industry, and that’s the reason why the attacks to payola are very cyclical, because the payola starts as a very common practice, then becomes so widespread that it actually takes the form almost of blackmail, that now the radio controls the access to listeners and they ask for a payment, an extortion, in order to reach the listeners. When this arrives to this point, in a normal situation, you should have an antitrust enforcement. In the payola industry, you have a surge in the protests, and often either the parliament gets involved or people like Eliot Spitzer, who want to run for a political position and think to make themselves popular by going after the payola industry.

Kate: Yeah, so let’s talk about payola or sponcon in the context of today. It shows up all over the place, and I think it’s important that we make the distinction that it can show up in cultural contexts. For example, if you listen to Spotify or Pandora, there’s a lot of concerns that the curators of playlists are being paid off by the artists themselves. That’s very different than if we’re talking about Twitter, which is actually a medium that people use for learning about the news and learning about information.

I think an important component of what makes this so widespread today is the internet. There’s just so many people offering up their opinions and offering up ratings and anonymously posting on Yelp or anonymously blogging, and it’s impossible to tell who’s accepting money and who’s not, and that’s why I think it’s important to make this distinction between news and culture or product reviews.

I think when it comes to culture and product reviews, I have a pretty good sense of when people have been paid for. In news, it’s more difficult to tell, and so I think we should talk about where payola shows up today, but also distinguish between news outlets versus culture and product sales.

Luigi: I think we should distinguish, but honestly, I think it’s problematic even in cultural issues, in the sense that I love wine and I really value the opinion of one wine critic, Robert Parker, who has a publication without ads. I trust him because over time, I really enjoy the kind of wine that he selects, but also, I am reassured by the fact he doesn’t take any ads. In fact, there is an economic paper looking at the comparison of ratings between Wine Advocate and Wine Spectator, and it finds that the difference in ratings are correlated with the amount of advertising that Wine Spectator gets. So there is this at least prima facie evidence that even traditional advertising might distort content in a major way.

Kate: OK, well maybe you like wine, but I like makeup, and I follow an Instagram makeup artist named Militza Yovanka, and she obviously accepts money from makeup producers. I think that she’s probably getting a lot of money from L’Oreal, I don’t know, different places. She posts these videos where she’s doing her own makeup using all these different products, and I know that she’s being sponsored by these products, but it doesn’t really bother me because A, she’s really good at doing her makeup, and B, I feel like I can tell the difference between when she’s doing something promotional and when she’s not, even if it’s not disclosed.

Luigi: I would like to test you on that declaration. You’re definitely right that you like wine more than I like makeup, so I think that you have clearly a lot of absolute and comparative advantages there. But I don’t claim I can tell the difference. And I have no problem if you announce that you’re just showing stuff that you have been paid to show. That’s part of what advertising’s about. I’m more concerned when you cannot tell the difference, and honestly, if it comes to wine or makeup, it’s not the end of the world. When it comes to news or important information that makes you decide, for example, on your lifetime savings, that’s quite important.

Kate: So when it comes to payola in culture, where do you fall?

Luigi: To me, the crucial aspect is deception, or the risk of deception, and in the case of payola, actually Coase has a great argument, and in my view, I’d say, “Look, music is an acquired taste, but you need to listen to it to know what it is, and while it’s true that the DJ is forcing me to listen the first time, actually I don’t buy the music unless I’ve listened to it. So it’s not like I’m deceived because I don’t know what I’m buying. I know exactly what I’m buying, and the only thing that the DJ is doing is exposing me to that music.” I don’t particularly like, for the wine, even if for most wine, the worst that can happen, you buy a bottle and unless this is a Château Lafite 1955, it’s not a fortune, and then if you don’t like the bottle, you can make up your mind and discard it.

I think that the argument is quite different if we move from the music industry to other systems of exposure, where the good is not that easy to identify. Suppose I am a travel editor of a major magazine, and I receive payment to promote particular locations. As a buyer, you don’t know if the reason why I rate this trip in Myanmar as the most valuable trip of my life is because it’s really great or because I got paid, and you’re only going to find out after you travel to Myanmar. So it’s very different from music.

In many other situations, it’s very difficult to not be deceived. If you trust somebody to give you an opinion, you would like this opinion to be unbiased. The more the good is an experience good, the more the good is a good that costs a lot of money, the more the risk of deception, the more I am against this practice.

Kate: Well, exactly. If it’s a really expensive product that you’re about to buy, then I think I would be willing to pay for a unbiased report, but if it’s just various shades of lipstick, I think that it’s not worth it for me to pay for an unbiased report. Instead, there’s so much competition in the blogging and Instagram space for these sort of relatively cheap products that if I get fooled by somebody, then I’m going to stop watching their Instagram channel and I’ll just go to somebody else, and so I think that there are incentives for people to report somewhat accurately.

Luigi: OK, so let’s agree that for lipstick and music, we don’t care, but then when it comes to portfolio investment or pension retirement plans or stuff like that, this is even more important than your restaurant or your car. If you are a reputable journal or magazine and you can rely on a very diversified set of advertisers, then you are not dependent on any one of them. Once the set of advertisers shrinks, because if you are a money magazine, there are only so many advertisers you can deal with, and annoying one of them can be very expensive. And actually, the most extreme form of this, a colleague of mine experienced a tragedy: her son was killed, 20 years ago, by a defective crib in the kindergarten where he was.

Kate: That’s terrible.

Luigi: Yeah, it’s terrible, and this person is a very lovely person who tried to transform this tragedy into a good for humankind, so she made a battle to try to expose defective products all over the place. The first place where she went to place the news of this tragedy and a warning for the defective crib were parenting magazines, and to her surprise, the New York Times and the major newspapers were willing to publish the news, but the place where she found the strongest resistance were parenting magazines, and why? Because if you are a parenting magazine, you rely very heavily on a few advertisers, and one of those was actually the producer of the defective crib. And if you have only a few advertisers, you cannot afford to piss off any of them because you end up losing, let’s say, 20, 30 percent of your ad revenue, and that is something that a magazine cannot afford to do.

The reason why this story, besides the tragic aspect, but the reason why this story is so important is because I fear that even the mainstream media is going that direction. There used to be a time in which advertising was plenty, and so magazines and newspapers were very independent because they could annoy any one of them and still have a queue of people who wanted to advertise in the magazine. I think that time has gone with the internet and the diffusion of Facebook and Google and different types of digital ads; mainstream media cannot be this picky anymore, and they are heavily dependent on a few large advertising budgets, and that ends up distorting the news they report.

Kate: I think that’s a really interesting point that you raise about the concentration of your advertisers, I think that it ... I agree it probably has something to do with the way that advertising has changed and the pressure coming from competition from Facebook and Google, but if anything, those are reasons that we need to be supporting our independent media organizations, and so I’m just sort of, I’m at a loss for what to think about that, because on one hand, this heightened competition is leading to adverse outcomes and reduced reliability of the news that we consume, but on the other hand, I want to be supporting our news.

Luigi: Yeah, but the way to support the news is not by hiding a problem that’s been going on for decades, now it’s become worse, but has been going on for decades. Because while it’s true that it was easier to annoy one single advertiser, it’s also true that when there was an entire industry and this industry was important, then even the traditional media in a traditional time did not do that great. There is a study showing that magazines that did not receive any advertising from cigarette companies, at the time where advertising was possible, were 40 percent more likely to report news about the health consequences of smoking than a magazine that did take advertising, and similar stuff has been true about research on passive smoking. I think that the acceptance of tobacco advertising has been correlated to less articles and articles more critical of the research on the damage of passive smoking. So I think that this problem has been going on for a long time.

Now, you might argue that this is simple correlation. It doesn’t prove that they pulled out the articles because they were writing negatively about the industry. It might be that if I am a cigarette manufacturer, I want to advertise naturally in a magazine that has as customers people who like smoking or are more open to smoking, and that’s a natural coincidence. However, even if this is pure correlation, it does have a very strong implication. If I want to maximize my ad revenues, I better not talk negatively about smoking when smoking could advertise, and the same is true for a lot of other products today.

Kate: Yeah, I also think that’s an important point. One of the defenses of payola that was raised earlier, which is that people are used to seeing advertising all the time and so they’ve naturally built up these defenses and ways to recognize advertising, that still doesn’t address the fact that there’s information that’s not being reported, and so on one hand, a promotion may be something that people can defend against, but people can’t figure out bad things about companies if journalists are not willing to uncover those bad things because they’ve been supported in other ways by companies.

Luigi: And actually, what is positive is our academic journals that we normally publish in and read in economics and finance tend not to take ads in any major way, and so at least this distortion is not present, but when you go to medical journals, medical journals do take ads, and most of the ads are from pharmaceutical companies, and there is literature documenting some concern by the editors about the influence of the ad companies or the companies that produce the ads, mostly pharmaceutical companies, on actually the articles that get published in scientific journals. So this is even worse than the bias in the normal newspapers, because this is the academic community that should decide what is good for us in terms of what medicine we should take when we’re sick being distorted, and the major episode, hopefully it’s isolated, but there’s a major episode of the executive editor of the transplantation and dialysis journal that rejected a paper in spite of a favorable peer review, and he said, and I quote verbatim, that “The author went beyond what our marketing department was willing to accommodate.”

Kate: So Luigi, you’ve written a ton in many different news outlets about your opinions about the economy, about politics. Has anyone ever approached you and asked you to accept money?

Luigi: Yes, actually. It was many years ago. It was during actually the Parmalat bankruptcy. You’re an expert in bankruptcy, so you might enjoy that.

Kate: Actually, Parmalat means a lot to me, because my first job having anything to do with finance was looking into the Parmalat bankruptcy, but yeah, go on.

Luigi: So at the time, the international creditors were afraid to be taken for a ride by the Italian judicial system, probably not completely without reason, and so I got a US lawyer who came to my office, and when a lawyer actually comes to your office, you know there is something pretty important, because their time is very valuable and they generally don’t come to your office, they ask you to go their office. So he came to my office actually with a colleague, so two lawyers in my office, and they were trying to convince me to write a piece defending the interests of international creditors, and I said, “Look, you might be right, but because you offered money for this, I’m not prepared to do anything.”

Actually later, I discovered this is more diffuse than you think. For example, after the Iraq war, Qaddafi, then a dictator in Libya, was trying to show himself to the West as a reformed guy, and hired a consulting firm in America. This firm hired a lot of famous academics. One was actually a former dean of the London School of Economics. And these academics started to write articles all over the world where they were celebrating how great the changes in Qaddafi’s regime were, and nowhere to be seen was any disclosure that they’d taken money for that.

Kate: Yikes.

Luigi: If it wasn’t for the fact that eventually Qaddafi was killed and this stuff was exposed, we would never have known about this.

Kate: So the FTC explicitly has rules against unfair or deceptive business practices, and we may think that, “All right, it’s a government organization, it’s slow moving, it’s not up with the times,” but actually just recently, they sent out 90 letters of censure to what they called influencers on Instagram and YouTube, saying, “You’re not disclosing your endorsements or your sponsorship. You need to be doing this,” and they even followed up with 21 of them who didn’t listen to the FTC. So these investigations are going on. I don’t think that the FTC has been harsh enough in enforcing actions against people who may have accepted payment for endorsements, but I imagine ... I mean, these rules have existed for a long time and they’ve applied to journalists, as well.

On top of that, there are plenty of organic rules within journalism that maintain codes of ethics or maintain the quality of the journalism that’s produced. Like for the first time, I published a few weeks ago something on The Hill, and I had to sign a contract to be an independent contributor with The Hill, and very clearly in a couple paragraphs of that contract, it said that you cannot have accepted any money for this, “We have the right to state in your article that you have accepted money in order for sponsorship, or we have the right to just not publish anything altogether if you’ve accepted money,” and I would’ve had to disclose that. I mean, I didn’t, but it was there in the contract, and also, if you’re working for a reputable news organization, then your ass is going to be fired if your bosses find out that you’ve accepted money from anybody, and I think that they maintain, at least at the highest levels, very strict codes of conduct.

Luigi: It’s true, but those codes of conduct were not able to prevent, for example, those articles I mentioned about Qaddafi. So I’m not so sure that they’re so effective, and now, some mainstream media accept endorsed or sponsored content written by actual journalists of that newspaper. If you on one article write sponsored content paid by somebody, how can you be independent on the other articles you write?

Honestly, the newspapers made a mistake in the early 2000s thinking that they will make money with online ads and that the only game in town was to conquer eyeballs and you will be done. What they didn’t understand is that there were two or at least three major trends that killed them. Number one is the supply of ads increased tremendously. The media industry used to be a fairly oligopolistic industry with ability of some market power. With the internet, you can reach customers in so many ways that you lost on market power.

Number two, that Facebook and Google can do targeted ads so much better than the traditional newspaper that it’s not even funny. So at the same time, the demand went down and the supply went up and prices of traditional ads went to the bottom, and this destroyed the traditional media industry.

And the last coup de grace, the last sort of killing aspect, was the fact that the media industry was living a lot out of classified ads, and Craigslist killed that goose with the golden eggs, and so now the media industry is competing on very thin margins, and the only way to resurrect it is to have people realize that content is valuable and you have to pay for it.

Kate: Yeah, there was an interesting survey conducted by some polling firm called Toluna. They asked people whether they agreed that there should be no charges to access news websites online, and 96 percent of people think that news online should be free, which is pretty shocking.

Luigi: But the point is, what is the quality of what you’re getting? I think that what we need to do is to educate people, and I think it’s a lesson that we all have to learn, which is if you don’t pay for something, it means you are the product. You are the one being sold, and there is an agenda underlying, and that’s a problem. And I think that we should all make an effort in paying for news, because if you don’t pay for news, you get what you pay for.

Kate: I agree with that, and I have noticed this trend in more paywalls, which can be a little annoying, but I think like five years ago, every article that I looked up, I could find some way to get it for free. Whereas today, that seems to be less and less the case, and I think it’s because it took awhile for major news organizations to get used to shifts in technology, and it wasn’t really obvious right away what the best way to preserve their integrity would be, and I think what’s arising is that these subscription models have become the way for news organizations to maintain their independence as well as the quality of their journalism. It’s really easy for people to be considered sources of news even if they aren’t actually, which makes it that much harder for actual news organizations to compete.

Like Snapchat is now under the FTC’s guidelines. Podcasts are not. Podcasts are still sort of a gray area, and as a result of that, if you listen to other podcasts ... So we haven’t accepted any advertising yet. That’s not to say that we won’t necessarily in the future, but other podcasts that do advertise, you’ll notice that when you hear an advertisement, oftentimes they’re read by the host him or herself. Right? They’ll just be like, “I use Harry’s razors and because I love it so much for my small business and my armpits,” or whatever, and it doesn’t need to be disclosed. So I think that it’s important for the government to pick up on this and to pull in podcasts, as well, under their supervision.

Luigi: Full disclosure, I’m not being paid by Wine Advocate. I wish I were. No, I’m just joking, and by the way, Kate is not paid by the famous makeup artist.

Kate: Yeah. I promise.

In the brave new world of cryptocurrency the latest frenzy involves Initial Coin Offerings (ICOs), which make Bitcoin look tame by comparison. Luigi and Kate explore this volatile, largely unregulated market and consider creating their own ICO.

Speaker 1: Bitcoin crossing the $14,000 mark.

Speaker 2: Cryptocurrency passing $15,000 for the first time ever.

Speaker 3: Now it looks like we may hit the $17,000 mark.

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

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

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

Luigi: And most importantly, what isn’t.

Speaker 6: If you think the DOW had a bad day, Bitcoin’s was worse. The price is now hovering around $7,000.

Speaker 7: What do you think of the volatility of Bitcoin and the chance that it could lose all serious value?

Speaker 8: How do you regulate the cryptocurrency market?

Speaker 9: It’s a fair question.

Speaker 10: In terms of cryptocurrencies, generally, I can say almost with certainty that they will come to a bad ending.

Luigi: Everybody’s talking about Bitcoin these days, but a phenomenon which is related to Bitcoin but is actually broader and quite important is this new phenomenon called initial coin offerings. What we’re going to try to do today is try to understand what is this phenomenon and to what extent this is a fraud, to what extent it is for real, and what you should be aware of.

Kate: You’ve probably heard about Bitcoin, and maybe you’ve also heard about Ethereum or Ripple, even. But there are certain types of cryptocurrencies called tokens that you probably haven’t heard of.

Luigi: My favorite one is Bananacoin. A token whose value is linked to the price of a kilo of bananas. This is actually a ICO, initial coin offering, that took place last month and raised a significant amount of money to actually finance an investment in a plantation of bananas in Laos to export bananas into China.

Kate: My favorites are a little more salacious. I’m not sure, but maybe you’ve heard of Groincoin or Tittycoin or Lust. There’s a whole bunch of them out there.

Luigi: Sorry, I sound like a dork, but what are all those coins?

Kate: As you can imagine, they are linked to online porn.

Luigi: I think it’s important that our listeners understand that ultimately what money is is simply a trusted ledger. I know that most people have in mind money as gold because historically, that was the way the trust in the ledger was created. But even today with the US dollar, there is no relation between the US dollar and gold or silver or any other valuable metal. The ultimate ledger is kept by the central bank, which is the Federal Reserve Bank.

To make this point, I think in a very clear way, I want to tell a story that is described by Milton Friedman in a paper in the early ’90s. He talks about a group living in Micronesia, the Yapese, living on the island of Yap. One characteristic of this group is that in order to transact among themselves, since they didn’t have any precious metal on the island, they used pieces of stone, gigantic pieces of stone that could not be actually transferred from one guy to the other, but could be reallocated in property from one side to the next. If I want to buy some milk from Kate, I simply reallocate one stone or piece of that stone to Kate in exchange for milk. Kate and I agree that that’s a transaction, and we write on the piece of stone this transaction, and everybody on this small island knows each other and they trust that this is the actual transaction.

The irony that makes this point very clear is that they were trying to mine for this stone on a far away island, and as they were bringing back one of these gigantic pieces of stone, the stone ended up falling at the bottom of the ocean. But everybody in the Yapese community knew that this stone existed at the bottom of the ocean. They used this piece of stone that nobody could see as a means of exchange without even seeing the piece of stone. This makes it very clear that what money is doing is simply keeping track of transactions in a way that everybody trusts.

Now in a small community like the Yapese community, the trust is given by the social network of social pressure. Once you start to have exchange at a distance, you either give a bond in this transaction, and that bond is the value of the metal associated, or you have a superior authority that maintains this record in a trustworthy way. That’s what the dollar is about. Or, and this is the innovation, you have a currency that keeps track of all the transactions without a central authority in a way that it cannot be modified by anybody—that’s what Bitcoin is about, it’s a currency based on the decentralized ledger that is not mutable because of a combination of cryptography and the distribution component of this ledger.

Kate: The history of Bitcoin, every single transaction that’s ever taken place, sits on everyone’s computer who’s mining Bitcoin. Everyone has the same exact copy of this ledger that accounts for all transactions. If you want to change a particular transaction, if I want to say, “Oh, I paid Luigi 10 bitcoin,” and then take that 10 bitcoin back and give it to myself again, I would have to find the block that contained that transaction and alter it. But if I alter the transaction in the ledger, that then changes the link to all of the other blocks in the chain. That makes it really hard for people to go in and hack or alter the ledger.

Why do I use dollars? I mean, yeah, sometimes I have actual, physical dollars and I use them to buy stuff. But for the most part now, I use my debit card or a credit card to purchase stuff. I trust that Bank of America, when I buy something, it’s going to keep track of the transaction that I’ve made. And then it’s going to deduct the amount of what I bought from my bank account and it’ll give it to whoever I purchased that thing from. Likewise, if money is transferred into my account, I trust that Bank of America is keeping track of that money and that Bank of America isn’t going to be hacked—or American Express or whatever credit card you use. I trust that they’re not going to be hacked to the point where they no longer have any track of who’s purchasing what. That’s the idea and the importance of a secure ledger.

By the way, there’s a TV show, a socialist dystopia TV show, called Mr. Robot, which I highly recommend. The whole premise of the show is that they hack credit card companies and therefore destroy all credit because people can’t keep track of who owes who.

Luigi: Yes, but given that something is not hackable and so potentially could be a currency doesn’t necessarily mean it will be a currency because what determines the success of a currency in part is driven by how many people are willing to use it. The irony of the Bitcoin in this moment is that people who invest in Bitcoin, invest in Bitcoin in the expectation that this will become a standard currency for exchange. However, the more they demand this currency for speculatory reasons, the higher is the value of this currency and the more it will appreciate. And the more it will appreciate the less people are tempted to use the Bitcoin for transactions because whether I want to buy a pizza or sell a pizza, if the price of the bitcoins in dollars fluctuates wildly, I don’t want to use that for transaction purposes. In fact, at the last Bitcoin conference, they did not accept Bitcoin as payment. They did not accept it as payment because it was very volatile.

Kate: We’ve talked a little bit about what cryptocurrency is and what currency is in general. But we started this episode by saying that we want to talk about tokens and initial coin offerings. What distinguishes a token from a cryptocurrency? I like to think of this example of going into a video game arcade. You take your dollars and you purchase the currency of that particular arcade. These days it’s like a card that has some tokens on it and you use those tokens to play games. One game may be three tokens and the really good games may be six tokens. That’s kind of the same idea behind the coins that are being issued in these ICOs. They are a virtual means of exchange that are linked to a particular company. This idea of a token has become super popular.

Luigi: I don’t have a lot of experience on video game arcades, but when I was a kid in Italy, in order to make a phone call you had to use a token. Let’s say that the token was worth 25 cents. Instead of using a quarter, you would use the token. Now, because that token was so widespread, people will take it in exchange for a quarter because the telephone company was selling tokens for a quarter, was accepting tokens for a quarter, so it was basically providing a liquidity for having a token worth a quarter. People started to accept the token as money. The difference between the two is not that big as you make it to be.

Kate: I’m not saying that there couldn’t exist some bizarre state of the world where tokens are so popular that they actually end up being used as currency themselves. But I don’t think that it was the initial purpose of the phone company or the telecom utilities in Italy that these tokens were then going to replace currency. It was just that they happened to be that popular.

Luigi: I agree. That was not the intention of the telephone company in Italy. But I think it is the intention of many of these cryptocurrencies to become a substitute for money. When you look at Ethereum, Ethereum is a cryptocurrency like Bitcoin and was created to enable a set of transactions. We use it as currency within the universe of Ethereum, but ideally they want this universe to be the entire universe.

Kate: Yeah. This is, I think, a little bit of a confusing point. But you’re absolutely right. But it doesn’t need to be a currency company that ICOs. For example, you could have Bananacoin that’s intended to be used for purchasing and supplying bananas. I don’t think whoever ICO’d Bananacoin was intending for Bananacoin to become like the world’s premier virtual currency. They intended it to be used within a certain, more limited context. The point that I’m trying to make is, yes, even though cryptocurrency companies can ICO, non-cryptocurrency companies like any regular company can try and raise money through an ICO, and that’s what becomes dangerous.

Luigi: Disney could raise money by selling Disney Dollars. Those are tokens accepted in Disneyland and they could raise money this way. Now, they don’t need to raise money. But if they needed, they could. However, I think that part of the confusion is exactly this is the reason why so many companies now are raising funds this way is because people are very excited about the increasing value of Bitcoin and they want to jump on the new Bitcoin wagon. They are buying Bananacoin because, I don’t think they’re speculating on the price of bananas, they are hoping that this coin will become more accepted and will be more valuable. That’s, in my view, the reason why so many people buy these tokens from unknown companies with unknown track records and with very vague projects.

Kate: What blows my mind is that these tokens are actually really easy to create. Luigi, if we were to start a company what would it be?

Luigi: It would be the Capitalisn’tcoin.

Kate: OK. This is our podcast coin, and you need these coins to be able to listen to our podcast. If I wanted to actually issue some of these coins to raise money to, let’s say, invest more in our podcast, I could do that relatively easily. Let’s say I’m going to start with Ethereum, which is another popular cryptocurrency. I’m going to link it to that. First I need some Ethereum. I need an Ethereum account and I need a virtual wallet that has my Ethereum in it. And then I need to be able to code just a tiny bit. I just need to be able to edit some code.

What I do is I go online, I download what’s called a smart contract, which was written by this person named Bokky Poobah. I edit a couple lines of the code that say, “All right, this is owned by Luigi and Kate. It’s called Luigi-and-Katecoin. This is the amount that I want issued.” I just hit enter. And then within a few minutes, we would have our own tokens that would potentially be linked to our podcast. And then all we would need to do is create a website, write up a 12-page paper that says this is what we’re going to use these coins for, and then give it to some exchange, some other website that’s selling these coins off to the public, and we would probably raise millions of dollars doing that. That’s exactly what these companies are.

Luigi: But the crucial part to understand is why people are willing to pay millions. Certainly if we produce a piece of paper with, let’s say, Katedollar—I think that sounds better than Luigidollar, Katedollar, a big picture of you in the middle—I’m not so sure people are buying that for a huge amount of value. But in many situations they do. Why? Because the companies promise to use those tokens in the future for some valuable purpose. For example, I have a student who actually is in the process of doing an ICO as we speak who invented a new way to store your cryptocurrency in a digital wallet that is very secure, and is trying to finance the production of this through some tokens. He promises that people can use these tokens to buy this crypto wallet or to pay for transactions in the exchange he will establish.

That’s what is interesting with ICOs because it’s in between some kind of crowdfunding. We know that people have raised money in crowdfunding by promising to give at a discounted price, or at zero, a product to the people who contribute to their endeavor. Here, instead of promising necessarily the product, you give immediately some tokens that can be used to buy the good or can be used for something else.

Kate: I’m sure there’s some completely legitimate businesses out there that have good business ideas and a team put together to actually use the money that they’ve raised to create good products. But what’s concerning about ICOs right now is just that a lot of investors think that this is an easy way to make a quick buck. They’re so interested in trying to double their money or make 1000 percent ROI right away that they’re not really doing much research into what these startups are.

For example, there is a token called UE Token. You can look at it at When you go to the webpage, it says immediately, “You’re going to give some random person on the internet money. And they’re going to take it and go buy stuff, probably electronics to be honest, maybe even a big screen television. Seriously, don’t buy these tokens.” They raised $40,000. I mean, yeah, $40,000 isn’t a whole lot. But there are still people who are not paying attention to the extent that they didn’t even read it. They just gave that person money. Hey, I would like $40,000 if I could. That was like a hack. That was obviously not real. But there are a lot of people across the world, like in Russia for example, who are trying to make websites and descriptions of companies that look very real that are raising hundreds of thousands, if not millions, of dollars from American investors through these tokens which will never be put to good use.

Luigi: If you’re saying that there is a speculative frenzy and things are out of whack, I completely agree. But this is not limited to the ICOs. We are of the view that we’re not there to regulate stupidity. To some extent, people can take a gamble as long as they are aware that they are taking a gamble.

Kate: Whoa, whoa. The US government is absolutely in the business of regulating stupidity. That’s why we don’t have casinos everywhere. And that’s why most forms of online gambling are illegal. That’s why even sports betting is probably going to be highly regulated soon. That’s why the Consumer Financial Protection Bureau exists. The government doesn’t want people who have worked really hard to earn $15 an hour and put away $3,000 in savings, the government doesn’t want that person to try and go triple their money by investing in cryptocurrencies in the same way they don’t want them betting on a horse. I think that the risks in cryptocurrencies, particularly in ICOs, are a lot worse. There’s a lot more potential for just outright fraud.

Luigi: I agree. But I don’t agree with the strong position that, for example, China or South Korea took to say every ICO is illegal. Some ICOs can be legitimate. We want, with the proper amount of protection, but we want people to experiment. I think that in some situations, the ICO could be a very effective way to raise money. Why do we allow crowdfunding of products by financing the purchase of future products and we don’t want to allow ICOs?

Kate: Here I think it’s important to talk about what exactly the SEC did. A few months ago the SEC took the position that they’re going to start regulating ICOs and tokens that are created by them. And the way they’re going to start regulating is that they’re going to distinguish between tokens that are utility tokens versus tokens that are security tokens. A utility token might be something like, OK, Luigi and I want to raise money for our podcast. We create a token. We issue it to people who want to purchase them. And if you buy a token then you can listen to one of our special podcasts because that token is linked specifically to a good that you’re going to get in the future.

But some startups are also creating tokens that are linked to, say, cash flows of the start up. A company might say, “Oh, we’re going to raise tokens. And if we make money in the future, you’re going to get like one tenth of one percent of the cash that we make each year.” That looks an awful lot like just a regular stock that people could purchase except the way that the stock was issued was behind the back of the government. Most companies when they issue stock, they have to comply with a bunch of regulations. And issuing security tokens is a way of doing this without government oversight. The SEC is saying you can issue these utility tokens, but you can’t issue security tokens.

Luigi: The problem is that this is a world market. The United States can prohibit the ICO. You can do the ICO in other countries. My student has organized the ICO in Singapore. We know that you can pay with bitcoins for an ICO, bypassing the banking sector. You’re an American investor. You can buy an ICO with bitcoins in Singapore. There’s very little you can do in the United States unless you ban Bitcoin and you put in jail everybody that even touches one.

Kate: You think that we shouldn’t try and regulate anything on the internet?

Luigi: No. But I think that there are some things that are easier to regulate than others. I think that the problem we have here is the fact that the internet is creating a world market for securities. Up to now the market for securities has been quite segmented. It’s been segmented by regulation. It’s also being segmented by the difficulties in subscribing across the border without using the traditional banking network. And the traditional banking network is supervised by the US authorities because this network works in dollars.

Now, with Bitcoin, this banking network can be bypassed. And that opens really a new world in terms of regulation because the power of the United States is dramatically reduced as a result of that. The power of the United States to nudge regulation all over the world has been reduced. And now we are in a world of more competitive regulation that will probably tend to go to the so-called race to the bottom because competition will lead to regulation to be lower and lower everywhere.

Kate: If anything, I think that regulation of ICOs right now is leading a race to the top. A lot of countries are trying to protect their citizens by enacting really strict regulations on ICOs. I think that the US should be part of that. I think that our citizens are only going to keep being hurt until we do that. But I also think that there is a point to be made about protecting people’s faith in well-established capital markets particularly in the US. The SEC regulates securities that are being issued by companies, and as you pointed out one of the problems with ICOs is that start-ups can make tokens that don’t really look like securities even though they may be securities. That will lead to an explosion of companies raising money through these ICOs and dodging the regulation of the SEC. That’ll be cheaper. It’s cheaper for companies to issue not under regulation than it is to issue securities while being regulated.

Right now we have faith that if you invest in a stock, you’re not going to be ripped off. There’s a sound system of corporate governance. And there is no guarantee with these start-ups that are issuing tokens through ICOs.

Luigi: I agree with most of what you said. I am, however, worried about throwing away the baby with the bathwater. Is there a lot of bathwater in ICOs? Absolutely. Is it all to be thrown away? No. It is an innovative way to raise money. I think it is possible—of course there will be litigation, but there is litigation in everything in the United States—it is possible to try to mark some boundaries of what is a security and what is not a security. And I envision that this method could be useful to launch new platforms, in the sense that we know that in a world of winner-take-all markets the rents tend to accrue to the creator of the platform and to some extent in a disproportionate way.

Let me make a concrete example. Suppose that now I want to compete against Uber or Lyft in the market for basically passenger services. The way I want to compete is by asking a lower percentage fee from the drivers and offering the same price to customers. Now, the drivers will come to me, but the customers will not see a lot of the benefits of coming to me, so without customers there will be no drivers and my platform will disappear. However, if I can incentivize customers to start using this platform by giving them some tokens and saying, “If my new platform will be very successful, these tokens are redeemable in free rides at some point,” then I have a very easy way to market it. That facilitates entry, facilitates competition, keeps lower the prices of Uber and Lyft. I think that overall it’s a great thing.

Kate: I acknowledge that tokens and ICOs represent an innovative way of raising money. But we don’t need some new-fangled cryptocurrency. We already have crowdfunding platforms that allow companies to easily raise money for a future product. Yeah, we would be putting a bit of a damper on companies that are legitimate that are raising money this way. I just think that the benefits of regulating it out of existence outweigh the costs. Also, by the way, I want to make an important distinction here. I think Bitcoin and blockchain technology is incredibly important. I think once the volatility that is in large part driven by ICOs dies down that it will be continually used as a medium for exchange. And I also think that blockchain technology and cryptography to secure ledgers and secure transactions, I think that that will start being used more and more by private institutions as well as potentially the government to make things more secure. We do need to worry a lot about cybersecurity. I think there’s a lot of value in blockchain. I just think that ICOs are too dangerous.

Luigi: Kate, we should rush to sell our Katecoin before you succeed in blocking all ICOs.

Kate: If you want to make Katecoin, be my guest. But I’m not endorsing this sort of activity.

‘Quitaly.’ ‘Italeave.’ Whatever you call it, Italy’s recent election results are stoking fears that the once staunch supporter of the EU may be the next country to exit. Kate asks Luigi, our resident Italian expert, how we got here and why it matters.

Speaker 1: The market is getting very spooked by what’s going on in Italy, and we know that-

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

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

Luigi: And most importantly, what isn’t.

Speaker 4: Italy officially becoming the next European country to deliver huge victories to far-right populist parties.

Speaker 5: The two biggest winners, the populist Five Star movement and the right-wing League, earned better than 50 percent of the vote.

Speaker 6: Some have said, in recent months, that the wave of populism is over, but it seems to be cresting again, at least in Italy.

Kate: On today’s episode, we’re going to be talking about Italy, its role in Europe, and the most recent Italian elections—whether we should be concerned about it here in the US. We really scratched our heads as to who we could have on the show to be an Italian expert. I think after some time, we realized that we’ve got our own expert right here. Also, what did you have for breakfast this morning?

Luigi: Avocado and grapes.

Kate: No prosciutto today?

Luigi: No prosciutto today.

Kate: Almost every time I talk to Luigi, he’s had grapes and prosciutto, which I think qualifies him to talk about all things Italy.

So, Luigi said something a couple weeks ago which really struck me.

Luigi: Yeah. I said for the European Union, the Italian elections were worse than Brexit.

Kate: That’s pretty crazy to me, because at least over here in the US, there was a ton of hype about Brexit when it was going on, and we’ve heard a lot less about the recent Italian elections. So, why is it so bad for the EU?

Luigi: There are two things that, in my view, can be worse than Brexit. The first one is this is an indication that a country that was super pro-Europe has turned around and become anti-Europe or Euro-skeptic. So you have to realize the that United Kingdom was always a marginal partner, at least in spirit, to the European Union. They joined relatively late, in 1973, and if you look at polls, the polls were always 50-50, 40-60 in favor of the European Union. So there wasn’t a sense that the European Union was really popular in the United Kingdom. Italy was a founding member of the European community that later led into the European Union. This was started in 1957 actually in Rome. The Treaty of Rome is the founding treaty of the European community. For the greater part of the last century and the beginning of this one, the support for the European Union in Italy was enormous. Like 80 percent of the people thought they benefit from being part of the European Union. This support, starting in the early 2000s, started to drift down. Recent polls are more like 50-50, and the vote gave a majority of the votes to parties that are anti-Europe. Not necessarily anti-Europe, but they are, let’s say, Euro-skeptic, if not anti-Europe.

The second is, this election could lead to what I prefer to call Quitaly, where Italy might leave the euro. By the way, according to the treaty, leaving the euro implies also leaving the European Union. So it will be similar to a Brexit but much more disruptive than the Brexit because it might involve the breakup of a common currency.

Kate: Right. This is a distinction that still confuses me, I’m a little embarrassed to say. Could you walk us through what you mentioned just now, the Treaty of Rome in 1957, but also how that led to the formation of the EU, as well as the eurozone and what the differences are between those things?

Luigi: Immediately after World War II, there was a very strong push to try to make France and Germany be allied to avoid what happened twice in the century, i.e. a major world war about the tension between France and Germany. The nutshell of what is now the European community started as a commercial deal, mostly between France and Germany, to make accessible to France some of the coal and steel in Germany, to make it more difficult for Germany to become powerful again militarily and start another world war.

That original agreement was formed by France, Germany, and then surrounding countries: Netherlands, Belgium, Luxembourg, and Italy. One of the big changes between the European community and the European Union was that when it became a European Union in 1992, it introduced also the free movement of people within the union. If you are an Italian, you can freely go and work in Belgium, and if you are from Poland, you can freely go and work in France. In the process, a lot more countries were admitted to this union, starting with Austria, that used to be a neutral country, and so on and so forth. Then, around that time also, some of the core countries signed a treaty called the Treaty of Maastricht to create a common currency.

Kate: So, to be clear, where the eurozone is the group of countries that adopt the euro, a single currency, whereas the European Union was just a broader set of countries with a centralized governing body that mostly oversaw ... What? Commercial deals? Trade agreements?

Luigi: The centralized part is very weak. We do have a European parliament, but it’s not very powerful. Basically, think about there is a commercial union that is called European Union, and then there is a common currency that is called eurozone. However, and this is important, in principle, the idea is that every country that belongs to the European Union eventually should belong to the euro. And, this is crucial for the discussion we’re going to have today, there is no way to exit the euro without exiting the European Union. So the two things, at least on the way out, they are connected.

Kate: So let’s go to Italy after the financial crisis. How has the economy been doing? What’s been going on politically since then? What are other factors that are leading up to the Italian election that just took place?

Luigi: So, the global financial crisis had, as a first-order impact, a strong reduction in international trade. Italy was hit by this much stronger than most countries. Just to give you a sense, German exports dropped by 10 percent. Italian exports dropped by 20 percent. The United States in 2009 had a recession, I go by memory, of 3 or 4 percent. Italy, 5.6 percent. So Italy was hit very, very hard. Then, by the time we’re slowly recovering, we are 2010, 2011, people started to doubt that the Italian government could actually pay its debt. Whenever there is a doubt like this in a country with an independent central bank but a sovereign central bank, the central bank tends to come to the rescue of the government. In the eurozone, this did not happen until late in 2012. In the meantime, Italy experienced a dramatic rise in interest rates, a fiscal crisis, had to cut the budget deficit in a major way, at the time we were just slowly recovering. It’s as if, let’s say, in 2009 the United States, instead of adding a gigantic stimulus package, had to cut their deficit by a huge amount.

That triggered a second recession that had a dramatic impact, also, on the stability of the Italian banks. Over the period 2008 and 2015, 35 percent of the loans to firms got into default.

Kate: That’s crazy.

Luigi: Three major banks basically collapsed, unemployment shot at 12 percent, and youth unemployment shot to 35 percent.

Kate: So what does this feel like for an Italian? Do you have friends and family who are really suffering from these two recessions?

Luigi: Yes. I have my parents. My father passed away in 2015, but at the time, both of them were alive. One of my concerns was, what happens if banks fail and they can’t buy food? One of my concerns was, I want to make sure that they have enough cash at home that if anything happens, they could actually go to the grocery and buy. The possibility of a generalized bank failure was not out of the feasible set. I have a lot of friends who lost their jobs and are unemployed or were unemployed for a long time. I have nephews and nieces who find it very difficult to find a job. I think the typical Italian of the generation of my kids looks forward to expatriating somewhere else. My son, who lives in the United States, got married at age 25, and when he announced this at the family gathering at Christmas, everybody thought he was joking. How could somebody at 25 support himself and actually start a family? In Italy, it’s inconceivable. Generally, you leave your parents’ house when you are 35. It’s not a coincidence that fertility in Italy is one of the lowest in the world. People don’t have kids, because generally, you don’t have kids when you stay in your mother’s house.

Kate: So, did Italy ever recover?

Luigi: Now, Italy is going again, but in 2017, people were celebrating that we grew at 1.5 percent after years of recession or growth below 1 percent. This is not enough, because Italy’s GDP, in real terms, is below what it was in 2007. We still have to recover from the beginning of the Great Recession.

Why the recovery was so slow, a number of things. One is we couldn’t devalue like, for example, the United Kingdom did to recover. The other one, which was quite important, is Italy had a banking crisis due to the fact that when you have 35 percent of your businesses defaulting, basically, it’s very hard for banks to stand. The Italian government found it very difficult to intervene in this banking crisis because there were a bunch of European rules that made this more difficult. That delayed the recovery in a major way. Now, the recovery slowly is taking place, but there is still a huge amount of discontent.

Kate: All right, so now let’s talk about the Italian political system and bring this to the recent election.

Luigi: First of all, it is important to understand Italy is a parliamentary system, not a presidential system, so our president is kind of the Queen of England—decides who to appoint but not much more. I’m exaggerating a bit for simplicity. What decides who rules is basically the set of parties, the coalition, who can get a majority in parliament. Traditionally, you could think about the party being divided into two major blocks. One called, not surprisingly, the Democrats, and very similar to the US Democrats. Another was a coalition of center-right parties, kind of the Republicans, but until very recently, led by Berlusconi, which is not that different from Trump. It’s just a kind of nicer version of Trump.

Kate: Then, more recently, I know that there’s been some turnover in your political system, but Matteo Renzi has been more powerful. He’s more of a Democrat, right? At least, more centrist?

Luigi: Yeah. In 2013, there was some elections in which the Democrat got a majority but not enough to rule. After some internal in-fighting, eventually Matteo Renzi, a young fellow, became the leader of the party and got a coalition with some of the conservatives in order to run the country.

Kate: Can we think of Renzi as like a Macron or a Justin Trudeau in Canada?

Luigi: Actually, the better example is Obama. If I may say, he turned out to be like Obama in that he was better at giving speeches than running the country.

Kate: Yikes. We’ll save that for a different discussion. So, then what happened?

Luigi: Two things happened. First of all, back in 2006 or ’07, a comedian, a professional comedian, started a movement. The first gathering of this comedian was a day that was called Vaffa Day that, I don’t know whether I can say it on air, but basically translated, I’m sorry to say, is ...

Kate: Just say it.

Luigi: Go eff yourself. This was basically a protest movement against the perception, and I will say also reality, of a country that was stuck with old politicians, old businesspeople, most of them corrupt. Just to give you a sense, the leader at the time, Berlusconi, was in his late 70s and had been in politics for more than 20 years. The largest banks were run by people in their 80s. The president of the republic was in his late 80s. It was what we call a gerontocracy. That is a fancy name to say ruled by old people.

Kate: A bunch of geezers.

Luigi: The great feature of this movement is it was appealing to both sides of the political spectrum. One some issues, it was more on the left side, like environment, like anti-corruption. On some issues, it was more right-wing. For example, concern about immigration.

Kate: All right, so I sort of like the idea of this guy. He at least sounds fun to listen to. Was there some expectation that he would actually do well?

Luigi: No, at the beginning, he was considered like a caricature, as you can imagine. He has a degree in accounting, which is something you don’t expect from a comedian.

Kate: From a comedian, yeah.

Luigi: But that puts him better than most politicians. Actually, the right example is like John Oliver. So imagine a John Oliver starts a political system.

Kate: So, what is this Five Star movement?

Luigi: The answer is we don’t know yet, but this is the interesting thing, is the movement, first of all, called itself a movement, not a party, because they try to be post-ideological. If you take away the jargon, they are trying to get people to express their opinions from bottom-up. So they tend to be less strict ideologically than most parties.

Kate: So in addition to Brexit, something that got a lot of attention in the American press was the refugee crisis from Syria, which involved a lot of provocative images of people washing up on beaches, boats full of people immigrating to Europe. To what extent has immigration and potentially anti-immigration sentiment been as strong in Italy as it was in England and Britain?

Luigi: It’s interesting that you mention Syria. You don’t mention Libya. There was a major refugee crisis from Syria that went through Greece and, eventually, to Germany. That was stopped by an agreement between the European Union and Turkey. There’s still an open crisis, actually, through Libya. Italy is at the front line of this crisis, and this is a crisis, you’ll be happy to know, that is not being caused by American interventionism. There was a major attack to Libya that destabilized the Libyan regime, and now, Libya is a failed state that favors illegal immigration to Italy. In case you don’t get your geography right, little Italian islands are very close to the shore of Libya, so there are a lot of people that make money by bringing potential immigrants to the border of the Italian sea border and then dumping them there and Italy rescues them. Then, this is the interesting thing. The European treaties say that if you rescue an illegal immigrant, that illegal immigrant must remain in the country that receives it. It’s as if all the illegal immigrants in the United States went through New Mexico, and New Mexico was responsible, out of the state budget, to pay all the costs of all the immigration. So Italians are mad about the situation, but they are not so mad against the immigrants. They’re mad against Europe.

Kate: Wait, but I thought the whole idea of the EU was that people could move freely between countries.

Luigi: Except if you are an illegal immigrant. The rules say if you’re an illegal immigrant, you have to remain in the country that accepted you. Of course, all this immigration created a huge resentment against the European Union that added up to the economic discontent. I want to be very clear: the economic discontent is not only the responsibility of Europe, but certainly, Europe did play a role. The rest of the role, I think, was played by the Italian establishment. The combination between the two created a perfect mix to have parties that are antiestablishment and anti-Europe to win the election.

Kate: OK, but as of right now, it seems like since no one has the majority, Italy is sort of stuck at a stalemate. Couldn’t this be good for the eurozone, then?

Luigi: Depends what you mean by good. Is it good in the sense that it postpones problems? Absolutely. It’s going to be more calm, and the markets seem to be very calm at the moment. I have to say that even Germany took six months to form a government, so it will not be surprising if it takes six months to form the Italian government. There is a possibility of new elections. So we don’t really know what is going to happen in the near future. The question is, can the eurozone reform itself in a way that makes it more viable for countries like Italy to be there? Or at some point, do we need to conceive a breakup? At some point, I conceive a breakup in which Germany will leave from the top. It’s much easier to leave a currency union from the top rather than to leave from the bottom. If Germany wanted to leave and create a northern euro, that I will label the neuro, it will be a strong currency and will make it much easier for the rest of the union to go along.

The problem of this is, seriously, where will France fall? This has always been the dramatic question in the European Union, because France is more like a southern European country than they want to admit, but they want to be in a coalition with Germany in order to avoid another world war. If Germany were to leave the euro from the top, France would be forced to either join the German currency union and basically destroy its economy or be with what they call, with a lot of contempt, the Club Med, and be with the southern European countries. I don’t think that any French president will allow that to happen, because it will touch their national pride.

Kate: It sounds to me, actually, like what happens in Italian elections don’t really matter for the eurozone or for the EU. If Italy is so screwed if you leave because that will trigger bank runs, which will just plunge Italy into another very deep recession, then, in some sense, you’re stuck. So Germany can just treat Italy however it wants, right?

Luigi: I think that we can look at the example of Argentina. Argentina was in a unilateral currency union with the dollar. For many years, the currency union worked very well. Then, there was an increasing problem in Argentina to export and an increasing problem in Argentina to pay the debt. All the governments have promised that they will never exit the currency, and eventually, they did, and they defaulted on the public debt. It took five presidents in two months to do that. It’s extremely politically disruptive, because the person doing it is not going to survive.

There is this famous line that if something is not sustainable, eventually, it will not be sustained. It’s not that deep, but it’s actually quite important in thinking about this thing. Is the euro sustainable for Italy long-term? I have my doubts. In many ways, the last few years have been the best possible world for Italy because interest rates were incredibly low, the euro, until recently, was relatively cheap vis-a-vis the dollar, and oil prices were quite low. The combination of these three, if you have to pick the best variables for Italy’s economy, those are the three variables. With this magic combination, we achieved 1.5 percent GDP growth. The upside, in my view, is limited. The downside is quite serious.

Kate: So, what should the leaders of Europe do, both the leaders of Italy after the most recent election as well as the leaders of the EU and the ECB?

Luigi: I think that in Italy, it’s relatively simple. Simple to say, very difficult to do. You need, really, to turn over the existing establishment. The message was very clear: Get out of the way. I think that, potentially, in terms of votes, the parties that won the election have the force to do that. Now the question is, it’s easier to send home people. It’s not easy to find qualified and competent and better people to replace them in a short period of time. I think that is their first mandate, and they should work on that. The second one is trying to do a good-faith effort in renegotiating the situation in the euro. For example, pushing for a European unemployment insurance, to me, should be a first priority. I think that negotiating hard on this, if they succeed, possibly, the situation is fixed. If they fail, I think they will have a stronger mandate to say, “You know, we can’t continue like this, so maybe we should think seriously about breaking away from the euro.”

The European leaders should pay attention. I think there was a sense in which people thought that you could govern Europe from Frankfurt. The perception was once we control the common currency, we can control the politics on all the European countries. I think the message from Italy is people are sick and tired of this. Part of the aversion toward the euro is that people are starting to see this game. So I think it’s very important for both the political authorities but also the monetary authorities to understand that the game has changed, and they have to change the way they play it.

Kate: So I don’t know if I speak for all Americans when I say this, but at the end of the day, I’m pretty selfish. I care about what happens here. So why should America care about what’s going on in Italy?

Luigi: I think for two reasons. First of all, if Italy were to exit the euro, probably the euro will break up in a major way. This will create economic and political turmoil in Europe with dramatic repercussions in the United States, as well. I think that just for those spillovers, you should care about it. Second, many people, after the 2016 election that brought a lot of populism to victory in the UK and in the United States—2017 sounded like a pretty stable year with Macron winning France and, in the Netherlands, the populist is not gaining too many votes, and in Austria, the right-wing candidate did not win, and so on and so forth. So people thought that was the end of it and things will subside. The Italian election suggests that, no, that people are upset. When they get to vote, they vote very strongly antiestablishment. In the grand scheme of things, the Five Star movement is not the worst thing that can happen, because they are pretty moderate in many policies, except for their anti-European bias. If they were to fail at the government this time, we could have more radical movements. I think that the easy way to manage Western democracy that prevailed for most of the period after World War II, I think is broken and is broken in Western Europe, is broken in the United States.

Kate: All right, well, Luigi Zingales, it was a pleasure having you on the show.

Luigi: Thank you, Kate.

10 years after dark pools of derivatives contributed to the Great Recession, former Commodity Futures Trading Commissioner Sharon Bowen tells Kate & Luigi how she helped bring transparency to the market and visited a few grain silos along the way.

Speaker 1: You know what, right now, breaking news here. Stocks all around the world are tanking because of the crisis on Wall Street.

Speaker 2: It was a historic day with Wall Street shaken to its very foundation today.

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

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

Luigi: And most importantly, what isn’t.

Kate: On today’s show, we have the great pleasure of welcoming Sharon Bowen. Sharon served as the commissioner of the US Commodity Futures Trading Commission, or the CFTC, from 2014 to 2017. Before that, she was vice chair of the Securities Investor Protection Corporation and before that, she was a partner at Latham & Watkins. Welcome to the show.

Sharon Bowen: Thank you, thank you for having me.

Luigi: Let’s start by going back to 2008. In September of that year, the world was coming to an end. On Monday, Lehman filed for bankruptcy. On Tuesday, AIG asked for the government to rescue them.

Speaker 6: What in the world is happening on Wall Street?

Speaker 7: Two-year note yields went from 190 to 166 in the blink of an eye.

Speaker 8: I have never, live, looked at the DOW Jones Industrial board and seen a 600-point loss.

Speaker 9: Who knows where this is going to end up? This is volatility we haven’t seen of course, since way before you and I were born.

Speaker 10: By what Warren Buffet once called financial weapons of mass destruction.

Luigi: Sharon, when was the first time in that ominous fall that you got a sense that this was really big and this was really scary?

Sharon Bowen: I would say it was the weekend before, I was starting to get emails to basically say don’t be surprised if you see numbers being thrown out about some investment banks being sold for $2 or some of them possibly going out of business. There were a lot of rumors over that weekend. When I woke up that morning and just saw the market just go straight, straight down, it was scary. It was absolutely scary, and I don’t think any of us really knew what it really meant. We just knew it was really bad. It was really, really bad. And you saw the pictures on the news of people packing up their boxes, businesses closing down, the restaurants that used to rely on the businesses to come to eat lunch were closed, and the dry cleaners that used to clean were closed. The taxi services and car services that used to be there closed.

Being in New York City, I saw sort of the ugly parts of the financial crisis pretty much up close and personal.

Kate: Are you allowed to talk about your clients at the time, and whether any of them were particularly affected by what happened to Lehman and AIG?

Sharon Bowen: Well, all of them were affected obviously. Lehman had been a client of my former firm.

Kate: Oh, wow.

Sharon Bowen: We knew people who actually worked there.

Luigi: When you were invited by President Obama to serve on the CFTC, did you feel like a sense of mission that here we are many years later, and we tried to prevent what happened in 2008 and as we will discuss with the listeners in a second, the CFTC plays an important role in preventing a repeat. Did you have a sense of mission?

Sharon Bowen: I did, but it actually started with my being the acting chair of SIPC, Securities Investor Protection Corporation. SIPC traditionally is a sleepy organization, but during my time, we had the Lehman Brothers bankruptcy, we had the Madoff scandal, we had MF Global. We had some of the most notorious–

Luigi: An easy time.

Sharon Bowen: Yes, and through that lens, I got to meet with many investors who were severely harmed financially from the marketplace, and as I mentioned before, seeing the devastating effects on family members and people’s retirement savings. I actually did, I really felt a calling to do it, plus as it turned out, I was the first African-American commissioner of the CFTC.

Kate: That’s amazing.

Sharon Bowen: It was quite an honor to play in that role, but as I said then at the time of my confirmation hearing, that I wanted to be a voice of the voiceless, those who traditionally had never had a seat at the table.

Luigi: That’s exciting because most people probably don’t know what the CFTC is, and you said giving a voice to the voiceless, and when people think about giving a voice to the voiceless, I don’t think they think of the CFTC as the primary place, but I think it’s a very important role. How do you explain to your kids, to your mother, to your friends what is the CFTC and why it was so important what you did there?

Sharon Bowen: There are two different ways that I explain it. For the everyday person, I try to explain how the electricity in your home, your heating bills, the gasoline you put in your car, the milk that you drink, everyday products are financed through instruments that we regulate in our commodities markets. We have our roots in agriculture. Initially, the CFTC really started as a means for farmers and ranchers and manufacturers to hedge against the future prices of products, so it’s a way for farmers and ranchers to mitigate the fluctuation of prices going up and being able to lock in today the price of a particular ingredient so they would have some certainty in terms of that price.

For other people, I will sometimes say it’s things like how much you pay for your mortgage. Interest rates, everybody’s tied to it, credit default swaps are tied to it, financial currencies are tied to it, so they’re financial instruments and obviously, derivatives, some of them a little bit more esoteric instruments, but again, they’re used for hedging.

Virtually every corporation uses it. Everyone is really affected by it, frankly, every day.

Kate: You gave the example of let’s say a farmer using commodities futures or derivatives to hedge the future price of some input, let’s say it’s like feed for their livestock, but one of the dangerous things about derivatives, correct me if I’m wrong, is that you don’t have to be a farmer in order to buy let’s say those derivatives. You could be like a regular person. It could be me, and if I want to take a bet on the price of feed going up, I could buy a derivative that will pay off if it goes up by a lot, and if it goes up by a huge amount, in let’s say like an unlikely event, chances are I won’t have to pay much to take that bet. Is that part of what makes derivatives so risky?

Sharon Bowen: Well obviously, there is speculation in our markets. You’re correct in the sense that we did hear, while I was at the agency, from some of the farmers and ranchers who really were concerned about the volatility in their markets and who thought that the high-frequency traders were in their markets and making price discovery much more difficult for them. Whenever we hear things like that from end users, we take those kinds of things seriously. We take a look at the markets, but speculation in and of itself is not bad. That is part of price convergence and price discovery, but it’s the excessive speculation and the manipulation of the market that we protect against.

Kate: By end user, you mean people who are truly using derivatives in order to hedge against risk, right?

Sharon Bowen: Correct.

Luigi: It will be useful to de-mystify the term derivatives, because people use it all the time and many listeners might say, “What exactly is a derivative?” Now, a derivative takes its name from the fact that there is a security whose payoff derives from the payoff of something else. If you own a house, hopefully you have insurance on that house and that insurance is a derivative because the payoff of that insurance derives from the payoff of the house. In that particular case, the insurance is a hedge, it protects you against the possibility of fire, earthquake, something that might destroy the value of what for many of us is the most important asset, which is your home.

Like for insurance, there are many derivatives that are meant to hedge, to cover the risk of what people do, from people planting in their harvest, to people using livestock to feed their animals, and so on and so forth. However, as Kate pointed out, in order for the market to work properly, you don’t have only hedges, you have people that provide the service with the hedges that have the terrible name of speculators, and those speculators in part serve to make the market liquid, in part may actually destabilize the market.

In the last 10 or 15 years, the number of participants in these markets has increased dramatically. And especially in many commodities markets, there used to be mostly final users, and around 2004-2005, we saw an impressive entry of the typical financial institutions, the Goldmans and Morgan Stanleys of this world, and not surprisingly, the final users started to complain because the volatility went up. What is your view on that, if you have one?

Sharon Bowen: Right, well see, taking it to the extreme, we can talk about the financial crisis, when in fact, we were not regulating those derivatives. We had no idea what was happening in those dark pools in the market, and as a result of the financial crisis, as you know, the Dodd-Frank Act came into place, and that expanded greatly the powers of the CFTC to regulate the so-called derivatives, the esoteric transactions that clearly exacerbated the financial crisis at the time. With that, extensive rules were put into place to require, for example, capital to be there that normally was not required by some of the financial institutions.

We required that they be cleared in a much more transparent way and executed on platforms. For the swaps and derivatives that were not subject to what we would call margin, we made sure that the cost of capital was even higher, so we really wanted to force onto a lit exchange those very transactions that were really dark and opaque. We had no idea what they were at the time. Through Dodd-Frank, we were able to bring some transparency to the market and to try to mitigate the systemic risk that those kinds of instruments really posed.

Kate: To clarify what you just mentioned about clearing, which was an important part of Dodd-Frank, yes, there were a lot of derivatives that were cleared prior to the financial crisis, but there were some derivatives that were sort of operating in the shadows. Let’s say I was a speculator and I wanted to just make some money by making a bet that locked in the future price of let’s say corn feed. If I were to make that bet one-on-one with my investment bank prior to the financial crisis for certain derivatives, the government might not know about it at all. This could’ve just operated in the shadows.

Part of what clearing did was not only to bring these transactions into light, make sure that somebody was monitoring them, but clearing or clearinghouses also make sure that whoever was taking the other side of the bet, whoever would have to pay out in the future, potentially, has enough money on hand, enough capital in order to meet let’s say what would happen if I were to receive some money in the bet. Is that an accurate way of describing the role of clearinghouses?

Sharon Bowen: That’s a really good job of it, I think. To bring onto the markets those transactions that were otherwise opaque. Most of those that got us into trouble were the credit default swaps and interest rate swaps and those kinds of transactions that were kind of off-exchange. You’re correct, one of the mandates was to introduce central clearing of standardized products into the market, and because of that, I mean at that time it was something like a $700 trillion notional amount market. It was a huge market that we really, frankly, didn’t know how big it was.

We have now created a whole new structure where these transactions take place in clearinghouses, and those transactions as you say are subject to margin, which is collateral, i.e. cash or highly liquid instruments to support the payment of those obligations. The clearinghouse stands in the middle of the buyer of the trade and the seller of the trade if you will, they stand in the middle and their job is to mitigate the risk that the trade would fail. That’s the purpose of the clearinghouse. Whereas before, people had to depend on each other’s credit as to whether or not they were worth the transaction.

That was the major difference in bringing clearinghouses and the transparency. At the same time, the participants in the clearinghouses were required to be registered. The third thing that happened was data had to be reported.

Luigi: Sharon, you mentioned the magic word, credit default swap. This word was unknown to the large public until 10 years ago, when it became a matter of conversation all over the country because they were one of those derivatives that might have caused or exacerbated the financial crisis. Let’s first explain what they are: credit default swaps is basically nothing else than insurance against the possibility that a borrower may default and not pay the actual amount. Instead of being an insurance written by an insurance company, it is actually an instrument traded on the market.

Here, I need to bring you back to history because historically, the CFTC did not have any authority to regulate these kind of derivatives, and a very courageous woman, Brooksley Born, in ’98 tried to actually ask for the authority to do so because she realized that these instruments were traded over the counter, which means between banks, and there wasn’t really a good understanding of what was happening, and in particular, there was a fear that too much risk was taken and this risk might materialize as it unfortunately did in September 2008.

When she insisted that, she found herself surrounded by a bunch of angry men, can I say that, starting from the Federal Reserve chairman at the time, Alan Greenspan, to the Secretary of the Treasury at the time, Larry Summers, and they actually said that this was a terrible idea and made everything possible to stop this from taking place, and so she ended up resigning. Did I tell the story correctly, Sharon?

Sharon Bowen: I wasn’t there at the time, but as I understand the story, you’re right. Former commissioner Born was one of the first to signal the problem that could be inherent in these types of products. My understanding at the time was that some of the other potential regulators, the Fed and the Treasury, thought because the transactions were between highly sophisticated investment banks trading with each other, they were sophisticated enough to be big boys playing in the same field, if you will.

Luigi: Yeah, you used the right term, big boys.

Sharon Bowen: Right.

Kate: One of the, I guess, concerns I think voiced by Greenspan and Summers and others against bringing these sorts of derivatives and swaps onto centrally cleared exchanges was that there’s some cost to having to do that, correct? You have to pay some sort of fee. You aren’t allowed to operate privately anymore. Also, you have to comply with the rules of the clearinghouse or the exchange. I think one of their concerns was that if the US started imposing these rules, a lot of these transactions would go offshore to potentially riskier domiciles. Do you think that that’s actually a legitimate concern?

Sharon Bowen: It was a concern and, you know, as a result of the financial crisis, we had the meeting of the G20 in Pittsburgh, which is really sort of the beginnings of the creation of Dodd-Frank, where the major financial centers and countries said, “We need to work together to make sure that our markets are protected globally,” because these markets are global markets, the transactions don’t stop at our borders. It’s really important, and at that time, a number of working groups, international working groups were formed to try to create standards across jurisdictions. I think our agency at the time with the CFTC, and I’m sure it’s the case today, works really closely with international regulators, particularly those in Europe, where things like interest rate swaps and CDSs are traded in a large percentage outside of the US.

You’re absolutely right, it was expensive. Industry did have to invest a lot of money, but I think it was well worth the cost to mitigate the kinds of risk that we would have such a devastating effect again. At least with the margin, having margin there and collateral—sort of the two defenses, if you will, to a failure of a clear member—that, I think, gives us the possibility that we’re less likely to have another taxpayer bailout, which was the whole point.

Luigi: Some people, not of course all, but some people interpret the cost benefit analysis as, I see a cost, I don’t see benefits, let’s get rid of all of it. That, of course, is wrong. It’s also wrong that any regulation is useful because as we were discussing earlier, there are a lot of pieces of regulation that are more burdensome than useful. Cost benefit analysis is useful, but it’s challenging, and particularly when the benefit is preserving the trust of investors in the marketplace, which–

Sharon Bowen: It’s priceless.

Luigi: It’s priceless, exactly.

Sharon Bowen: Yeah, it really is priceless. I mean you do want to have investors have the confidence to be in our markets. If they think it’s a rigged system, that’s not a good system. I think that transparency is always the key. Having fair, transparent markets, as long as we can keep our markets fair and transparent, I think you’ll have investor confidence. That works for all participants, not just investors, but competition is competition. The brokers, they compete against each other so they’re not going to want to see one person game the system over someone else either. They want to see a level playing field.

Kate: I want to switch gears, if I may. If I’m correct, when you resigned from the CFTC, you cited your lack of ability to form a quorum amongst commissioners as part of the issue. In order for there to be a quorum, there’s supposed to be five commissioners, there have to be three for there to be a quorum, but there were only two commissioners that were even standing at the time that you resigned, right?

Sharon Bowen: When I left, two new commissioners were in place. In June, I had announced my intent to resign, I didn’t give a date certain. Part of my announcement of my intent to step down was my hope was that I would add a little pressure if you will to Congress because if I left, it was questionable how much chairman Giancarlo could do by himself. And you’re right, it should be a five-person commission, and whichever party is in charge in the White House gets to pick the chairperson of the agency, and the majority would be three Republicans, two Democrats.

I can tell you, my experience is the CFTC is not a partisan agency. There is no Republican answer or Democrat answer, it’s that we all are trying to achieve the right answer. During the time I was there as a commissioner, I think the number of times that all of us voted unanimously was like over 95 percent. For the most part, we pretty much reached consensus.

Luigi: Should we take from this, I don’t want to put words in your mouth, but should we take that maybe some of this anti-regulatory stand that we hear in the newspaper that seems to destroy this is a bit excessive? That in reality, this is a normal process of pendulum that after a crisis, you tend to regulate and when you regulate, sometimes you tend to overdo it, and then you go a little bit back and you try to find what is really important and dismiss the parts that might be excessive or excessively burdensome?

Sharon Bowen: No, I think that’s right. Also, not just us, but the Europeans with MiFID II, they’re also going through a review of their rules to see how they can make their rules better at the same time but yes, no, you’re absolutely right, and that makes sense. These rules are complicated. Some of them did have unintended consequences that we really attempted to try to eliminate those cases where we were putting undue costs and burdens on particularly end users who were not posing a systemic risk to our market. The kinds of changes we made were to try to correct some of those unintended consequences.

I think at the same time, the industry is fully invested in the protections we now have in place and you would be hard-pressed to find, you’ll find them complaining about the cost but you’d be hard-pressed to find one who would not say that we’re not better protected today than we were before 2008.

I think that makes us more competitive. In fact, some of them will tell you, that makes us more competitive and it makes our financial markets, frankly, the envy of the world because in fact, our markets are safer.

Kate: But there are still derivatives out there that are relatively opaque, right? There are derivatives that aren’t cleared, particularly ones that are more complicated. Is there any way to know whether they pose systemic risks?

Sharon Bowen: All swaps, whether they’re cleared or uncleared, are reportable and subject to margin, but are there dark pools out there? I’m sure there are dark pools that are out there but-

Kate: What is a dark pool exactly? Can you just define that really quickly?

Sharon Bowen: Yeah, that’s off-exchange. I call it dark because it’s not on an exchange—there’s no transparency, which is why it’s dark. I’m not sure why it’s a pool, it could be a park.

Luigi: The name sounds very ominous but why are you afraid of those dark pools?

Sharon Bowen: We got bit by one in 2008. It was like an avalanche. It hit us in a way that we had no idea, it was a pretty bad bite. We should all be afraid of dark pools.

Luigi: I think then the major problem is you don’t see them coming because-

Sharon Bowen: Correct.

Luigi: The reason why they’re called dark is because you don’t see the data, and transparency is a big help in those situations.

Sharon Bowen: Yes, absolutely.

Luigi: Going back to the decision-making process, you are saying that there is a procedure of course ...

Sharon Bowen: Yes.

Luigi: ... where you hear all the sides but one of the concerns is banks have very good lawyers and lobbyists that are representing their side, and farmers and individual users are not as well-organized and they tend not have good lawyers and good lobbyists. What do you do to-

Sharon Bowen: You’d be surprised by that, actually.

Luigi: How do you make sure that you’re not fooled by this imbalance? It’s kind of you are a judge in which on the one hand, you have a slick lawyer, on the other hand, you have somebody defending himself?

Sharon Bowen: Right. Well, it’s interesting, so all three of us had Wall Street backgrounds, and none of us had an ag background. And so we all met the farmers and ranchers. We went out to the grain elevator here outside of Chicago, we made trips to see the whole process, which really, frankly, I encourage everyone to do that. You will view food a lot differently after you go through that-

Kate: Can you just show up at a farm and ask to be on a grain elevator?

Sharon Bowen: It’s a lot more sophisticated than you can even imagine, the use of GPS and the use of technology to tell you how often to water. I mean it’s just fascinating, but because of our financial backgrounds, I think people were, they knew they couldn’t pull the wool over our eyes, frankly. We had represented some of them in past. We had the business background and Giancarlo also had represented the wholesale markets, former chairman Massad had worked on derivatives when they first started, as I did too in my career. So we were pretty familiar with the financial part of it, so there was no hocus pocus with firms being able to pull a fast one on us.

Kate: The Intercontinental Exchange, ICE, isn’t that one of the clearinghouses that regulates derivatives?

Sharon Bowen: They do have a couple of the clearinghouses that we regulated at the Exchange.

Kate: With all due respect, are you concerned at all about going from the CFTC to a clearinghouse that you were formerly regulating?

Sharon Bowen: Yeah, so the way I would view it is, I bring a level of expertise, obviously as a board member, I’m not a part of the management with the day-to-day operations of any of the subsidiaries. Frankly, the things I’ve always stood for, transparency, which is really key, investor protection, those are the kinds of traits and qualities that ICE really stands for.

Luigi: I suspect you’re probably one of the toughest customers on that board.

Sharon Bowen: That’s correct. It takes guts for someone to want to have a former cop on the beat, if you will, on your board, it means you have confidence in your operations.

Kate: Sharon, I have a term for you, it’s a little bit of a jargony term: you’re a BAMF POC boss lady, which is a very specific economics term that stands for badass mofo person of color, extraordinary woman.

Sharon Bowen: Oh, OK. That’s a good one.

Kate: Yeah, it’s a term that we throw around a lot in academia.

Sharon Bowen: OK.

Kate: I wanted to ask you if you could tell us a little bit about how you got to where you were, what the toughest parts of your journey were, and also whether you have advice for young women and young people of color for how to make it in law and finance?

Sharon Bowen: That’s about three books that you just asked me.

Kate: OK.

Sharon Bowen: I can give you-

Kate: Well, can you give it to me in two minutes?

Sharon Bowen: I can give it to you in two minutes. I had an interest in markets pretty early on in college. Majored in economics at the University of Virginia. Didn’t know what I wanted to be when I grew up. Applied to business school and law school. Northwestern and the University of Chicago were the only two schools that gave me full scholarships to both the business school/law school. Went to Northwestern for law school/business school.

Luigi: Sorry you made the wrong choice.

Sharon Bowen: Yeah, you know, what can I say?

Kate: It’s pretty rare.

Sharon Bowen: Yeah.

Kate: I mean I’d never heard of anyone who had a full ride at both.

Sharon Bowen: Yeah. No, I got academic scholarships to both schools, but wasn’t really sure what I wanted to do. I spent summers at Goldman Sachs, Chicago Board of Trade. Started my career at Davis Polk & Wardwell. Like most young people, thought I’d work for two years, retire at the age of 30 at Goldman Sachs. Loved the practice of law a lot, and as a fifth-year corporate associate, as Latham was growing its New York office, became a partner, had great clients, great work. Just really fortunate.

The advice I would give to people is to follow your passion in terms of the things that motivate you to want to get up every morning, and treat it like a marathon.

Kate: Well Sharon, it has been a great honor and a great pleasure having you on the show. I learned a lot today about the CFTC. I think I maybe understand what it does now.

Sharon Bowen: Pleasure to be here.

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

Academic articles

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


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.