Luigi Zingales of the University of Chicago talks with EconTalk host Russ Roberts on whether the financial sector is good for society and about the gap between how banks and bankers are perceived by the public vs. finance professors. Zingales discusses the costs and benefits of financial innovation, compares the finance sector to the health sector, and suggests how business education should talk about finance to create better behavior.
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Readings and Links related to this podcast episode
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About this week's guest:
Luigi Zingales's Home page
About ideas and people mentioned in this podcast episode:
Articles:
"Does Finance Benefit Society?" by Luigi Zingales. 2015 Presidential Address to the American Finance Association. PDF file.
"Bootleggers and Baptists--The Education of a Regulatory Economist," by Bruce Yandle. AEI Journal on Government and Society. PDF file.
"Do Business Schools Incubate Criminals?," by Luigi Zingales in Bloomberg Review. July 2012.
"Goldman Sachs' Blankfein on Banking: 'Doing God's Work'," by Matt Phillips in The Wall Street Journal. November 2009.
"The $9 Billion Witness: Meet JPMorgan Chase's Worst Nightmare," by Matt Taibbi. The Rolling Stone, November 6, 2014.
Financial Regulation, by Bert Ely. Concise Encyclopedia of Economics.
Savings and Loan Crisis, by Bert Ely. Concise Encyclopedia of Economics.
Adam Smith. Biography. Concise Encyclopedia of Economics.
Web Pages and Resources:
Volcker Rule . Wikipedia.
Fundamental Theorems of Welfare Economics . Wikipedia. First Welfare Theorem.
Principal-Agent Problem. Wikipedia.
Corruption. Lessig.org. Larry Lessig on institutional corruption.
Podcast Episodes, Videos, and Blog Entries:
Richard Epstein on the Rule of Law. EconTalk. June 2009.
Cathy O'Neil on Wall St and Occupy Wall Street. EconTalk. February 2013.
Kling on the Unseen World of Banking, Mortgages, and Government. EconTalk. July 2010.
Coyle on the Economics of Enough. EconTalk. March 2011.
Finance Archives. EconTalk.
Highlights
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0:33
Intro. [Recording date: January 26, 2015.] Russ: We're going to be talking about his recent paper, "Does Finance Benefit Society?" And that's I think with a question mark, not an exclamation point; but it's a question mark at the end of that phrase. Luigi, welcome back to EconTalk. Guest: Thank you. Russ: Now, as I said, it could be 'Does Finance Benefit Society!' with an exclamation point. But you are starting with some skepticism. And you start with the discrepancy between what academics think of the financial sector, relative to what the public thinks of it. And I want to begin with the academic perspective. What do economists and professors of finance typically think of the financial sector and its contributions? Guest: So, I think that economists and in particular finance professors tend to be quite bullish on the benefit of finance in general and of financial innovation. They think financial innovation boosts economic growth and of course there are exceptions: there are some problems. But by and large their judgment is extremely positive. Russ: And how about the public? Guest: The public doesn't seem to share this, in the sense that even the more educated public, like the readers of the Economist, the magazine The Economist, when confronted with the statement, 'Financial innovation boosts economic growth,' they voted 57% no. But then, if you ask sort of the average American, the phenomenon is much, much stronger. You have a 22%, the thing that finance actually hurts a great deal the U.S. economy. And another 25% that it hurts a bit. So, the majority of Americans seem to think that it actually does more harm than good. Russ: And of course we're right and they're wrong. Guest: I think that the point is, whether we are right or wrong, I think that this difference creates a problem. I think we need to understand why there is such a big difference. Russ: And? Guest: And the answer is: You can argue that in part it's due to the fact we don't explain what we are doing and the benefit of finance. And as finance professor, is pretty important. By the way, this article is basically the long version of a speech I gave at the end of my year as President of the American Finance Association. So, it was meant to address the financial academic at large. And so, I think we should be concerned that we don't explain it well. But we should be even more concerned that the public sentiment is important, in my view, for the support of a good financial system. Once the public at large is resentful about the financial system, the rule of law is at risk. And when the rule of law is at risk, finance starts to work not so well. And in fact my claim is that the only kind of finance that can work in those situations is the most corrupt and phony[?] ones, and making the problem even worse. So, I'm very much afraid of a vicious circle that goes from public resentment with interference with the rule of law to inability to maintain a good financial system; to even more corruption in the financial system that leads to more public resentment. And so on and so forth. And I think we, as financial academics, we have a vested interest in stopping this vicious circle. Russ: I note that you gave this talk at the end of your time in office at the Association. But let's put that to the side.
5:01
Russ: I think in the paper you point out that it's not just this political feedback loop system that you are worried--correctly so, in my opinion, and you talk about it quite eloquently in the paper--about the fact that the public is on to something. And that the standard justifications for finance are a little bit incomplete. They leave out some of the various things that we'll be talking about. Before we get there, though, talk about: What's the rosiest case? Make the most attractive case you can for the contributions of finance. And of course when we say 'finance' it sounds like, are we in favor of credit, or borrowing, or the ability to make a loan or finance a business. And of course that can be crucial to the effectiveness of the economy. But we're really talking about at the margin--the growth in the size of the financial sector in recent decades, the growth of complex financial instruments that are not fully understood. What's the most attractive case that an academic financial economist can make for the full story? Guest: Oh. First of all I would start with venture capital. I think what the most dynamic, most innovative part of the U.S. economic sector, the one that drives U.S. economic growth are the young startups. And the explosion of startups is in large part the result of a viable venture capital sector in the United States. So, in that sense, financial innovation was very useful in promoting economic growth; and even the best type of economic growth. The other aspect is, we today take for granted that in spite of the sort of variability in exchange rates and so on and so forth, the financial system can operate. Remember that before 1971 when the dollar broke its parity with gold, most economists thought it was impossible to operate in a fully flexible exchange rate system. It was only Milton Friedman who presciently said that this was the best arrangement. Today it is a fact of life; we deal with that. And I think that many financial instruments help us do that. Companies routinely borrow in different countries, and good companies hedge against the currency risk so that the fluctuations don't affect the real side of the economy. Russ: That's a more general argument you hear about a whole bunch of financial innovations. I think about this in two ways. Tell me if I have this right. One is, it allows economic actors, whether they are firms or individuals, to deal more effectively with risk. To smooth risk, to put multiple eggs in your basket, kinds of eggs--that's [?] in that metaphor. But you know what I mean: the argument that you can smooth risk and cope with it more effectively by some financial innovation that's taken place. In your example, the currency change, floating currency rates, is one example. But it's widespread in other aspects of business. The other is an arbitrage argument, that finance helps get the prices right. And this is a Hayekian argument; you refer to it in passing in your paper--the idea that with prices sending signals, it's really important that they send the right signals. And arbitrage opportunities and a good financial system get taken advantage of so that prices reflect full information. Are those the two key things that would be the general argument for financial innovation? Guest: Those two are very important. I will add a third one, which is to match talent with money. I think that in the old days where the financial system was not too developed, the only way to develop a new idea was to be born rich, to have resources and use them. Today and increasingly so to the extent the financial system works well, you can start a company, apply an idea, or even run large companies even if you are not born rich and don't have a lot of money. I think that that is really the third key aspect of a good financial system. And I want to say very clearly: the reason why I am so concerned is that the potential of all of finance is enormous, and a good financial system is really important, not just to growth, but also if you want equality of opportunities. Russ: So, in your paper you write, "There is no theoretical basis for the presumption that financial innovation, by expanding financial opportunities, increases welfare." So, the ones we've been talking about, say, the existence of a venture capital system where bright, creative, innovative people can get access to capital, say, the equity market where firms can go public and issue stock, or, say, the bond market where firms can borrow money and promise a fixed return--those are what you might call 'vanilla' finance. Venture capital is a little more complicated. But most of the growth, it feels like a lot of the growth in the financial sector is in the more complex set of innovations. Those are the ones where the welfare effects are uncertain; and they may not be so good. Is that correct? Guest: Actually, that's not my main argument, in the sense that, whether an instrument is good or bad does not necessarily depend on its complexity. We can come back to this in a second, but payday loans are sort of old-fashioned pawn shops revisited. So it's not particularly fancy. But still they might be quite bad overall; and I will come back to the issue. And the one I was describing, hedging of debt, if you want a currency swap, is a bit more fancy; but I see as a good instrument. So, I don't think it's the technical component that makes an instrument good or bad. I think that what I say in this speech and this paper is we have been a bit too lazy in saying that everything is good. And in fact if you dig deeper, even in the theoretical foundation, there is no presumption that every new instrument is good. The reason why as economists we tend to believe that competitive market is the lever, sort of a good efficient outcome, is because we rely very heavily on what we call in jargon the First Welfare Theorem, which is quite broad, quite general; and in the market for goods applies pretty closely to reality. When it comes to financial markets, in order for the financial markets--in order to be able to apply the First Welfare Theorem to financial markets, you will have to have what is called in jargon, 'complete markets,' which means that you have to have every security, trade, every price, every state of the world, and so on and so forth. Which is not a realistic assumption. So, this is simply saying that there is no presumption one way or another. Which doesn't mean that financial innovation is bad. But certainly it does not mean that every kind of financial innovation is good.
13:07
Russ: Well, I want to move away from the formalism because I think--I suspect most of us who like market outcomes are not relying really on the First Welfare Theorem. The First Welfare Theorem is a technical result. It's an interesting achievement in human thinking; but I think deep down, and certainly for me, when you ask, Is innovation in the grocery business a good thing? So in the last 50 years, if you think of all the innovation in the grocery business, the idea of a 7-11 or a smaller grocery, the self-checkout, the growth of a very large grocery, the delivery of groceries to your house using ordering on the Internet. There's been all kinds of--a coffee shop in the grocery store. There's so many innovations in the grocery business besides the fact that the food could be better or worse, etc. But everything is constantly changing. Firms are constantly looking for an edge. And the reason that most--I think economists would argue deep down, why is that a good thing and not wasteful or destructive even--they'd say, 'Well, if it's not good most people won't buy it. There aren't a lot of spillover effects that would possibly complicate the analysis.' And that's that. In finance, or a couple of other sectors--we'll talk about health, for example, which you bring up--we don't have that confidence, because we understand that the relationship between the customer sometimes and the outcome is not tightly linked. Customers don't bear the full cost; the people paying for it don't bear the full cost or the people necessarily consuming it. And that's when we start to get into issues, it seems to me, of whether innovation is welfare enhancing. Do you agree with that or disagree? Guest: Oh, I completely agree with that. My only sort of qualification is, the First Welfare Theorem is really the formalization of Adam Smith's intuition-- Russ: Correct-- Guest: [?] in 200 years, economists are trying to formalize what Adam Smith said; and finally in the mid-1950s they achieved that. Whether you want to rely on Adam Smith's intuition or on the formal proof, I think it's very reassuring that there is a foundation to what was a great intuition. But you are absolutely correct: this intuition applies very well in the grocery store business and most businesses. I think in finance it doesn't apply very well, I think for two reasons. One is exactly what you said, that they often, the buyer does not fully internalize the cost and the risk that they are taking. The other one is that very often the buyers are not that sophisticated. That's true in a lot of businesses. But I think that finance, especially the more sophisticated financial innovation, is very good at preying on the unsophisticated component. And if people are not fully aware of what's going on, competition and markets don't work particularly well. And I think that that's a bit of a problem. Russ: Usually in those situations, my response is: Okay, well, so there are complicated. And people will find mechanisms for getting information. I don't know much about cars, so what do I rely on? I rely on brand names, obviously that's one way: which means it's costly for a firm to abuse me if it makes a poorly made car. But I don't just rely on that. I rely on friends who are more informed than I am. I might look at magazines and stories that are written about the cars to get some better idea of what they're about. I can drive it around, of course, which is some information, not great information, of course: it doesn't say a lot about what's going on under the hood. So, usually in these situations we get information from all kinds of places; and the competitive marketplace provides them. Now, you could say the same thing is going on in finance: Oh, sure, they are complicated and people are poorly informed; but that's why they get a broker, they go to a website, they get advice from friends. And yet, it doesn't seem to work quite as well. Why? Guest: First of all, it takes a long time to figure out if you have made a big mistake in your pension fund. And by the time you figure it out, it's too late. Second, the level of noise is very high, in the sense that you invest in the stock market just before September 2008, in principle that's the right strategy; in practice, you see your wealth drop 50% in a few weeks or months. And you think that the person advising you is an idiot because he told you that. And vice versa, if there is an immediate rise in the stock market, you think that person is a genius. And of course he's neither a genius nor an idiot. In that case it was just bad or good luck. So, separating luck from true performance takes a long time and a lot of sophistication. So the reputation doesn't work as fast and as well. It does work, because we have seen that in the early 1970s financial economists started to say that the best way to invest is through index funds, and slowly index funds gained an enormous market share, from nothing they gained an enormous market share in the United States. So, there is learning going on. It just takes a long time. And in the meantime, the problem is not only that some people get duped. The problem is that there are a lot of resources that are spent trying to dupe people better rather than trying to innovate in the right direction. I think that that is the thing that worries me the most.
19:22
Russ: Yeah. The irony, though, is that--well, let's talk about this for a minute before we talk about the irony. The financial sector is very diverse. You've got customers at the individual level, you have firms, you have products that are sold to other financial institutions by financial institutions. When I think about the worst kind of problems that we are discussing, I'm thinking of derivatives, mortgage-backed securities. And these were not sold to everyday people. They were sold to so-called sophisticated players who were running pension funds, who were running other financial institutions. So it is a little bit strange when you talk about being duped or naive or being unsophisticated. I think the real issue is that problem of randomness and uncertainty and probability that we all struggle with. As you say, there's a lot of noise and sometimes it's very hard to extract the signal. It's complex. There's a lot of causation, a lot of causes going on at the same time. Guest: Yes. But I think that the duping applies more to sort of ordinary human beings. When it comes to sophisticated people, what is a place[?], what we economists call 'agency'--the fact that the buyer doesn't really fully reflect, absorb the cost of his or her actions. So, if I am a bank and I take too much risk and things don't work out well, the government bails me out; so I don't fully reflect the cost. If I am a trader and things don't go particularly well, I walk away. Now, of course the CEO (Chief Executive Officer) should internalize this; but also a CEO can walk away. Now, you say, what about the shareholders? The shareholders unfortunately are dispersed and not so present in monitoring the CEOs of this world. So I think that in the financial sector we have a lot of agents buying securities, and as a result we have a lot of suppliers who design securities to really extract the most out of this agency problem. Russ: But just to push back a little bit--that agency problem exists in most corporate settings. And it gets overcome somewhat or solved somewhat, or it's not so bad. I think what happens here is that, as you point out, it's a little bit harder. But usually our economist responds, well, we'll have to come up with better methods--for restraint on, say, a rogue trader or a rogue CEO. Part of the issue is that financial institutions changed their structure quite dramatically over the last 20 years or so. In the 1960s and 1970s and part of the 1980s, they were typically investing and spending their own money. They were partnerships. With the growth of leverage and public investment banks, it seems to me that's one explanation for why this sector has grown so dramatically. Do you think there's truth to that? Guest: There is definitely truth to that. You are right in saying that in every sector there are agency problems and the economy evolved to try to fix them. The question is: How fast are we catching up, and how many resources are wasted in the process? So, take, for example, derivatives, that can be very useful in many situations. But they also provide pretty strong incentives for CEOs to basically manipulate earnings by playing with them. And it took a few scandals, like if you remember the Orange County and Procter and Gamble and so on and so forth, for a number of regulations and directives that limited the massive use and especially the abuses. So, I think that eventually things will get fixed. The question is how long is this 'eventually' and how many resources are wasted along the way. Because the financial sector is so fast at creating innovation. And it's sort of maybe much faster than a lot of other sectors. Russ: You don't have to necessarily come up with physical changes in atoms and molecules. You can manipulate bytes and 1s and 0s, I guess is part of that reason. So that sounds optimistic, that we catch up. But do you really think that in the wake of the Crisis of 2008 there have been fundamental changes in how financial institutions are run? It seems to me we're back where we started. I don't have any confidence that we're going to avoid a serious crisis for a while, because we've compensated for some of the disincentives and agency problems. Do you? Guest: I think that there have been some improvements. I think that there was much more emphasis on forcing financial institutions to have higher level of capital. And to some extent this is having an effect. And it is actually changing also the businesses these banks are in. Have we fixed the problem? First of all, fixing it completely is impossible, because we're very good at avoiding the last financial crisis, like generals are always good at winning the last war. But it's the next war, the next financial crisis we need to deal with. And that's much more complicated. But I don't think, also, that everything that could be done has been done. For example, I think that the Volcker Rule, to separate proprietary trading from non-proprietary trading, is very difficult to implement. I would prefer a separation between investment banking activity and commercial banking activity; and that separation was not done because of the lobbying pressure of banks. And there are a lot of other things that could have been done faster, better, if there wasn't so much political power residing in the current financial institutions. Russ: Yeah; as you talk about a great deal in the paper, that's a reality that is a little bit ominous.
26:08
Russ: Let's talk about fraud. You give some measures of how much fraud and dishonesty there is in the financial sector in terms of fines and other measures. What do we know about that? How much do we think we have uncovered versus have left behind or ignored or missed? And why is it that there has been so little punishment in this recent financial crisis for fraud relative to, say, the Savings and Loan problem? Guest: I think that's a very good question; I don't have the full answer. We know that in recent years, the financial institutions paid an enormous amount of fines. But the individuals involved in that did not pay. So, when I charge JPMorgan for fraud done by Countrywide--sorry, Countrywide went to Bank of America. So, when I charge Bank of America for former fraud done by Countrywide, the current shareholders of Bank of America are paying, not necessarily the individuals at Countrywide who did the fraud. So, I think that while politically appealing, it doesn't really solve the problem. And I think that there's been too much of that going on, and too little open discussion of how pervasive the fraud was. I think that if you look at the narrative about a financial crisis, most people will talk about, of course, subprime loans. But I am not so sure that most people will point out that the real problem about subprime loans was the extent of fraud going on in them. Russ: I don't know if we know the extent, right? Going back to the principal-agent problem, both the borrower and the lender at the first level of the transaction had an incentive to commit fraud, either because they were naive about what could happen in the future--and I'm talking about fraud here, say, you disguise your income. So, I lie on the form about what my income is; and you make me the loan anyway. The problem is, you would have made me the loan anyway if I'd been honest about it. Because, one argument being, oh, we both think that prices are rising so this is not going to be a bad thing; or because we think we are going to get, you think you are going to get bailed out, either directly by selling this to somebody else or indirectly by eventually being compensated for that loss in a literal bailout by the government. So it seems to me that that fraud isn't really at the root of the problem. Am I being too optimistic there? Guest: Yeah--I think I disagree with that. I think that while it is possible that the loan will be made anyway, the question is: If the loan would have been made anyway, why commit fraud? And in fact I think that the reason is that some other people would have caught the problem sooner had they seen the data so falsified. And so, while it may be that the transaction between the two of us would not have changed, other transactions down the line would have changed if we didn't commit fraud in this particular transaction. Russ: Fair enough. We both wink, because you are going to sell it to Fannie (Fannie Mae). And Fannie won't take it; Fannie has a rule that it has to have a certain set of compliance; this loan has to comply with certain regulations. But of course Fannie also started to think, well, maybe this isn't so bad; everything is going great. They put pressure on the political system to allow them to be more aggressive. So, it's a little complicated. Guest: No, of course, the tolerance toward fraud goes up in booms. And I think that's a well known phenomenon. However, I think that the institutions that are deputized to prevent that--for example, auditing--did not do their job. And it's harder to lean against the wind. But that's no excuse not to lean at all. Russ: Yeah. No, I totally agree.
30:45
Russ: But let's go back to the question of the literal fraud. Somebody filled out a form; people did fill out forms that had lies on them. People rubber-stamped them at the financial institutions. People knowingly sold them to other folks knowing that they were not fully describing what their contents were. You think the problem with punishing the actual perpetrators rather than the institutions is a result of just that there's so many of them? You can't just point to one person in an organization? Or is it a political issue, that the political power of individuals has protected them so far? Now, I want to just add: a lot of them paid a fierce reputational cost. But they probably should have gone to jail, too, on top of it. Guest: I completely agree. I think that being many makes it easier to get away with that. So definitely that's a big factor. The other factor is it's easier to pay fines with somebody else's money--that's part of what takes place. But I think that there was an attempt to look the other way. Not to consider the seriousness, maybe because too many people were involved. And too many important people, influential people. Russ: Yeah. I find it--well, it's depressing. Of course, it's doubly depressing because part of it was motivated by people who had good motives to help people who weren't getting loans. And so there was a bootlegger and baptist coalition here of a bunch of people who had what appeared to be good motives to increase homeownership with people who just wanted to make money off of that, and of course did--didn't end up paying much of a price for it. Nobody paid much price for it. It's a rather extraordinary event in American economic history, if you think about it, how the bulk of the cost was borne by taxpayers; how little of it was borne by decision-makers, either the politicians or the financial institutions themselves or the people who made the decisions--with the exception of the fact that a lot of people lost their houses. Which is very unpleasant; it's bad for your reputation. But they didn't go homeless; a lot of them had no equity in those homes anyway. So, I don't know. I guess the real question, to come back to what I started with, is we don't really have a very good measure of how much fraud there was; and I suppose we never will. Guest: Yeah, but we have some indication. A colleague of mine has a paper looking at the most benign version of fraud, which is misreporting of income, etc. And he finds that on average more than 10% of those loans--private label loans, by the way--had problems. There is also a very interesting article, of all places on Rolling Stone, talking with [?] JPMorgan, who tells you how pervasive fraud was in their loans. So, I think that there is some evidence but it's not as generalized as we would have wanted. And I think that the Financial Crisis Inquiry Commission bears the full responsibility for that. Instead of doing a serious analysis, they ended up in a political squabble. Russ: Are you surprised? Guest: I am surprised. Because think about when the Challenger went down, when the shuttle went down. The Commission--first of all had very prominent people in it, including the Nobel Prize winner in physics, Richard Feynman. And they came out with a very clear responsibility; they could prove it. And that made a difference. So, I think it's not always the case that these commissions end up in nothing. But this time was definitely one case. Russ: Well, I guess this goes back to one of my arguments that long-time EconTalk listeners are maybe a little tired of, which is, economics is not physics. It's not engineering. It's in a complex world. And if we had said we need a commission for what happened in Vietnam--why didn't Vietnam turn out better for the United States? You could put the greatest generals, the greatest politicians, the greatest academics, historians--I don't think they'd come up with a great conclusion. Because the nature of the problem is very different from the Challenger problem. I think it's multi-causal. It's just the nature of reality. But I take your point in general. Maybe to reinforce my point is that when you are in a multi-causal world, you might expect things other than truth to emerge as a motive for the people involved. Guest: It is true. But you know, what determines why the rocket exploded is also probably multi-causal. Temperature was one. It was not just a defective O-ring. I grant you that physics is more precise than economics. But I think that you can at least try to go some way in that direction. And I think they made no attempt. Russ: Fair enough. That sums it up nicely.
36:21
Russ: At one point in the paper you write, "The healthcare sector is a particularly good comparison for the financial one. Both sectors provide a service everybody needs, but very few people understand and thus both sectors depend heavily on trust. Both sectors are plagued by conflicts of interest and experience enormous abuse and fraud. In both sectors, the buyers often do not bear the entire cost of their decisions. Finally, both sectors are much bigger in the United States than in most other countries." And you have a lot of interesting things to say about that comparison between health and finance. They've both grown dramatically. We could talk about, again, it would be interesting to speculate about why they've both grown. But I think most people would agree that the growth hasn't been as productive as it otherwise would be. What do you think we can do about the financial sector growth that has been unproductive? And do you have any lessons for the health care sector that might be relevant? Or is it totally different? Guest: I don't think it's totally different. I think that my lesson is very simple in principle, very difficult in practice. Which is to expose all the waste and abuses. I think the reason the full[?] understanding in the health care sector of how wasteful it is, in the sense, in the United States are 32nd for the overall life expectancy, below Portugal and Greece, in spite of the fact they spend more than 4 times per capita than Portugal and Greece. Now, you might argue that the reason why that's the case is because in Greece they have olive oil and good wine and in the United States they-- Russ: Different genetics. A lot of things, yeah. Multi-causal. Guest: But there is actually a picture that I presented in my presentation that is not in the paper because it's not a picture I [?] use, but I found it, which is fascinating because it looks at life expectancy changes as a function of changes in health expenses per capita over a number of years. So, you keep the country constant, so more or less the genetics constant, and over the years you increase the money spent; how much life expectancy goes up. And you see that all developed countries have the same slope; the United States has a much lower slope. So, every extra dollar of money spent in health care produces less benefit in terms of life expectancy in the United States than in countries like the United Kingdom, Germany, and so on and so forth. That to me is a good indicator of the fact that we are wasting money. Russ: Yeah. I wouldn't rely on that, actually. This comes back to our earlier point about the First Welfare Theorem. I would think, well, this is kind of complicated; there's a lot going on. I'd rely on something simpler, which is that the incentives to add a piece of technology, the incentives in the way we've structured our health, our medical professional programs in the United States, are designed that when you subsidize things, you are going to get things that aren't worth what their true value is. Right? We've encouraged--and most of it's good. Most of it's good. I think we have a very good health system. I just think it's inefficient. I think we've spent more money--as you point out, we get less bang for the buck. But I think we understand the underlying reason why: it's the way the system compensates innovators, the way hospitals compensate their doctors and the people who supply the equipment that they use, and so on. It's not fraud. There is fraud; there is a lot of fraud, obviously, in the payment systems and there's literal fraud--there are doctors who prescribe things that aren't necessary because they want to make more money. That's not the problem though; that's not the biggest problem. The biggest problem is the fact that the incentives are misaligned, it seems to me. I think, for the financial sector, I'm a little more worried about the outright fraud. Maybe I'm being overly cynical there. Guest: I think you are right, in the sense there is fraud in both sectors. I think it is more important than people realize and sort of make it to be. But the biggest problem is what Larry Lessig called 'institutional corruption,' which is perfectly legal, but de facto is playing with the sort of wrong incentives. There is a lot of money, for example spent in health care in trying to market drugs that are absolutely equivalent, sometimes even likely worse than existing drugs. But they are just patented, and so they are protected; while there are genetics that are equivalent that don't give the same margin. And so you give big subsidies in the form of conferences, money grants, etc., to doctors so that they prescribe those medicines that are more expensive. This is perfectly legal, but it's very wasteful. Russ: Yeah. I find that deeply offensive, but I don't know how much of the magnitude of the problem it is. And of course you in your recent appearance on EconTalk talked about the same problem, the financial sector where the conferences and other types of swag and subsidies are a way to buy off the economists and finance professors about the nature of the business. Guest: Absolutely. The two things are very much connected. And what is ironic is as economists we see very clearly the problem in the health care sector, and we point fingers. And we're not afraid to point fingers. When it comes to us, then all of a sudden we say we are different. Russ: Of course we are. We are highly principled. We're not like those doctors. When people say to me--you know, because I have a Ph.D. they call me Dr. so-and-so--I quote a friend of mine who says, 'Oh, no, I'm the other kind of doctor; I'm not the kind that helps people.' But here we have this example where we look down on the people who are actually saving lives because they occasionally prescribe a higher-cost drug. Whereas we're only just destroying the economy through multi-trillion dollar investments and things that aren't productive. So I don't know--it's kind of a funny thing.
43:18
Russ: Let's talk about the payday loan example that you use in the paper, that you mentioned earlier. You argue in your paper that payday loans are not a good innovation. And I'm a little bit surprised. There's arguments on both sides; of course some of the arguments say they are good were financed by the payday loan industry--I think we talked about that in our last episode. But talk about payday loans generally. Guest: I'm not saying that all forms of, say, short term lending to unsecured, very high rate is bad. The problem with payday loans is they are designed in a particular structure. So, instead of being installment loans that you borrow a certain amount and then slowly over time you will pay, you borrow a certain amount and then you have to return it plus a large fee. All in one instance, on a very short time horizon. And most people who do that don't fully understand the cost of this. And when it comes to repay them, they are of course unable to. And there is a very interesting experiment in Colorado where they forced to offer payday loans in the form of installment loans. And with much lower rates. And we have seen that not only there were few defaults and few problems, etc., but--and this is the ironic thing--the supply went up. Now, you are saying, 'Wait a minute. If you make something less profitable, how is it possible that supply went up?' And the answer is that before, there was too much entry in the payday loan industry. So, if I can find a sucker and overcharge him, and with free entry, too many people will enter this industry trying to find suckers to exploit. And you know that there are today more payday loan outlets in the United States than Starbucks and McDonald's combined. Russ: Yeah, I saw that statistic. I was surprised. Carry on. Guest: Yeah. It's really shocking. In Colorado, when they introduced this reform, the number of payday loans went down dramatically; as a result, the few that remained were more profitable. And they could get by with lower rates. And so the system overall became more efficient. In a system where the customer is not smart enough to see the difference you have to help competition go in the right direction, not in the wrong direction. And the current payday loan system might still be better than the alternative, which is illegal usury laws; but is not as good as what they've done in Colorado. So there is a way to improve things. We need to understand what's going on. Russ: It'll be interesting to see if that result holds up, especially if other states follow suit and pursue that. [?] a similar argument about taxicabs--we have to limit the number of taxicabs because otherwise so many people just enter the market and then they won't be able to make much money and then they'll charge higher fares--I'm not going to dig up the papers, but there were papers that said that competitive equilibrium with taxicabs is going to be very unhealthy so we have to have regulation. As we move towards a more competitive equilibrium through innovation, through Uber and Lyft and other firms, it seems to have gotten a lot better. It could be this is different. I'm open minded about that. We'll see. Guest: No, I completely agree. But the fact that an argument is abused doesn't mean that it's never right. Russ: That's correct. I agree. Good point.
47:31
Russ: Let's turn to what is to be done. In the paper you talk about different areas. You talk about policy positions that economists and financial professors might take. You talk about research we might do. I want to start, because I want to make sure we get to this--I don't want to leave this till last: let's talk about the classroom. So, I've never taught finance before, but I've taught in a business school. And you teach in a business school. What are we doing to our students perhaps that we ought not to be doing, and what should we be doing instead when we talk about the financial sector and these issues we're discussing today? Guest: Yes. First of all I want to be clear, because when the typical economists talks about something inefficient, the answer is we need more government regulation of some kind or another. And I'm not that kind of economists; and I think in this particular sector, the financial sector, government regulation is often the problem, not the solution. And I was addressing a bunch of financial economists, not a bunch of policy makers, so I thought that the most important thing was to discuss what we can do as a profession, rather than what somebody else can do. And one of the things, as you pointed out, was what we do in the classroom. And I think that we have a little of envy vis-a-vis physicists, and so we think that we can behave like physicists in having just a positive approach, describe reality without entering into what we call in economics 'normative'--without saying what you should do. Just describe facts, like a physicist describes the walking of the atoms, doesn't really say what is the right way or the wrong way. However, there is a fundamental difference we don't perceive--which is, physicists don't teach to atoms. We do teach to sort of business people, especially us in business school. And so we should be concerned about the impact that our teaching can have on people. And the impact it seems to have--there are two sort of interesting studies. There are actually many, but two in particular I cite in my work. One is showing that the teacher of economics seems to be making people more selfish. There's definitely a selection, that more selfish people tend to enter economics. But also that once I expose to more economics, you tend to be more selfish. So there is a bit of this step between we take for granted that people pursue their self-interest--that's an assumption; but then without sort of openly saying it, we use it so often that people feel like entitled that this is the right thing to do. Russ: Because it's 'rational.' Because we show them how rational it is for people to, say, price discriminate. And so, 'it must be okay, because it's rational.' But that's not true. It doesn't follow. It's a terrible mistake. Guest: And there is a very recent article published in Nature at the end of last year showing that bank employees behave more dishonestly when their professional identity is rendered salient[?]. This is an experiment. So, if you take a bank employee and you remind him or her that he's a banker, he is going to behave differently than if he is reminded that he is a postal worker. And what is interesting is if you take a postal worker and you remind him that he is a postal worker, he doesn't behave more dishonestly. If you remind him that he is a banker or you tell him that he should act as a banker, he does not behave more dishonestly. It's just the combination of sort of existing banker and the kind of saliency of the professional identity that makes people more dishonest. And so, I think we should be careful about the subtle normative messages that we give to our students without taking full responsibility. Generally in business school what we do is we teach without any moral consideration, and then we have some separate classes dedicated to ethics. And that basically says, when you do business you should not really care about any moral notion, but you should watch your mouth in a class talking about ethics. And I'm saying we need to change this. If we think there is room for morality in our teaching, it should be in the classroom where we teach finance, or, as you said, marketing or price discrimination or other stuff. It should not be separated in a little ghetto where nobody cares about it. Russ: Yeah. I've been thinking lately about whether we should teach Adam Smith's theory of happiness in our micro classes. Smith said 'Man naturally desires not only to be loved, but to be lovely.' Meaning respected, honored, and admired, and worthy of respect and admiration and honor. And maybe if we taught our students that that's what brings true satisfaction instead of, say, x1 and x2, maybe they'd be more lovely when they get out into the world. I don't know. But certainly, if you teach people that it's rational for businesses to price discriminate or to arbitrage in certain situations that are maybe not so healthy for some of the players, or to sell stuff to people who don't understand their products, maybe that would change how they behaved. You'd think it would. You'd think it would matter. Guest: I think that--first of all, I agree 100% with what Adam Smith said. I think he does play an important role. People do care not only about money but they care about social prestige, how other regard them, and so on and so forth. So, if we change the perception of social prestige, for example, even in business school, as a function of other dimensions, I think this will play a role in the way people act. Russ: You want to suggest how a business school curriculum might look if we put the ethics into--who would be teaching those classes? You and me, of course. But who else would be able to teach these ethical practice classes without having that dividing line? Guest: I think that it's not a question of teaching ethical classes. I think it is exposing ethical problems in business decisions. So, I teach a very old case in my entrepreneur class where somebody starts something close to [?], and as a way to finance this innovation he is smart enough to go and raise money from his future customers. And I advertise this as a great idea. Then I present another case of somebody who tried to sell a handheld device to museums. And then I said, okay, now how do you go about raising money? And they immediately say, 'You go to museum curators and you try to raise money from them.' And I said, 'Okay.' Russ: How's that going to work? Guest: Exactly. I start to make them sensitive that there are some conflicts of interest. And my rule is: Are you comfortable with this news appearing in The New York Times or Wall Street Journal and your name, in the newspaper the next morning. If you are comfortable, go ahead. If you are not comfortable then you should probably not do it. Russ: I totally agree.
55:43
Russ: Let's close with an issue that came up in your paper about--at one point you say, well, it's sort of inevitable there are going to be ethical issues in finance because the only metric is money. It's interesting--in the middle of the crisis--I think it was an actual quote; I have to be careful but it got repeated this way: that Lloyd Blankfein, the head of Goldman Sachs, when challenged about his actions during the crisis said, 'We're doing God's work.' And I think, when I was younger and romantic about the financial sector as I was about most sectors, about their effectiveness, I thought, well, yeah, of course the financial sector does important, useful things. That's what we started this conversation about. And yet, now I'm not so confident. And I think it's because of the incentives they face. But we could imagine a world where people in the financial sector really saw what they were doing as important. They understand the connection, say, between that arbitrage opportunity and the outcomes being better. Or maybe worse under certain circumstances. Do you think there is any value, going back to the classroom, to giving more time and space for students to understand the unseen impacts of finance both good and bad that would maybe change the culture of that world to be about something other than keeping score via money? Guest: I think it would be very important, in two dimensions: first to make existing students more sensitive to this problem, but also in attracting more sensitive students to finance. I think that if the only method of finance is money, it will attract only certain kind of people. And if it is about more than just money, it will attract also a different kind of people. Russ: People have complained that the kind of people that have been attracted to finance in the last 20 years have been "the best and the brightest." Let's put the best to the side--but, the brightest, that the most talented people have gone into finance rather than so-called 'real' fields where they could have had a bigger impact on humanity. Do you think that's a fair critique of what's gone on in the financial sector in terms of what's gone on, on the employment side? Guest: It is a fair critique to the extent that we realize that some financial innovation is wasteful. If we think that all financial innovation is very productive, at least in the same way in which technical innovation and other innovation is productive, then we can rely on standard economics argument to say, 'What's the problem with that?' Once we start opening up the possibility that some of this financial innovation is purely rent seeking, then we have a major distortion that is costly to the very growth of the U.S. economy. Russ: So, your last two appearances here have been very critical of the hand that feeds you, to some extent. Of course, the hand that literally feeds you is the U. of Chicago. But the club that you are in, the club of financial economists, economists who work with financial issues, your last appearance and your previous paper was about how captured the financial economics world is, that they have integrity issues they need to be aware of just as there would be if they were looking at other people. This paper is about the very underpinnings of the experience, that the financial sector itself maybe is not so good for people and other living things. What kind of reaction have you gotten from your colleagues and friends in the industry and in academia? Guest: I actually got overall a surprisingly good reaction, in the sense that when I presented this last paper to the Finance Association, I had an overwhelming positive reaction. Now maybe only those with positive things came and talked to me. You never know. But I think overall it was not bad at all. For the previous paper on economists' capture, I think I got more skepticism. But the important thing for me--I don't expect everybody to be converted right away--is that I was not marginalized in the profession. Because hopefully people understand that I'm not really biting the hand that feeds me. What I'm doing is preventing that that hand will deteriorate in the long term. I want to be the critical conscience of the profession rather than being the guy spitting on the profession. And so far I think I have succeeded.