Russ Roberts

Zingales on Capitalism and Crony Capitalism

EconTalk Episode with Luigi Zingales
Hosted by Russ Roberts
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Moretti on Jobs, Cities, and I... Stiglitz on Inequality...

Luigi Zingales of the University of Chicago and author of A Capitalism for the People talks with EconTalk host Russ Roberts about the ideas in his book. Zingales argues that the financial sector has used its political power to enhance the size of the sector and the compensations executives receive. This is symptomatic of a larger problem where special interests steer resources and favors based on their political influence. Zingales argues for a capitalism for the people rather than a capitalism for cronies or the politically powerful. The conversation concludes with a plea by Zingales to his fellow economists to speak out against behavior that is legal but immoral--lobbying Congress for special treatment that exploits others to benefit one's own industry, for example.

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0:36Intro. [Recording date: June 19, 2012.] Russ: Your book is a really fantastic ride through a whole bunch of economic, philosophical, and ethical issues related to the current state of the economy and how they can become better. I hope we can capture some of the flavor of that book in this podcast. I want to recommend it very strongly to our listeners as just a fascinating and educational look at a wide range of issues, many of which we have touched on in this podcast; but you come up with some different takes and different explanations. It's a very interesting book. You start off by talking about U.S. history and capitalism's history in the United States and you talk about meritocracy and the idea that it is at risk. Talk about what you mean by a meritocracy and why you think it is at risk in America these days. Guest: A meritocracy is a system where reward and responsibility is attributed on the basis of quality and merit. So, you promote the most capable manager--you have at the university the professors being the most bright and productive researchers and teachers and so forth. It seems like it's an obvious sort of a system, but much of the world is not dominated by a meritocracy. It's all based on, at least historically, right of birth; and if you are the son of a king you become a king, regardless of how stupid you are. And if you are the son of a large landowner, you tend to be a landowner regardless of how stupid you are, and so on and so forth. And even recently, a lot is based on political connections. You become a large manager of a state-owned company because you have friends in high places and so on and so forth. So it's not as straightforward as most people make it to be. The second point is that one essential element of meritocracy is that you have some level of pay inequality: in order to motivate people to do better, you have to pay them more. So, there is an intrinsic tension between meritocracy and democracy, because democracy tends to have a more equalized pay, because the vast majority of the people tend to be envious of people who make more. And how you make compatible a democracy and a meritocracy is really a challenge, a challenge that in my view--historically the United States has resolved very well; and I don't think it is resolving as well today. Russ: Well, one of the ways we solved it historically is the Constitution, which limits the power of the democracy to extract resources from the minority. There are also strong cultural norms, a theme that runs through your book; one of the reasons it's such an interesting book is you don't ignore those norms as an economist; and I don't think economists should. So, I really enjoyed that part of the book. Obviously, as the Constitution eroded somewhat in limiting the powers of government, as governments got stronger, the ability of the body politic to extract resources from the few is growing. But, as you focus on in the book, unfortunately the minority is also extracting a lot from the majority because of their political power. Guest: Absolutely. I think that there is definitely a stance of this. I always tell this true story--I teach entrepreneurship and in 2009 I had some young fellows approaching me with a business idea. And it was an interesting idea, so I started spending some time talking to them. And then I asked them why they came to me. I'm not the only professor of entrepreneurship in the country. So, why did they pick me? And to my disappointment, the answer was because you write a lot, you are a public figure so you might help us lobbying for getting more of the top money from Washington into our business venture. And I said: Wait a minute, if [?] the first activity is about lobbying, we are really in deep trouble.
5:59Russ: That's a really bad sign. I certainly agree with that. What are some of the other reasons you think--there are some trends in our economic system, some of which are misleading but certainly look very bad, which have gotten people worried about the state of the income distribution. Talk about some of those trends and why those pose political threats to a real capitalism. Guest: In order to have support for a meritocracy in a free market system, we need to have a generalized perception that this is creating wealth, that everybody gets a decent share of this wealth that is created, and that the system overall is fair. And unfortunately, all these three conditions are weakening in the United States in recent years. The rate of growth has gone down on average. This is true for all the industrialized nations, but it does create more problems because the pie is not shrinking, but it's not growing at such a high rate that everybody's benefited from it. And then we have a worsening of income inequality, and in particular I think there is a significant traction that is falling behind. And the typical American dream was that my kids will be wealthier than I am. A large fraction of the population today does not experience that. The median young male that enters the workforce at age 20 or 22 is making 19% less in real terms than his father made at the same age. So, I think that's clearly a challenge. Now, part of that has to do with the fact that--at least in my view--the United States had it very easy at the end of WWII, when there was kind of a rent or a surplus that was divided among the population that made everybody better off. Unfortunately, it's not easy to [?] this trend, but this creates clearly a problem of consensus. And then to add insult to injury, there is a generalized perception that I don't think is typical of this country, of mistrust of sort of the way institutions work and the way the rules of the game are designed. One thing that struck me as an Italian moving to America was the trust that average American had, at least at the time, toward the institutions is completely unheard of in Italy. Russ: Tell the story about the taping up of the windows. Guest: Nah. Russ: It's a one-liner, but it's a good line. Guest: One of the first things that happened was a tornado watch in Boston. So, there was this public ordinance that you were to go home, tape your windows, and stay inside. And my reaction was that if the mayor tells you to tape your windows, it must be that his brother is selling tape. And the fact that he's telling me to stay inside means that I have to do exactly the opposite, because my experience, immediately, is that if you do the opposite of what the government tells you to do, you are doing fine. And I think that was not the tradition here. And I admire a lot of things work better because there was this trust. And this trust was not completely unjustified. It's not a coincidence that for the United States the first idea of government for the people, by the people, and of the people. I think in recent years the bailout played a big role in that, but I think it was a turning point. People started to realize that things were changing; you have this perception that the government is run by sort of corporations and their interests rather than the interests of the people at large. Shortly after the financial bailout I went with a colleague of Kellogg Booth [?] it is called the Financial Trust Index where we try to get a sense of how much Americans trust their financial system. We have some questions about institutions as well, and one question we ask at the end of 2008 was: Do you think that in the bailout Hank Paulson acted in the interest of the country or in the interest of Goldman Sachs? Of the 80% of the people who answered that question, 50% thought in the interest of Goldman Sachs. Which is pretty scary. And shortly after, 6 months later, we asked a similar question about Obama; and the only difference is now whether Obama was acting in the interest of the Union or the interest of the financial industry. Still only a minority thought it was in the interest of the country. Russ: How would you answer that question, by the way? Let's go back to Hank Paulson. It's a tough question. Guest: I think that--it's a difficult question. Russ: You only have two answers. Guest: I think he was honest in acting in the interest of the country but he thought the interests of the country and the interests of Goldman Sachs were one and the same. Russ: Yeah, that's what I think the problem is. We'll come back to that later. The other thing I want to just mention in passing, and I think we'll come back to later--you said that the median male worker today makes 19% less than his father. Do you believe that number? Guest: Yeah. I think that first of all I said on purpose males because females had an improvement in the income distribution, so I think in part if you want real equalization that maybe males 25 years ago were earning a rent at the expense of females and now things have equalized, because a female will make more. But it is true. My interpretation is that in the 20 or 30 years after WWII, the United States turns out as the only place on earth to do business in a particular way. And as a result of this uniqueness, everybody was getting a rent just out of being American. If I wanted to invest, why would I invest in countries like France or Italy that could easily fall under Communist regime? I will only invest in the United States. And why should I invest in India where there was sort of no rule of law and not even an appearance of capitalism? So, as a result of that, just out of being an American and living in the United States I was getting sort of a rent. The people in this country were getting sort of a scarce resource, and as we know in economics, a scarce resource is earning a rent. This rent has disappeared because today there are Indians and Chinese and Brazilians and you name them that are as good, as effective. And while I think this is still probably the best country to do business, other countries are not so far behind. Now, I think the average American is facing a tougher competition from the rest of the world. Now, this is fantastic for the rest of the world. If we look from a world perspective, I think this has created the largest amount of wealth in the history of humankind, probably; the coming to richness of China and India are fantastic phenomena. But [?] some bad repercussions at all. Russ: Yeah. I just don't believe that number. We've talked about it a lot on this program, and maybe we'll come back and talk to it later. I think it might be true of people who don't finish high school; I think that's true that the median high school dropout doesn't do as well as he did 25 years ago. But there's a great deal of evidence that suggests a different story; it's a challenge of which data you want to interpret and how you want to talk about it. Guest: Yeah. I think if you look for example at household income or individual wage, the number is very different because we have more female participation. So I am not obsessed on the exact level of that number. However, I think that all the numbers point in the fact that you don't have a bright prospect in front of you if you are not particularly well educated. The median American with a high school degree does not have a bright future as he used to have 25 years ago. Russ: I agree with that. Guest: I think that 's pretty much a fact. Making more or less, we can debate. You can argue how you compute inflation; we know inflation tends to be overstated; we have terms that's maybe is a bit more. But I think we are going from a world in which, if I remember correctly, in a generation you are gaining 79%, so you are like twice as rich as your parents, to a world in which we are debating whether you are rich or not, so that's a dramatic change. Russ: Well, I'll agree with that.
16:04Russ: Now, as an example of how inequality, for the reasons behind inequality increasing in the United States and in the world, you give a very nice example of Tiger Woods and the people who work at the Masters Tournament keeping the greens nice. Which is a relatively unskilled job. Tiger Woods has a very skilled job. You use the example of Tiger Woods; he remains the most famous golfer in the world. He is not any longer the best golfer but he will be the best example we can use for a while at least. Talk about what has changed in the prize money at the Masters relative to the greens keeper salaries. Guest: I wanted to look at a sector or an example that was not affected by sort of corporate greed or corporate governance problems. So, a fairly competitive, a very competitive sector, like the sport industry, and in particular golf. Golf is easy because we have a pretty good track record of prize money, etc. And what is stunning is that the dramatic increase in the ratio between the prize money of one particular golf tournament, which is the Augusta Masters Golf Tournament and the minimum wage which is prevailing in the economy, which I assume is the wage that you pay sort of the people who work on the golf course. Russ: Actually, I think they make more, Luigi, but let's use that as a rough approximation. Guest: Yeah, I know they make more, but I think it was an easy benchmark. And I don't think it would change dramatically if I were to do otherwise. But the point is that not only has this number increased dramatically, but it has increased dramatically particularly since 1980. So, it parallels perfectly this acceleration of income inequality we are seeing in any other sector. And what makes it particularly stunning is that if you ask people why do they participate in the golf tournament--is the money a primary concern, the answer is no. The prestige of the tournament is such that people would participate just for the right to have the green jacket and trophy and not the money. So then the question is why the prize money has exploded and why has it exploded since 1980. Russ: Because it seems wasteful. You'd think if it's just the prestige, they could cut the prize money. Guest: Exactly. But the point is that this tournament is competing with other tournaments. And this tournament is making a gigantic amount of money. Even if this is, I think, the only tournament that is still owned by a golf club, so this is not a profit maximizing entity. And in fact they are undercharging for the ticket prices; for at least the last four years and once you have the ticket you can sell it on the internet for a multiple of the price you pay. So, they are not really maximizing revenues by any stretch of the imagination. But this tournament went from being a regional tournament where even a normal professional golf player could win, in 1948 the winner was sort of somebody who was playing golf not full time--to an international event that is broadcasted in most nations in the world. In Australia and Japan they wake up early to see it. And that produces so much revenue that you don't want to jeopardize the risk of falling behind and becoming second to the British Open or the American Open just for $200,000 or $300,000. So, of course you are going to up the ante just not to be behind the other tournament. And all the tournaments went up in prize money starting in 1980. So, I think is just the enormous return that these tournaments have that push up the prizes.
20:31Russ: The ratio then of the winner or even the runner up, to the people who work at the golf course has increased tremendously, and that's due to globalization and technology--the ability of people around the world to enjoy the tournament, which has pushed up the profits to the club hosting it. I love that example. It's obviously a different view of inequality than the one that says somehow the rich have changed the rules of the game. But of course, that has also happened to some extent in certain sectors. I want to talk about the financial sector in particular. But I want to start with a very interesting point you make about the repeal of Glass-Steagall. Now, a lot of people blame the crisis on the repeal of Glass-Steagall and the Gramm-Leach-Bliley Act, accomplished that in 1999. It was a Democratic president who signed that but I think it was a Republican Congress that pushed it; but it was a bipartisan bill. It got a lot of support from both sides of the aisle. And you make the argument that its direct effect in causing the crisis was very small. So I want you to explain that. And then the more interesting point--but you still point out the political implications of that were not small. That's fascinating. So, talk about those two things. First, why it had little direct impact but its political impact was not trivial. Guest: So, just to make sure that everybody is on board, I think that what Glass-Steagall used to do is to separate commercial banks from investment banks. And during the crisis, the banks that were most exposed and suffered the most and some of them failed to be bailed out were pure investment banks that would have existed even before the repeal of Glass-Steagall and would have got in trouble even before the repeal of Glass-Steagall. And in fact, one of the solutions or partial solutions to this crisis was to have some rescues, so you had J.P. Morgan buying Bear Stearns, and you had Bank of America buying Merrill Lynch, and this was made possible by the repeal of Glass-Steagall. Because during Glass-Steagall JPMorgan could not have bought Bear Stearns and Bank of America could not have bought Merrill Lynch. The only sort of bad example in this picture was Citigroup. Citigroup was both an investment bank and a commercial bank, and it was highly exposed and was really saved by the government because otherwise it would have gone bust. And by the way, during the crisis, the way you got some confidence back for banks like Morgan Stanley and Goldman Sachs was for them to file as commercial banks. So, I think there is no question; in my view, the separation of investment banking and commercial banking was not the [?] factor in causing the crisis or precipitating the crisis. Russ: Did you mean to say that without Glass-Steagall, that if Glass-Steagall were still in place, that JPMorgan could not have purchased Bear Stearns? Guest: Yeah. It could not. Because it was an investment bank. Russ: Aren't they both investment banks? Guest: JPMorgan is a commercial bank. JPMorgan Chase is actually both, a huge commercial franchise. Russ: Okay. I get the point, then. The argument for Glass-Steagall of course is that commercial banks are FDIC insured, and the story is that if you merged them the money would somehow get mixed together and that made the investment banks that had commercial arms or vice versa too big to fail. But the truth is, the investment banks were viewed as implicitly insured anyway. So, it's in a way it does seem to be not a very important piece of legislation, the repeal of it. Guest: In addition, the investment banks were heavily exposed to commercial banks through sort of a lot of loans. If an investment bank had failed, probably would have brought down the commercial banks that guaranteed the credit. So, the separation itself I don't think is the most effective way to limit risk. Russ: And you are also suggesting it's a red herring when we think about what caused the crisis itself.
25:28Russ: However, talk about the political implications, because that's really very clever. Guest: So, my concern is about the power that an industry has in Washington, and this power is a function of how large its firms are and how homogeneous its firms are. We know as economists how important is the competition in the economic sector. We forget how important is the competition in Washington and particularly in the lobbying sector to have a balanced view of the world. To the extent financial firms have different interests, they sometimes lobby one against the other. And with this competition you get a fairer and more balanced view. If you have everybody agreeing one direction, it's very difficult for the government to have a balanced view. One economist who worked for the Bush Treasury told me that during the summer of 2008, every time a cell number would call him and the area code was 212, the message would be the same: Buy toxic assets. Everybody on the Street was lobbying in the same direction. And so is it that surprising that the first proposal of Hank Paulson was: Buy toxic assets? That's all the advice he was getting. And I think that this homogeneity is a problem. Russ: Yeah, I agree. But you give the example in the book of the bankruptcy law, which I think is a very nice example. Guest: The bankruptcy law is an extremely important and delicate law. It's not something that generally attracts the public interest, because first of all people don't think they will ever go bankrupt; they tend to be over-optimists, so they think it doesn't affect them. And, two, the devil is in the details; and these are exactly the type of things that are not really subject to good public scrutiny, because we are all too busy to spend time looking at the details of a law. So, in general, the game was played by a few constituencies. And historically there were divergent opinions, but during the last reform in 2005, there was a coalition that, according to a lot of bankruptcy experts was remarkable in the way they kept their positions united. And I think that the reason is to be found in that there was a massive consolidation in the financial industry, and as a result, everybody was doing exactly the same thing and everybody had the same interests. So the natural divergence of the interests that creates competition, creates a debate, disappeared. Ironically they achieved their goal too well, because it backfired for the financial industry itself. Russ: In what way? Guest: Because they reached two goals. The first one was to make extremely difficult to file for bankruptcy and get rid of your credit card debt. Which again in principle is not a bad idea, but the result, because they were so successful, the result was that many more people actually were unable to pay their mortgage. Because in the past what happened is that you will go into personal bankruptcy to get rid of the credit card debt but will keep paying your mortgage and stay current on that, because the mortgages don't go into personal bankruptcy. But now that you don't have that option, the only way that you had was basically not to pay. And so, according to some studies, the number of bankruptcies during the recent financial crisis was significantly higher as a result of that law. And we know there are some inefficiencies associated with the process, so there was quite a bit of money lost for that. The second is that one of the features of the bankruptcy reform that very few people understood at the time it was passed is that it gives some kind of super-seniority in bankruptcy to all derivatives. Not only if you have a derivative claim you are paid first, but basically we knew that derivative with another counterparty passed [?] the cost, including the transaction cost, to the bankruptcy estate. Now you think that the transaction costs are small because they represent .15% of the notional value, so it's only 15 basis points. However, the amount of derivatives, the notional value is so large that this transaction cost becomes a pretty important one. So, in the case of Lehman, that alone accounted for roughly $60 billion lost in the bankruptcy estate. That's not a trivial amount of money. Russ: So, let me make sure I understand this, because I think a lot of people find derivatives and bankruptcy a little bit intimidating. Guest: Only a little bit? Russ: The simple way--let me try to summarize. I'm one of them, by the way, but I like to pretend I'm not. The way I understand what you said is the following. There was a small provision that was not well known to the public, and maybe not even well known to some of the insiders, of this bankruptcy law of 2005 that allowed the holders of derivatives--a very rarified form of insurance--to jump to the head of the line in bankruptcy and get first claim on the assets that were still available. Is that a correct summary? Guest: It's actually worse than that. Russ: Sorry, sorry; no, it's worse. Let me try. It's worse because not only do you get first claim, but you could even charge the remaining assets a fee for reestablishing the insurance policy with a different entity. Guest: Exactly. Russ: It's an unbelievable thing. You'd think that would have encouraged the growth of derivatives. Guest: And it did. Russ: And it would be interesting for someone to look carefully at how that provision actually got in the law, because somebody very wise and foresightful went and lobbied for that and got it done. Guest: Absolutely. I think somebody should study because it's very important. That's exactly the point I'm concerned about, that somebody smart was able to sneak that in without anybody sort of seeing it. Why? Because there was too much consensus. And if you have more dissention you have more discussion about these items and that's what democracy is about. You try to avoid mistakes before they are done. Russ: And the other point, which you make later, and which I'm going to mention now just in case we don't get to it, because I think it's so important, is that there may have been a time some time in the past where you'd actually feel a little bit guilty lobbying to get that kind of change put in the law because it clearly is a way of sneaking to the head--it's like cutting in line. And cutting in line is socially unacceptable in America. It's not as socially unacceptable in every country, but if you are at the grocery and someone elbows their way to the front and mumbles something about being in a hurry, people get mad. If you explain: My car is on fire, my children are in there, I have to pay for my groceries first; people will say: Oh, go ahead, go ahead. But in general you have to have at least a story to tell. And what this is, is a guy, somebody with a lot of derivatives said: Hey, this is going to be good for us. And instead of saying it's just not right, they went and did it anyway. The lack of shame, guilt, and ethical behavior is part of our problem. But I hope we can come back to that because you have some interesting things to say about it. But I just want to mention that that is implicit in your discussion. Guest: Absolutely.
34:25Russ: I wanted to spend some time--we don't have time because there are too many good things to talk about, but I want to mention to listeners that there are some beautiful metaphors in the book for understanding moral hazard and risk-taking. I'm referring to the asteroid and also the roulette wheel. So, if you get the book, you'll enjoy those sections. But I want to move on to some other issues. In particular you talk about the growth of the financial sector in our economy and how wages of workers there have also grown dramatically. Why did that happen and what are the implications? Guest: As economists, we tend to think that when a sector is growing, it's because it's producing more wealth; and when wages tend to be high it's because people are more productive and they create more value. I think this is true in general, in particular if there is no distortion created by government intervention or some form of monopoly. Let me give you an example that I think is familiar to some people why some form of monopoly can lead to an extension of a sector that is not really justified by productivity but is really distorted. Take the real estate agent sector, especially the time where there was a multiple listing service that could not be replicated very easily. It was a sector that had some market power. However, it's a sector where there is also free entry, so it's not that the real estate agents are earning an extra amount of money if they can charge more money to their clients. It's that too many people will enter into the real estate sector. The real estate sector, the brokerage sector, will be too large and everybody on average will make, at least in equilibrium, the same wage as in any other sector; it's just that you have too many agents in the economy doing too many deals each and so not being very productive. Russ: Too few deals. You said too many. Guest: Sorry, too few deals. Russ: They are wasting a lot of time trolling for clients because each one is worth a lot, but it's an artificially high amount. Guest: Exactly. You said it very well. The real waste is that in order to get a listing, you have to sort of look for many, and that's kind of time wasted; but for you it is very valuable because once you get a listing you get a lot of money. So, I think that this is an example. I fear that this is in part what happened in the financial industry because we gave some unique privileges to the financial industry, and one is this too-big-to-fail implicit subsidy that allows some people to earn an extra amount of money. The result is: Who is going to get the value of this subsidy? Could be the shareholders, but most likely are the managers in that industry; they are earning a disproportionate amount of money. That explains why so many were glad with moving into the financial industry and why the financial industry grew so much in recent years. And not all of it can be the result of efficiency. Russ: The obvious other aspects--you mentioned too big to fail. We're going to come back and talk about that. But the willingness of the Federal Reserve to coddle the financial sector in various creative ways that go beyond its narrow mission statements is also part of the problem. Guest: Yeah. Russ: So, that's very depressing.
38:40Russ: Let's move on to an even more depressing phenomenon which you identify. You give what for me was a novel explanation. There is a famous paradox associated with my colleague here at George Mason U., Gordon Tullock, who noted that even though businesses spend a great deal of money trying to influence political outcomes, in some sense tragically and paradoxically they don't seem to spend enough given how much is at stake. So, given how much value the government can transfer from the rest of us to the winners of legislative contests and special legislation and various things, there's a huge incentive to steer that toward yourself. And if anything, even though the amounts are large, they don't seem large enough. You'd think people would spend more to be the winners of these legislative contests. They would spend more on candidates that would favor them. There have been various explanations given for this. Give us some of those and then your explanation. Guest: So, I think that--I don't exactly remember the other explanations. I only remember mine. Russ: Yeah. Stick with yours. Guest: Which is--one explanation is, of course politicians are not just interested in only money. They are interested in money and votes. So you might decide for certain policies even if they are not, you don't get money for that, if you can get a lot of votes. But even if controlling for this factor, Gordon Tullock's argument is really very powerful. In my interpretation there are two factors that explain that. One is that it's a biased competition, because there is one side, which is generally business side, who can collect money and martial resources very effectively, and the other side that cannot. And since the interest of the people at large is not well coordinated, not well funded; there was a friend of mine that said that truth is another special interest, and a particularly not well-funded one. I think that the same can be said in general for public interest. It's another special interest but not a well-funded one. The fact that the price is not high enough is because one side is not present at the bargaining table. Russ: So they don't spend very much because they don't have to. It's cheap. Guest: No, they cannot afford to. Russ: I meant the winning side. Guest: Yeah. The winning side is not spending enough because they don't have to. Absolutely. Russ: So, go ahead, and this is the depressing part; but it's possibly true. Guest: The second part is that traditionally there was a kind of ideological bias[?] to taking money, and even on the business side there was a bit of a reluctance to play the game in a very aggressive way. Now business has learned how to do it very effectively, and so there is very little limitation on escalation. The fact that in the last few years we've seen an explosion is I think part of the result. Business from being reactive has become proactive. In the past, much of the lobbying was to prevent bad legislation from the government. And that's why as conservatives we didn't see lobbying as such a big cost, because they were fighting along the same agenda. Today it's so proactive that you want to create legislation to favor me, and that's really bad in a new dimension. Russ: The idea that earmarks for example are growing and special interest groups are growing because they are getting better at it and are less ashamed of it is a deeply depressing but possibly a very true thing. Very scary. Guest: Absolutely. But also, I want to stress, one part that I find more difficult is that when I talk with free marketeers, they tend to be more understanding of lobbying, because they say lobbying is part of freedom of speech, part of democracy. And I think all this is true. I don't deny that. But I think they have this more benign version of lobbying because they think about the reactive lobby--the lobby against the government intervening. The problem is the proactive lobbying. Russ: I agree, but there's an even worse aspect that I find among people who are free-market oriented, of which I am certainly one. When I'll say for example that what's wrong with the financial system is that Goldman Sachs or Citigroup or others have lobbied the government for special favors, they often will reply: But that's profit maximization. Yes, that's true, but it's evil profit maximization. It's the opposite of making a better product. It's a zero-sum game. It's exploiting me. And you. It's a terrible justification. Well, what would you expect them to do? Well, the answer is: I don't expect people to do everything that's legal but immoral. And if that's our social contract, our culture, our ethic, which you talk about later in the book, we are in big trouble. If the only thing that discourages immoral activity is the law because of transaction costs, it's going to be a very bad place to live, those kind of societies. Guest: Absolutely. And I think that you really point a finger in the right spot, and the point is there is too much confusion between being pro-market and being pro-business. Russ: Absolutely. Guest: And people tend to justify everything that business does as right just because you are for free markets. Russ: And the invisible hand; the invisible hand solves everything. That's not what Adam Smith said. Guest: No, he didn't say that. Russ: He said the opposite, actually, that businessmen like to get together to collude. I certainly accept the position that it's politicians who listen to that lobbying who are equally at fault; but please don't tell me that it's just natural somehow and healthy that businesses try to use the government to take money from the rest of us. That's a terrible thing.
45:42Russ: Let's move on to a related example, a topic I've talked about a lot on the program. The example you use is Robert Rubin and moral hazard. So, talk about Robert Rubin's role in increasing moral hazard. Guest: I think that what is important to understand--I want to speak more broadly and then I will arrive to Rubin--is that the most dangerous lobbying is the lobbying that has a noble idea as a front justification of it. So, we know the damages that the lobbying in favor of a home for every American as created because that sounds good. And everything that sounds good sounds difficult to assess. And so one sort of very pernicious form of lobbying is this idea that we need to rescue every country or every firm that is in financial trouble because this is good for the country. This idea is a kind of a perverse mix because more socialist or left-leaning view that the government should be a benevolent player in the market economy and business interests--that businessmen are very interested in having a government intervening to absorb the losses, especially if they can keep the profit. And so I think that marriage is the worst possible marriage. And Robert Rubin, who worked at Goldman Sachs, became Secretary of Treasury, and then went to work at Citigroup represents the symbol of this dangerous marriage between business and more sort of a welfare state attitude. And he was the ideologue behind a number of rescues, from the Mexico bailout during the Tequila Crisis to the East Asian Crisis, and all these rescues helped tremendously the banks who lent the money to these countries get their money back without there being any cost of their aggressive lending. And that clearly fostered more alliances because banks understood that the government will save them whenever in trouble. And Rubin was also very instrumental in the passage, the repeal, of Glass-Steagall; and a thing that is pretty sad, left the Treasury and went to work at Citigroup, a bank that was tremendously helped by Glass-Steagall, within a few months. He stepped down and then went to work for Citigroup within a few months. And at Citigroup he got a position which was not an operating position but which was remunerated extremely well--if I remember correctly it was $20 million a year. And during that period his job was basically to lobby the government. He lobbied the Bush Administration trying to induce them to save Enron, and Enron--surprise, surprise--a big client of Citigroup. So, what he had done, according to an economist's [Economist?] article, would have done would have been illegal if Clinton in the last day of office would not have removed that ban from the law. It was clearly something not particularly ethical, and Rubin did it; I think he was also instrumental in getting Citigroup help tremendously during the financial crisis. Russ: Tens of billions of dollars. Guest: And in spite of this he walked away with $140 million from Citigroup, a company that was on the verge of being bankrupt, and pays no reputational cost! So today, Rubin is on the Board of Trustees of Harvard Corporation, probably the most prestigious higher education company in this country and the world. Russ: Yeah, but tens of thousands of EconTalk listeners think less of him now than they did before. So, that's some consolation. But yeah, it's deeply depressing. I just want to make two comments on that. One is that long time listeners will recognize the phenomenon that Luigi is talking about, which is the marriage of high-sounding ideals with narrow self-interest as the bootlegger and baptist theory of regulation of Bruce Yandle. We have a podcast on that. The other point I want to make, which I think is crucial to make--and even you said it this way--you talk about the rescue of Mexico, or the Mexican rescue. And it wasn't a rescue of Mexico. It was a rescue of Mexico's creditors. They were mainly American banks. And I notice you cite in your book an article from The Nation that actually found the amounts that Mexico was in debt to Goldman Sachs and Citibank I think at the time, right? It was billions of dollars. So that rescue, which was justified as for world stability and financial markets would collapse if Mexico defaulted--those banks would have collapsed. Which would have been a good thing, because it would have sent a lesson to the rest of the world. And a few people did note it at the time, that this was a terrible rescue. And it was justified because it "didn't cost the taxpayer anything." It was just a guarantee that never got invoked. Well, it was a guarantee that eventually paved the way for the 2008 crisis. And I want to close this section by a discussion of the sign at the Grand Canyon. So, you remember that piece of your book? Guest: Absolutely. Russ: Talk about that. Guest: When you go to the Grand Canyon there is a sign: Please don't feed the wild animals. Of course the reason is that if you feed the wild animals, they lose their habit of searching for food for themselves, and that's bad for their long-term survival. I always wonder, number one, why don't we put a sign like this in Washington saying you shouldn't feed the free enterprise system; but number two is sort of: if the animals were in charge of setting the sign, they would probably not like to have the sign; and the humans who put those signs there. So, businessmen don't like to put signs "Don't feed us." And I think that's part of the problem. We should be part of the people at large imposing this restriction because that keeps the economy helping and the survival of the free market system in the long term. Russ: Just to quote an interview we did with Milton Friedman: he always liked to point out that business people love capitalism, but not for themselves. Their industry is always special; it's different. So people always assume--again, it's this difference between pro-business and pro-market--they are always surprised when businesses lobby for special regulations or intervention. And they always say: but they are supposed to be capitalist. No. They are not. They have special interests that are very different from capitalism as a whole and consumers as a whole.
53:39Russ: Let's turn now to--well, one more diagnostic observation before we get to some of your solutions. You have a nice point about the divergence between wages and productivity. A lot of people have pointed out that wages and productivity have diverged, going back to I think the mid-1970s. They used to pretty much move together, and now all of a sudden they seem to be very different; that workers don't get what they produce any more. And this has also encouraged people to be very anti-free market. But you make some very thoughtful observations on that divergence. Guest: Yeah. I think that part of this divergence is due to compensation versus wages. One of the major items in this difference is the cost of health care. So the feeling that most Americans have that their wages are not going up in real terms is true; but it's not because companies don't pay them more and more. It's because a larger fraction of that is absorbed in costs of health care. And so you don't see these costs because it is on purpose hidden from you. It's taken away before you get your pay stub. And you are not allowed to choose, not allowed to bargain for maybe a different combination of products. And in a sense that's a huge subsidy to the health care industry. Russ: Yeah. So that's one reason. The other reason is a different measurement problem, right? It's about--you have a second. Guest: Yeah, how you deflate productivity. There is clearly a divergence in the different price indexes, and in particular the price index that includes both the cost of business production and the cost of non-business production, which is education and health care, which are not part of the traditional business sector, goes up at a higher rate because the cost of health care and the cost of education has gone up more than the cost of other goods. Russ: I've seen other studies that point out that the mix of computer and other costs to business are very different and technology is very different for the consumer; and the amount we consume, and we use different baskets of inflation in trying to deflate the nominal numbers to real is part of that. But what you show is that it's small once you make these kind of corrections, but it's still there. There is some gap. Maybe it would be due to some measurement error, but it could be actually there's a change in how our private sector economy, the free market part that's left, actually does compensate people. And you then turn to ways we can fix that or make it better. Obviously, focus on things like improving education for people who have low skills and low productivity. Guest: I think this is actually one of the biggest problems we are facing today in America. Everybody is focusing on the business cycle fluctuations and I think it's terrible that unemployment is higher than it used to be. But I think there are some more scary long term trends. And one, which a colleague of mine has pointed out, is that if you look at the employment of prime age U.S. males--and again it's not because females are less important; it's because when you look historically there has been less change in [?] participation in males than in females. From 1979 to today, the employment went down from 79% to 69%. So, when I say employment, these are not just people who are out of work; these are people that are out of the work force. Russ: You are talking about labor force participation. Guest: Yeah. And the question is why. I think there is not a full answer to that; but in part it's that they give up. Because they don't really have an attractive job. The more intense the competition is and the more unequal the payoff is, the more people who are a bit behind give up altogether. Russ: We did an interview with David Autor of MIT on the growth in disability, which is part of those people who have dropped out of the labor force because they are paid to. They don't get a lot of money from disability, but some of their labor market options are not very good either, and that's what they've turned to. We've made it more generous and easy to get. Guest: No, I think this is a serious problem; and again, using my golf example: the way in which sort of golf keeps a game interesting, when two people have very different abilities is to create a handicap. If you had to play with people with a very different handicap than you on an equal footing, you will probably not play because the game would not be interesting. And I think we need to try to do something in that direction, but to not waste valuable resources but also to create the sense that everybody has a fair shot, because that's crucial to the consensus we were discussing earlier.
59:34Russ: Yeah, well I'd get government out of the education business. You propose vouchers; and there's a private sector solution coming which is websites like Udacity that Sebastian Thrun has started. I'm hoping to get him as a guest soon on EconTalk. But that's going to I think change the face of public education. And private education. It would be a good thing. Guest: But I think many people are opposing vouchers because they claim that disadvantages kids whose parents are not particularly attentive or particularly able to select schools. And I think they have an argument on this ground. But if you want this can easily be fixed by making vouchers different in value. If you think some kids are particularly disadvantaged, you can make their voucher be more valuable, so the school seeks them out. I think that would be a private sector solution to the problem of poor neighborhoods, and so on and so forth. Russ: Yeah. I have a different problem on the other side, which is I think part of the problem of public education is that people don't pay for it. And when people don't pay for something they don't treat it as well as something they've earned; and I think giving away schooling is part of our problem. I worry that if we have vouchers there's going to be political pressure to increase the size. But when everybody complains about whatever solution like that, I always say: Compared to what? It's unfair to low income people who have trouble selecting their--as opposed to now? It's disgusting. It's a criminal thing what people have done to stop more competition in the schooling business. It's terrible. Or it should be criminal. But it's certainly unethical.
1:01:26Russ: I want to talk a little bit--you talk a lot in the book about ethics, which is an area most economists are uncomfortable with. And the way that I think most business schools have handled the ethical problem is by having a course on it. Which I think is kind of funny. Talk about the role of trust and ethics and how we might move toward some self-enforcing improvements on rent-seeking and other problems we've been talking about. Guest: I think that business schools have relegated ethics to separate courses because we economists have always been very uncomfortable with even the notion of any ethic. We like to pretend we are sort of scientists, like physicists. But there is a big difference. Physicists don't teach to atoms the law of physics. We teach to individuals the law of economics. And so our teaching, whether we want it or not, has an impact on what people do. So, even if we don't say something is right or wrong, when we say it is irrational to vote, for example, I don't think it is really conducive of people participating actively in the electoral system. I am not a moral philosopher, so I don't want to talk about the ethic with the capital[?] or the religious morality or right or wrong in absolute terms; but as economists we know that certain behaviors are detrimental to society overall. So it is not a question about redistribution. Very often people talk about more or less as a way to redistribute. Here I am willing staying with sort of the economic part of efficiency. But the efficient point of view lobbying very actively to get some special tax advantage, etc., we know is detrimental to society overall. And being neutral, not taking any position, is indirectly endorsing this attitude. And I think we should stand up and criticize that openly in class. And even at some level, have some social norms within our alumni community--that certain behaviors are not considered good. After all, we do have students sign a code of honor about not cheating in exams. And cheating in exams, if you are not caught, it is in the self-interest of people. That's exactly why we have a code. But why are we willing to have the sign-up code and we don't have a code about not cheating in business, or not cheating by the rules of the game through lobbying? Russ: Couldn't agree with you more. As a minimum, we as economists who understand the effects of these laws should be encouraging people to feel guilty when they steal money from their fellow citizens on behalf of their institutions. That's just wrong. And that would include, as you point out very well in the book, our own institutions. Educational institutions which have their own earmarks and their own lobbying efforts--we are the beneficiaries of lots of rent seeking. Guest: Oh, absolutely. Absolutely.

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COMMENTS (22 to date)
Per Kurowski writes:

The “haves and the have nots” are closely correlated with those perceived as not risky and those as risky. In this respect, do not capital requirements for banks which so overly favor those perceived as not risky, not represent an expression of the mother of all crony capitalism?

The discussion of Glass-Steagall is confused. Gramm, Leach, Bliley (1999) only repealed two provisions of GS. The 'affiliations' provisions.

So, it is now legal for a holding company to own both a commercial and an investment bank (though their balance sheets must be kept separate; a commercial bank cannot hold as an asset, stock in an investment bank). It's also now legal for the same person to be on a board of both types of institutions.

What didn't change was the definitions of commercial and investment banking, nor the prohibition of FDIC insured deposits being used to underwrite corporate securities (Sen. Carter Glass's pet peeve). Oddly, Wikipedia's article on Glass-Steagall is pretty informative on this, as well as being quite lengthy. I'd provide the url, but that would traumatize Lauren, so those interested will have to look it up for themselves.

As to why Jamie Dimon could take over Bear-Stearns, I'm guessing that it was because JPMC didn't take Bear over and run it as an investment bank, but merely bought some of its assets. Banks could always own corporate securities (despite GS), they just couldn't 'deal in them'.

They could also own real estate, and RE related securities, such as MBS. So, nothing done by Gramm, Leach, Bliley changed that. Though the privileged treatment of them under Basel II sure did.

rhhardin writes:

irrational to vote but..

Because, of course, the odds that anything you care about comes out one vote short is zero.

But suppose you and your neighbor disagree about some political issue.

If you both vote, it's 1-1 and you cancel each other out.

But if you persuade your neighbor your way, and don't yourself vote (for the rational reason), then it's 1-0 your way.

Persuading is more powerful than voting!

Now suppose you persuade a hundred, or a hundred thousand, instead of one. There's no limit on persuading.

You then have an actual chance to decide an issue that you care about.

It's not voting that makes democracy, but persuading.

Ken Plahn writes:

Great podcast, as always. It would be great if you interviewed Sebastian Thrun. I took two Stanford online courses last fall. One was taught by him and Peter Norvig. I'm currently taking two courses through Udacity.

It's unbelievable how effective this approach to learning is. Brick and mortar may go the way of the newspaper.

George Balella writes:

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David Zetland writes:

Great interview and good context for economists. Most of us are NOT laissez faire robots (the others are corrupted by consulting fees of blind ideology). It's important that those remaining intellectually honest economists point out the ways in which political institutions are abused (via a public choice/rent seeking cabal between politicians and lobbyists) to redistribute wealth from the majority to the minority.

Tibor R. Machan writes:

I would be a laissez-faire robot since I am convinced that free men and women do better at everything than even partially regimented, enslaved ones. Please do not use such terminology--it corrupts dialogue and is typical of Leftist ideologues!

Per Kurowski writes:

The “haves and the have nots” are closely correlated with those perceived as not risky and those as risky. In this respect, do not capital requirements for banks which so overly favor those perceived as not risky, not represent an expression of the mother of all crony capitalism?

Artful Monk writes:

This was confusing as previous podcasts about the GM/Chrysler bankruptcies conveyed a message about the lack of rule of law. However, the guest indicates that the bankruptcy laws were altered to favor creditors with derivatives. So is the uproar over GM/Chrysler bankruptcies about creditors not getting their desired outcomes for expenses related to lobbying Congress to change the law? If so, it is tough to shed a tear for those creditors who tried to manipulate the system in their favor and maybe it will serve as a market signal for those creditors to not waste money lobbying.

Also it seems that Corporatism is an unfortunate byproduct of a Capitalistic system. Although some may believe that one’s vote doesn’t matter because most elections aren’t decided by 1 vote, it does matter in the aggregate. In the last presidential election, only 130 million of 200M eligible voters cast a ballot. One way to counteract the power of corporations is to have more people vote thus reducing rent seeking profits for everyone. If people don’t care enough to vote, then they shouldn’t be surprised when corporations give money to candidates who claim to be business friendly; who in turn pass legislation in their favor.

N. Vianna writes:

Greetings,


Thanks for the talk and the program. I usually don't comment, but Roberts once again brought his disgust about the education system in America. At one point he included the statement "...compared to what", suggesting that a different state of affairs could hardly be as bad as it is now in the education system of the U.S.

I like this reference to 'comparison' because I think many of the theoretical and practical problems we have now, including those economic, can be less dogmatically discussed by simply looking around the world for examples of what fails or succeeds and in which ways. This is how arguments for a universal health care system are strengthened. And the same would go for education. Where in the world does a system of private education succeed for most of the population? Or, what are other successful countries/places doing in regards to primary and secondary education? Clearly, in the U.S. there is not enough evidence that charter schools fare better (see your podcast with Diane Ravitch).

Now, more specific to the discussion of this podcast, but on the big question encompassing the whole talk, who is to regulate the regulators? The problem of increased wealth on one group is that it is bound to influence economically and politically; the latter comes as a consequence of the former. It is this way that there is something intrinsically true and special about equality (democracy) even though the market and privatization (meritocracy) also has its benefits.


NV

Ken Plahn writes:

Artful Monk, I have to disagree with you. Corporatism is not a natural outcome of a capitalistic system. It occurs in communist systems, as well. It is a case of the politically connected taking advantage of government powers to pursue their own self-interest. This occurs when the government yields too much power. Limiting the power of government reduces the power that can be taken.

As for the GM bankruptcy, I believe it was a case of the government changing the rules of who is first in line during the managed bankruptcy, that upset people. An example of politically connected gaining advantage. Giving derivatives first in line status is a rule of law, but a case of hiding things in regulations to gain advantage.

Bogart writes:

An economy is supposed to be "fair"? What measure of "fairness" do you use? How do you make things fair when the interests, desires, abilities, knowledge and happenstances are so dramatically different for different people? And my measure of fairness in society is exactly correlated to my measure of morality in society which is simply the degree to which people respect private property rights.

You both discussed causes of our current financial mess but only touch briefly on the US Fed and other central banks which are at the core of this. Without newly created money not back by savings these investment banks would never be able to hold 30 to 1 and higher leverage ratios.

Lastly you discussed education and the corruption associated with this voucher idea. I absolutely agree that vouchers would not resolve and issues in the education system as these issues are a moral in nature not financial or economic. As long as government forces people to pay for the education of others then the whole system will continue to focus on bureaucracy, regulation and increasing corruption.

Artful Monk writes:

No argument here that corporatism can occur in communist systems as well. But we live in a democracy where people have the power to determine the role of government unlike communist countries. It’s easy to say that we should limit the power of government; however no one offers a path to reduce that power. The current electorate favors an expanded government role. Hence the only way to change that tide is to increase the electorate such that either limited govt proponents gain more power or the increased voters reduce the opportunity for rent seeking profits.

As for the GM bankruptcy, it is still not clear how the rule of law was broken. One can understand how institutional corruption mentioned in this podcast could play a role but that hasn’t been the argument by proponents. Often in Chapter 11 bankruptcy, the absolute priority rule rarely holds and seniority only gives a creditor better negotiating power. GM pensioners/creditors came to an agreement on how to divide assets, with both sides approving the settlement & all dissenter legal appeals resolved. As much as we want to believe that the GM bankruptcy appeared corrupt, seems like the rule of law worked in this case.

Ralph writes:

As someone who worked at the tournament many times when I was young, I can tell you that many of the people who work at the tournament for that week do so for free just to be there, to see, and sometimes meet the players, who are very friendly during the practice rounds. A few also get a chance to play the course afterwards.
I was just a high school kid on Spring Break and am not a golfer.
I love econtalk, Russ.

Ralph writes:

I once saw a billboard in Greenville, SC that said (best I can remember), "In a Moral society laws are unnecesary. In an Immoral society laws are unenforceable."

Great podcast Russ. I'll be buying this book. Thanks.

Allan writes:

Ken Plahn:

It is a case of the politically connected taking advantage of government powers to pursue their own self-interest. This occurs when the government yields too much power. Limiting the power of government reduces the power that can be taken.

If you have an unwanted pregnancy, you can mitigate the recurrence by confining women to convents or burlap bags. We live in a world where there's a continuous gradient between private goods and public goods. Obviously the interface is going to be a bit messy, as it is between men and women.

Defining one or the other party out of existence has been tried and found wanting. I think it would be better if men treat women with dignity and respect, but then I'm a bit old fashioned.

If the private sector can't get their bone under control, I guess putting government in the clamps is the best we can do.

corvi42 writes:

I found Zingales observations on how financial firms became so aligned in their lobbying efforts very insightful. By becoming vast integrated institutions, each of which subsumed all aspects of the financial industry within themselves, they became like so many homogenous clones, all with more or less the same interests.

However, the observation of how changing the law created a situation where credit card debt comes to cause foreclosures really highlights the flaw in this. These institutions are so large and cover so many different activities, that the competition which used to be inter-firm, has become intra-firm. This is why so many of these firms were acting against their own self-interest. Not just because of a mis-alignment between the incentives for those at the top and the long-term health of the firm, but also because there are so many divergent interests between all the different divisions within the firms. The mortgage arms in this case are in competition with the credit card arms, and the result is that laws are passed which result in that competition being quite unhealthy.

Manny C writes:

This is a homerun of a podcast. As Russ pointed out in the opening, Mr Zingales adds richness to the earlier discussions and debates about the causes of the financial crisis and the potential repercussions of how it was handled . The use of original, deep-insighted metaphors also added to my basic understanding of economic and financial concepts and phenomena. Thank you Mr. Zingales and Econtalk.

Glen writes:

Russ - I appreciate your outrage at big business using lobbying to craft favorable laws rather than just defending their position. But I think that you may be falling victim to the opinions of some of your recent podcast guests -- businesses are supposed to find ways to maximize their profits. If government doesn't do much to interfere with markets, big business has little incentive to interfere with government. Only when government continously interferes with markets do businesses start to realize that they can go on the offensive instead of merely playing defense. We could try to outsmart businesses and make it illegal to lobby in promotion of new legislation, but we all know that the profit motive and continued governmental interference with markets will drive big business to find other ways of satisfying the interest of their shareholders for maximum profits.

Arnold writes:
One of the first things that happened was a tornado watch in Boston. So, there was this public ordinance that you were to go home, tape your windows, and stay inside. And my reaction was that if the mayor tells you to tape your windows, it must be that his brother is selling tape.

So I am at home watching the 6 oclock news in San Diego, CA. and the weatherman is interviewing San Diego's fire chief. The Chief recommends that San Diego residents purchase this fire retardent mesh that keeps embers from getting in to vents and under eves during this very dry high heat season in CA. I snickered to myself thinking that the fire chiefs brother must be selling fire retardent mesh. Great podcast. Bought the I book. Good stuff!!

erling writes:

Interesting episode :)

Jakob Engblom writes:

Seems I should try to listen to these as soon as they come out, tend to come in a bit late to the discussion apparently. Anyway.

Interesting podcast, pretty scary to hear even more about how the US democratic system is broken. I liked the point about how being "pro-business" is not the same as being "pro-market economy". Very very true, but I hadn't heard it expressed with such lucidity until now.

From my Swedish horizon, some of what is going on in the supposedly capitalist US is just amazing. I think it would be very interesting if you could get some international comparative economics into a podcast - in many cases, your guests hint at other ways to do things, but never really bring up the examples of other countries. To me, that is the most natural thing to do - if your way seems a bit broken, look at how other people have done the same thing.

I guess back here, one counterpart to business lobbying is the strength of the trade unions. I don't approve of all the questions they tend to drive, but it seems that something like that is a necessary counterpart to plain profit-maximizing immoral business (hopefully, some business can indeed be moral too, as it used to be). And maybe also political parties with direct state funding is a good idea, as it reduces the dependency on external funds and thus on lobbyists and people with money.

Finally, you should really try to find someone to interview about the Swedish experiment with "education vouchers" all the way from daycare up to the university level. As I see it, the effect has been to segregate high-school kids in a new way: rather than by area of residence, it is by how engaged parents are in their kids schooling. Not sure if it makes that big of a difference. It is also a bit unclear if it does not also entail compromises in quality, since profit-maximizing private school companies will tend to try to drive down costs as the income side is pretty fixed. I would say the jury is still out on whether this really was a good idea or not, in the long run. In the short run, it certainly stirred things up and unleashed some creativity, but now it is all consolidating and becoming quite scary. At the university level, it has worked much better.

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