EconTalk http://www.econtalk.org/ Copyright 2012 Mon, 30 Jan 2012 06:30:00 -0500 http://www.movabletype.org/?v=4.21-en http://blogs.law.harvard.edu/tech/rss Fama on Finance Eugene Fama of the University of Chicago talks with EconTalk host Russ Roberts about the evolution of finance, the efficient market hypothesis, the current crisis, the economics of stimulus, and the role of empirical work in finance and economics.

Play
Time: 1:01:37
How do I listen to a podcast?
Download
Size: 28.3 MB
Right-click or Option-click, and select "Save Link/Target As MP3.
]]>

Readings and Links related to this podcast

Podcast Readings
HIDE READINGS
About this week's guest: About ideas and people mentioned in this podcast:

Highlights

Time
Podcast Highlights
HIDE HIGHLIGHTS
0:36Intro. [Recording date: January 17, 2012.] Russ: Your impact on the field of finance has been immense--in a whole bunch of areas, but one that stands out is the efficient markets hypothesis (EMH). I'd like you to sketch out the evolution of that idea in the field, how it was understood initially, and how it has changed over time. Guest: How much time do we have? Russ: Well, four or five hours, but let's try to keep it to under 10 minutes for this first question, if you can. Guest: Okay. I'll go back to the beginning. The way Harry Roberts tells it, Holbrook Working in the 1930s started to become interested in whether speculative prices moved randomly. He was mostly an agricultural economist, looking at agricultural commodities, and he took a series of random numbers, simulated them, and brought them to his faculty at Stanford, faculty lounge, I guess; showed them to them and they agreed they were an agricultural series. So he thought from that that maybe a random walk kind of model would work pretty well for agricultural prices, prices of other commodities. But then there was a big gap from there to like the end of the 1950s. And what opened things up was the coming of computers, which made computations much easier. And the most readily available data was stock price data. So, basically, statisticians, econometricians took the data and started doing calculations on it, calculating autocorrelations with their estimates of how predictable returns are based on past returns. And then they stopped. Economists got into the mix and said: Okay, how would we expect prices to behave if they were set based on all available information? Which is basically the EMH, but it wasn't stated in those terms at that time. So, they said: I think they should be a random walk, an hypothesis pulled out of the air. Russ: When you say it's a random walk, explain what that means. Guest: That means that expected changes are successive changes are independent of one another. It also means they have identical distributions, but that part is not important. It's basically the independence part that's important. It basically means that you can't predict future returns based on past returns. Russ: And yesterday doesn't tell you anything about tomorrow. Guest: Right. Returns from day to day are basically independent of past returns. Now that was a very extreme hypothesis. Let me give you an example. You wouldn't say that about tomatoes, for example. Tomatoes are going to be cheaper in August than in January, for the most part, because they are seasonal. It has to do with supply and demand--mostly supply of tomatoes. There's a similar thing operating in prices of stocks, bonds, whatever. Basically, there's an expected return component, what people would require in order to hold those securities; and there's no reason that that has to be independent through time. There's no reason why that's not predictable or why it doesn't go--and there's lots of evidence that it is--higher on stocks during recessions and lower during good times. So there can be predictability in returns that is consistency with efficient markets. What people didn't understand in the beginning was that propositions about how prices should behave had to be joined to a statement about how you think they ought to behave. In other words, what you need is some statement about what we call a market equilibrium. What is the risk-return model you have in mind underlying the behavior of the prices in returns? So, for example, stocks are very risky; they require a higher expected return than bonds; and you have to take that into account in the tests. So there is this, what I call the joint hypothesis problem, which is basically what I added to the mix, but it's kind of an important part of it. It says whenever you are testing market efficiency you are jointly testing efficiency with some story about risk and return. And the two are joined at the hip. You can't separate them. So, people infer from that, it means market efficiency is not testable on its own. And that's true. But the reverse is also true. A risk-return model is untestable without market efficiency. Most risk-return models assume that markets are efficient. With very few exceptions.
6:18Russ: And so when we say markets are efficient, what do you mean by that? Guest: What you mean is that prices at any point in time reflect all available information. Russ: Now that idea--what's the distinction between the weak form and the strong form that people talk about? Guest: Two words that I used in 1970 that I came to regret. Because I was trying to categorize various tests that were done. So, I called weak form tests, tests that only used past prices and returns to predict future prices and returns. And I called semi-strong form tests, tests that used other kinds of public information to predict returns, like an earnings announcement or something like that. And then I called strong form tests, tests that look at all available information; and those are basically tests of if you look at groups of investment managers and you look at returns that they generate, you are basically looking at all the information they had to generate to [?] securities, and what's the evidence that the information they had wasn't in prices. Russ: And empirically, where do we stand today, do you believe and what has been established about those various hypotheses? Guest: Well, believe it or not, the weak form one has been the one that has been subject to the most, what people call anomalies, in finance. Things that are inconsistent with either market efficiency or some model of risk and return. The big one at the moment is what people call momentum--prices seem to move in the same direction for short periods of time. So, the winners of last year tend to be winners for a few more months, and the losers tend to be losers for a few more months. In the strong form tests, Ken French and I just published a paper called "Luck Versus Skill in Mutual Fund Performance," and basically looked at performance of the whole mutual fund industry--in the aggregate, together, and fund by fund, and try to distinguish to what extent returns are due to luck versus skill. And the evidence basically says the tests it's skill in the extreme. But you've got skill in both extremes. That's something people have trouble accepting. But it comes down to a simple proposition, which is that active management in trying to pick stocks has to be a zero sum game, because the winners have to win at the expense of losers. And that's kind of a difficult concept. But it shows up when you look at the cross section of mutual fund returns, in other words the returns for all funds over very long periods of time. What you find is, if you give them back all their costs, there are people in the left tail that look too extreme and there are people in the right tail that look too extreme, and the right tail and left tail basically offset each other. If you look at the industry as a whole; the industry basically holds a market portfolio. That's all before costs. If you look at returns to investors then there is no evidence that anybody surely has information sufficient to cover their costs.
10:11Russ: Which says that for any individual investing, certainly someone like me, that is, who doesn't spend any time or very much time at all looking--in my case no time, but let's suppose even a little time--trying to look at what would be a good investment. The implication is to go with index mutual funds because actively managed funds can't outperform. Guest: Well, no, it's more subtle than that. What's more subtle about it is, even if you spent time, you are unlikely to be able to pick the funds that will be successful because so much of what happens is due to chance. Russ: So, for me the lesson is: buy index mutual funds because the transaction costs of those are the smallest, and since very few actively managed funds can generate returns with any expectation other than chance to overcome those higher costs, I can make more money with an index fund. Guest: Right. Now, it's very counterintuitive, because we look at the whole history of every fund's returns, and sort them, and really the ones in the right tail are really extreme. Russ: Some great ones. Guest: They beat their benchmarks by 3-6% a year. Nevertheless, only 3% of them do about as well as you would expect by chance. Now what's subtle there is that by chance, with 3000-plus funds, you expect lots of them to do extremely well over their whole lifetime. So, these are the people that books get written about. Russ: Because they look smart. Guest: What this basically says is that there is a pretty good chance they are just lucky. And they had sustained periods of luck--which you expect in a big sample of funds. Russ: Of course, they don't see it that way. Guest: No, of course not. Russ: A friend of mine who is a hedge fund manager--before I made this call I asked him what he would ask you, and he said, well, his assessment is that efficient markets explain some tiny proportion of volatility of stock prices but there's still plenty of opportunity for a person to make money before markets adjust. And of course in doing so, make that adjustment actually happen and bring markets to equilibrium. Somebody has to provide the information or act on the information that is at least public and maybe only semi-public. What's your reaction to that comment? Guest: That's the standard comment from an active manager. It's not true. Merton Miller always liked to emphasize that you could have full adjustment to information without trading. If all the information were available at very low cost, prices could adjust without any trading taking place. Just bid-ask prices. So, it's not true that somebody has to do it. But the issue is--this goes back to a famous paper by Grossman and Stiglitz--the issue really is what is the cost of the information? And I have a very simple model in mind. In my mind, information is available, available at very low cost, then the cost function gets very steep. Basically goes off to infinity very quickly. Russ: And therefore? Guest: And therefore prices are very efficient because the information that's available is costless. Russ: But what's the implication of that steep incline? That information is not very-- Guest: It doesn't pay to try to take advantage of additional information. Russ: It's not very valuable. Guest: No, it's very valuable. If you were able to perfectly predict the future, of course that would be very valuable. But you can't. It becomes infinitely costly to do that. Russ: So, your assessment, that you just gave me of the state of our knowledge of this area, I would say remains what it's been for some time--that at the individual certainly there is no return to--prices reflect all publicly available information for practical purposes for an individual investor. Guest: For an individual investor? Even for an institutional investor. Russ: Correct. So, what proportion of the economics and finance areas do you think agree with that? Guest: Finance has developed quite a lot in the last 50 years that I've been in it. I would say the people who do asset pricing--portfolio theory, risk and return--those people think markets are pretty efficient. If you go to people in other areas who are not so familiar with the evidence in asset pricing, well, then there is more skepticism. I attribute that to the fact that finance, like other areas of economics, have become more specialized. And people just can't know all the stuff that's available. Russ: Sure. Guest: There's an incredible demand for market inefficiency. The whole investment management business is based on the idea that the market is not efficient. I say to my students when they take my course: If you really believe what I say and go out and recruit and tell people you think markets are efficient, you'll never get a job. Russ: Yes, it's true. And so there's a certain bias, you are saying, to how people assess the evidence. Guest: There's a bias. The bias is based, among professional money managers, the bias comes from the fact that they make more money from portraying themselves as active managers. Russ: That's true in macroeconomics as well. We'll get to that a little later in the conversation.
16:50Russ: I was going to ask you about the current crisis. Guest: I have some unusual views on that, too. Russ: I'd say that the mainstream view--and I recently saw a survey that said--it was an esteemed panel of economists; you weren't on it but it was still esteemed, both in finance and out of finance. And they asked them whether prices reflected information and there was near unanimity. Some strongly agreed; some just agreed. But there was also near unanimity that the housing market had been a bubble. Guest: The nasty b-word. Russ: Yes; and was showing some form of what we might call irrationality. Guest: Okay, so they had strong feelings about that, getting mad about the word bubble. Russ: Why? Guest: Because I think people see bubbles with 20-20 hindsight. The term has lost its meaning. It used to mean something that had a more or less predictable ending. Now people use it to mean a big swing in prices, that after the fact is wrong. But all prices changes after the fact are wrong. Because new information comes out that makes what people thought two minutes ago wrong two minutes later. Housing bubble--if you think there was a housing bubble, there might have been; if you had predicted it, that would be fine; but the reality is, all markets did the same thing at the same time. So you have to really face that fact that if you think it was a housing bubble, it was a stock price bubble, it was a corporate bond bubble, it was a commodities bubble. Are economists really willing to live with a world where there are bubbles in everything at the same time? Russ: And your explanation then of that phenomenon? Guest: My explanation is you had a big recession. I think you can explain almost everything just by saying you had a big recession. A really big recession. Russ: And why do you think we had a really big recession? Guest: I've heard some of your podcasts; I'm with you. I don't think macroeconomists have ever been good at knowing why we have recessions. We still don't understand the Great Depression. Russ: True. Although Ben Bernanke would argue, and Milton Friedman would argue and he did before he passed away, that monetary policy is a huge part of it. Guest: Let me reflect. I had this discussion with Milton, actually; and what I pointed out was from your own data, they show that there were massive free reserves throughout the Great Depression. And my point is: we can't force people to move demand deposits. Or to make love to anyone. Russ: Well, you can but it's not very productive. Guest: It's not very productive. M1 and M2--those things are basically endogenous. Russ: I have the same feeling. Guest: The only thing that's sort of exogenous is the monetary base. Russ: What did Milton say to that? Guest: All I gathered from Milton was: Interesting. Even when you won you thought you lost. Russ: Yes, I know. I had plenty of those. So, are you saying that that's analogous to our current situation? Guest: Oh, no. What I'm saying is that for example people want to blame the recession on the housing sector crashing and subprime mortgages. But if you are an economist and you are thinking about that, you have to be saying that there was some misallocation across markets, that margins weren't being equated across markets. That's pretty hard to accept because people are acting in all markets, working in all markets. That's a pretty tough one to follow. Russ: Well, a lot of people swallow it. Here's their version. They say things like there are these things called animal spirits that you can't measure, but that doesn't mean they are not real; that people get all excited about a particular asset class--in this case it was housing. And as those prices start to rise it becomes rational to speculate that it will continue to rise. And as that happens--as you would admit, people are making money along the way--and then they don't. They stop making money; the prices collapse. And this happens from time to time because of irrational exuberance; and that's just an aspect of capitalism. That's the standard counterpoint. Guest: Okay, but it wasn't just housing. That was my point when we started. The same thing was going on in all asset markets. Russ: Well, the timing isn't quite identical for all asset markets, right? The stock market--the housing market starts to collapse I think around early-mid-2006. Guest: It stops rising, right. Russ: And then begins a steady decline. Guest: That decline was nothing compared to the stock market decline. Russ: But when did that happen? Guest: I don't know the exact timing. Russ: It's not around then. It's later. Guest: The onset of the recession started with the collapse of the stock market. The recession and the collapse of the stock market, the corporate bond market, all of that basically coincides. But that also coincides with the collapse of the securitized bond market. Russ: Mortgage-backed securities. Guest: The subprime mortgages and all of that. Russ: Well, yes; that happens through 2007, 2008. I guess there is some parallel. So, you are going to reverse the causation. Guest: I'm not saying I know. What I'm saying is I can tell the whole story just based on the recession. And I don't think you can come up with evidence that contradicts that. But I'm not saying I know I'm right. I don't know. I'm just saying people read the evidence through a narrow lens. Russ: Yes, they do. Confirmation bias. Guest: And the rhetoric acquires a life of its own; so there are books written that basically all say the same thing about the crisis. Russ: And you are arguing that they have essentially cherry-picked the data. Guest: Well, they just look at pieces of the data and the fact that the housing market collapsed is taken to be the cause; but the housing market could collapse for other reasons. People don't just decide that prices aren't high any more. They have to look at supply and demand somewhere in the background. Russ: We did have people holding second and third homes who didn't have the income and capability of repaying the first one. Guest: Sure. Standards were relaxed. But then you have to look on the supply side, the lending side. The people who were lending to these people had the information. Russ: Yes, they knew it. I don't think that they were fooled. They were not overly optimistic about the value of those loans. They were willing to do that because they could sell them. Guest: The puzzle is why they were able to sell them.
24:17Russ: Correct. Now my claim is the people who bought them did it with largely borrowed money. Guest: No, that's not true. These were bought by people all over the world. Russ: Correct. Guest: No one borrowed money. Remember now: savings has to equal lending. For everyone that's short bonds, somebody is on the other side. The net amount of leverage in the world is always zero. Russ: That's true. Guest: So you can't tell a story based on leverage. Russ: So what's your story? I have to think that through. It's undeniably true, and I'm not going to argue with that point. So, what's your explanation of why people bought these things? Guest: Well, I have no explanation. Again, I'd say the market crashes because of the big recession. Even a minor depression if you like. Remember that all the people buying these subprime mortgages all over the world, they are the ones making the loans in the end, they were sophisticated investors. Institutions, big banks all over the world. They thought these things were appropriately priced. They might have been at that time, but they weren't ex post. Russ: So you are not going to allow me to make the claim that the incentives they faced to worry about how appropriately priced were distorted. Guest: The incentives to make money are always there. The question is whether the market lets you make money. So, these people that wanted to securitize all these mortgages, they could have failed at any time in the process; and they would have failed big time because in order to do these things, you have to initially finance them yourself. So when the investment bankers were bringing out the securitized mortgages and other kinds of securitized assets, they initially held them. And they held them afterwards, too. Russ: They held many of them. Guest: Well, initially they held them all, because they are bundling them together; they have to come up with the capital and then they can sell them. So, they could have failed right at that point because the market says: Forget it. We're not paying you par value for these things. Russ: But when they did fail, which they fundamentally did because, at least for them, even though the world wasn't leveraged, they were leveraged, they should have gone out of business. Guest: Right, exactly. Russ: But they did not. Guest: That's awful. That's the worst consequence of this whole episode. Russ: So, my narrative is the anticipation of that distorted their decision-making. Guest: Sure, but that doesn't satisfy what address what goes on on the demand side. Russ: Why? Guest: Because people on the demand side have to buy these things. Russ: Well, the people who were buying them, and selling them, were fundamentally the same people, right? Guest: Okay, so if greed causes me to put out securities that I know are no good, why would I hold them? Russ: Because I can hold them at a very low cost. I have uncertainty; I don't know what's going to happen. There's an upside; there's a downside. Guest: It's really a low cost if you know you are going to get bailed out. Russ: Right. My argument is it dulls your senses. Guest: It does; I agree with you there. Any probability that you are going to be bailed out is going to distort your decision. Russ: So, is your argument then that that was relatively unimportant? Guest: No, no. My argument is it can't explain why people who weren't generating these things and weren't going to be bailed out by us, investors in Norway, whatever--why were they buying? Russ: Well, I'm happy to admit that some people just made a mistake. After the fact. Ex ante they certainly didn't think they were throwing away their money. And a lot of those people making those investments around the world, we bailed them out, too. The European banks got some of the benefits. Guest: Yes, because they were mixed into the same piles that involved our own investment banks. And so they got bailed out in the process. If they were holding credit default swaps (CDSs) that were sold by AIG, they got bailed out. Russ: Although I think Goldman was the number 2 holder of those. The first was--I can't remember; it was a foreign bank, either French or German.
29:19Russ: So, you have publicly said that that was a mistake, those bailouts; we should have let them fail. Guest: It's irrelevant because there is no political regime that will let that happen. Russ: Correct. But let's suppose, let's live in a fantasy world for forty seconds. Suppose on March of 2008, Ben Bernanke and Hank Paulson and the others who got together to talk about the impending bankruptcy of Bear Stearns had just let them go. They would have opened for business Monday morning without enough cash to cover their positions; they would have had to tell their creditors: Sorry; I can't honor the promise I made to you the other day or the other money; and you won't be getting the payment you anticipated. The justification for the intervention was that if we had let that happen there would have been an enormous crisis: credit markets would have frozen up and we would have had a worldwide depression. Guest: I don't know about that last part. That's what we'll never know. The issue is: How long would it take to straighten things out? And I think it's really overrated that it would have taken a large amount of time. So, banks fail all the time, and the FDIC goes in and draws a line in the sand about who is going to get paid and who isn't; stuff is put up for sale and everything goes on. I don't know how long it would take to solve a multiple failure problem. We'll never know. Russ: Well, the Lehman Brother's bankruptcy is still in process. Which is now three years old. This was the argument made at the time--like you, I'm skeptical about it but it has some legitimacy--it's that bankruptcy is complicated enough as it is; when it's a large investment bank with international creditors like Bear, Lehman, it would take a long time. In the meanwhile everybody would be thrown into turmoil. Blah, blah, blah. Do you think there's anything to that? Guest: It's possible. What happened in the Lehman case is it's held up by multiple jurisdictions. So, you have to settle with the British shareholders. Russ: The Japanese, Korean. Guest: Who all have their own set of laws about what happens in a bankruptcy. And that's what I think they've been fighting over for three years. It's pretty clear what assets [?]. Russ: But isn't that an argument for justifying what Bernanke and Paulson did? Guest: I don't know. Because who knows what would have been done if all of them went down. The problem really is that the investment banks weren't subject to the same disposition rules that would face an ordinary commercial bank. They are not subject to the FDIC. And the FDIC can come in and arbitrarily do it. That's what you buy into when you sign up for it. Whereas for the investment banks, they are not really banks; and they are not subject to those rules. The ongoing problem is that you haven't killed their incentive to finance things the way they always have. Russ: Well, I guess my claim is that part of the problem is that we gave a regulatory advantage to triple-A rated stuff, which allowed very large and different amounts of leverage compared to other stuff. That gave an incentive to these folks to find more triple-A. The amount of triple-A is essentially, until recently, there's just not enough of it to go around, if that's the most profitable thing you can do, because that's the thing you can leverage; so they found a way to invent more of it. And that included not just the things we are talking about, but European sovereign debt. Hey, that's safe; let's leverage that, too. Guest: Right. Russ: So, once we said: this is the stuff that you can make scads of money on because you can leverage it and use other people's money. Guest: You are slipping back again, though. Russ: Because? Guest: You are saying that people will buy this stuff even though it isn't triple-A. Russ: Correct. Guest: Why? Russ: Well, that's the puzzle. Is it because they were stupid, ex ante? Guest: We are talking about the world's most sophisticated people who invest. Russ: So is the alternative argument that people just made a mistake? Guest: After the fact, definitely. Whether it was a mistake before the fact, that involves estimating the probabilities of extreme tail events, which, as you know, are very difficult. Russ: So, where does that leave us? Story-telling, of course. Guest: Which is very entertaining but it's not convincing. I don't find it convincing.
34:45Russ: Before I forget, I was going to ask you--I don't want to miss this chance to ask you this: Does your research inform your own personal portfolio decisions? And has it over time? Guest: Oh, sure, always. Russ: Has it changed over time? Guest: Well, I'm not as young as I used to be. Russ: That's part of the theory, too. Guest: Right. So, my portfolio has become somewhat more conservative. I'm also a stockholder in an investment management company, so that part of it is very unconservative. Russ: That's true. Recently--a related question to what we were just talking about before that--the government published the transcripts of the Federal Reserve deliberations in 2006. I don't know if you've looked at that. Guest: No. Russ: Well, one of the most obvious things you learn from reading those transcripts--well, first of all, this is 15 really smart people, very savvy. Their job is to try to figure out what could happen next that could be dangerous. And in 2006, we were on the edge of a collapse in the housing market. And as you argue, maybe just a general problem coming that would be unforeseeable. But what was interesting was that they made the same mistake that I made at the time; and I heard lots of other people much smarter than I am made the same mistake. They said: Well, it's true that there could be a housing price fall; it's been going up for a long time, but the subprimes are essentially only a small part of the whole housing market; housing is only a small part of the overall investment market. So, if this does occur, there's not going to be much of a consequence and we don't have to worry about it. Now, one of the things I think was mistaken, certainly for me as someone not very well versed in finance, and I think most economists are not very well versed in finance, is that we did not understand the role that leverage would play if asset prices fell by a relatively small amount. Do you think that has been a lesson that some people have learned from this crisis? And should we learn that lesson? Guest: Well, leverage will put some people out of business. Russ: Correct. Guest: So, what's the problem? Russ: Well, the problem is that if lots of people go out of business at the same time it allegedly has a multiplier effect--I hate to use that phrase--but that there is some credit market contagion, systemic risk, etc. Guest: That's a word I don't think existed 20 years ago. Russ: Which one? Guest: Systemic. Russ: But let's go back to our mutual friend, Milton. Certainly Milton would argue that the contraction of the money supply at the onset of the Great Depression precipitated by bank failures was something that the Federal Reserve should have paid attention to. Guest: What could they do? Russ: They should have injected liquidity into the system. Guest: Well, but if you have massive free reserves, what is that going to do? Russ: Well, that's a problem. Again, I wish Milton were here. I'm mystified by monetary policy generally, as anyone who has listened to these podcasts knows. Guest: Well, I am too. In the podcasts of this program that I've listened to, I've heard everybody talk about the Fed controlling the interest rates. That's always escaped me how they can do that. Russ: Yes, I'm mystified by it myself. Guest: But I'm in finance, so you've got an excuse. Russ: When I interviewed Milton in 2006 and I asked him why there had been a change in public discussion at least of what the Fed does from changing the money supply to instead manipulating interest rates, his answer was: Well, that's what they say but that's not what they do. They like to say they manipulate interest rates because it makes them feel powerful. All they really do is change the monetary base. And in fact he said, if you look at M2, that's the thing to look at. Guest: That's the thing to look at if you want to know what's happening to business activity. But it's not something you can do anything about.
39:28Russ: I'm with you there. While we're on that subject, do you have any thoughts on why the Fed is paying interest on reserves? Guest: Oh, absolutely. Because they know that if there is an opportunity cost from these massive reserves they've injected into the system, we are going to have a hyperinflation. Russ: So what's the point of injecting the reserves if you are going to keep them in the system? Guest: Exactly. Russ: So what's the answer? Guest: The answer is: this is just posturing. What's actually happened? That debt is now almost fully interest-bearing, all the liquidity that they've injected. So, they've actually made the problem of controlling inflation more difficult. Controlling inflation when they didn't pay any interest focused on the base: cash plus reserves. But now the reserves are interest-bearing, so they play no role in inflation. It all comes to cash, to currency. How do you know? Currency and reserves were completely interchangeable; that's what the Federal Reserve is all about. So I think they've lost it. Now what happened, they went and bought bonds, long-maturing bonds, and issued short-maturing bonds. It's nothing. They didn't do anything. Russ: But they are smart people. Guest: Right. Russ: Ben Bernanke is not a fool. If you could get him alone in a quiet place with nobody else listening and say: Ben, what were you thinking? What do you think he'd say? Guest: I don't know, but I wouldn't believe it. In the sense that at most he could have thought he could twist the yield curve. Lower the long-term bond rate. Now I'm looking at the long-term bond market--it's wide open. Even though they are doing big things, they are not that big relative to the size of the market. Russ: Yes, I am mystified by that as well. I don't have an explanation. Guest: Let me put it differently. So, if I look at the evolution of interest rates, is it credible that in the early 1980s the Fed wanted the short term interest rate to be 13-14%? Russ: No. You are making the argument that it's endogenous; that they can't control it. Guest: Maybe they can tweak it a bit; they can do a lot with inflationary expectations. That will affect interest rates. Turn it around--all international banks think they can control interest rates; and at the same time they agree that international bond markets are open. Inconsistent. Russ: Correct. It reminds of this CNN reporter, credible insight into economic policy. He said: Macroeconomics generally--and fiscal policy, but he could equally as well be talking about Central Bank policy--he said: Politicians who think they can control the economy are like a little kid who is playing a video game; he hasn't put the money in yet and he is watching the arcade game do all its bangs and bells and whistles and noises. Which is an advertisement for the game. And he's pushing the buttons, and he's attributing all the successes on the screen to himself even though he hasn't put the money in yet because he misunderstands the underlying process that generates what he is seeing on the screen. There is some truth to that. Guest: There's a lot of truth to it.
42:51Let's turn to fiscal policy, which you've written some interesting things on lately. You have been very skeptical, as have a few others. And by the way, I should add, before we get into this I should just mention: your view that it's an open question about whether the crisis was averted by these rather remarkable open interventions by the Fed and the Treasury Department in the last few years--it's not a mainstream view. Certainly most economists believe--and I'm with you--but most economists believe that the Fed and the Treasury and the policy makers did a good thing. Guest: That's not taking into account the long term costs. Russ: For sure. And that would be true of most of these interventions. I always find it remarkable that the auto bailout was a success, quote, "because very few people lost their jobs." As if that's the only effect we would ever want to look at. Guest: The long term effects of that are horrendous. Russ: And it's not clear that they saved very many jobs, either. Clearly they changed the incentives. Guest: Not just changed the incentives--they changed the ordering of precedence in contracts. That's something that's really dangerous. Russ: Yes, they abrogated the rule of law. It's very depressing. But on this issue of fiscal stimulus, most economists believe it's a good thing, it works. We are in the minority who suggest that maybe it isn't effective. And recently you wrote a piece suggesting, I would argue, that it's never effective--unless it's well-spent. And I would contrast it with the Keynesian view, which I heard come out of Joe Stiglitz's mouth personally--people can't be what they actually believe--I heard him actually say: It doesn't matter what you spend the money on; it's all stimulus. You are very much on the other side. So, explain why. Guest: When he says it doesn't matter what you spend the money on, I think he thinks there are multiple choices that would all be good. He doesn't think that if you just wash it down the sink, that's good. Russ: Oh, no; he said, when pressed and he was asked: If you ask people to dig ditches and fill them back in, would that stimulate the economy? And he said: Yes; but it's not as good as doing something productive. I can't explain it. It's a mystery to me. Guest: It's a mystery to me, too. Russ: But he's not on the show right now; I wish he were; I'll try to get him down the road. But in your view, talk about what you think the effect of stimulus is and why you are skeptical. Guest: This is a case where you can't be sure. If you look at the empirical evidence, it basically allows you to say anything you want, because the estimates of the effects of stimulus are subject to so much uncertainty. So, I think, though, if I interpreted Christina Romer's stuff properly, or she and her husband's stuff, what it says is that the only thing that clearly gets a pretty good statistical support is permanent [?]intervention [?]. And the other stuff is just [?]. I think that's probably--I'm an empiricist in the end, so that's probably, I don't know. I have my position that I think it's a waste of money, because it will all be wasted. Eventually, you have to finance it. You have to finance it now, which means eventually you have to pay back, future generations have to pay back, for things that are then mostly useless maybe. But the evidence doesn't, like you say. So it's possible for Stiglitz to say one thing; it's possible for you and I to say something entirely different. And neither one can point to the evidence. Russ: I don't view it as a very scientific enterprise. I view it as essentially ideology being wrapped up in scientism, scientific looking, statistical estimation. It seems to me there is too much noise. Guest: I don't agree with what you said when you started; I don't think most economists do think it works. Maybe I'm in the wrong cocoon. Russ: Yes, you need to get out more, Gene, I think. Although I'm in a different cocoon over here on the East Coast; I'm in the only cocoon, I'm at George Mason University and occasionally I'm at Stanford; so we just happen to talk about the three places where there is an overwhelming majority that is skeptical; but outside of those three, I think it's pretty much the other way. Guest: Well, Bob Barro.Russ: Lonely voice, in that enclave. Guest: I think with Barro, famous macroeconomist at Harvard, there's a younger guy. Russ: Alesina. Guest: Council of Economic Advisers. Russ: Oh, Mankiw. Guest: He's skeptical, but what he says is: Once you get into politics, you become a Keynesian. The political pressures are enormous. I think that's right. Russ: It's a terrible view of our intellectual opponents, though. It's not very nice. We don't like it when they attribute our views to being friends of business, which I find repugnant. So, it seems embarrassing to suggest that they hold their views because they like being powerful. I think there's some truth to it, but it's not very nice. You want to hold that view? Guest: Hold which view? I don't know. I don't think economists are different from other people. They all like, have their views, excepted [accepted?] by everybody else, no matter what their views are. Russ: We're prone to incentives; there's no doubt about that. Guest: I've had a tough time for a long time because I believe in efficient markets. Russ: Get a lot of flack.
49:13Russ: Let's go back to finance for a minute. I will put a link up to your recent article on stimulus where you make a theoretical argument against stimulus. Guest: There's no data, right. Russ: And I think basically--it's interesting how the Chicago school has been pushing this--you are using what I would call accounting identities. The money has got to come from somewhere. I expressed it as the resources have to come from somewhere. Guest: That's the right way to say it, actually. Russ: And so I don't understand where the free lunch comes from. Guest: There is no free lunch. Russ: But the counterpoint is that there is a free lunch because there are all these resources laying around. And then it's a question--Milton said this also--how much of the stimulus goes towards the unused, so-called-- Guest: But that's the problem of implementation, which is horrendous. The same problem in regulation: implementation, which is always the killer. Russ: But let's go back to finance. There's been a big trend in recent years towards what's called behavioral finance. What's your assessment of that? Guest: I think the behavioral people are very good at describing microeconomic behavior--the behavior of individuals--that doesn't seem quite rational. I think they are very good at that. The jump from there to markets is much more shaky. Russ: Explain. Guest: There are two types of behavioral economists. There are guys like my friend and colleague Richard Thaler, who are solidly based in psychology, reasoned economics but he's become a psychologist, basically, and he is coming from the research in psychology. Now there are other finance people who are basically what I call anomaly chasers. What they are doing is scouring the data for things that look like market inefficiency, and they classify that as behavioral finance. But to me it's just data judging [?]. Russ: They don't tell you about the times they can't find the anomaly. Guest: Exactly. In all economics research, there is a multiple comparisons problem that never gets stated. Russ: A multiple what? Guest: The fact that the data have been used by so many other people and the people using it now use it in so many different ways that they don't report, that you have no real statistical basis to evaluate and come to a conclusion. Russ: My view is you should video your keyboard so we can see your keystrokes and then we can see what didn't come out. The dishes that didn't come out of the kitchen because you didn't like the way they tasted. Guest: Right. I've had people say to me that the people who do this anomaly stuff, when they come and give a paper and I'll say, when you do this, that, or the other thing, and they'll say Yes. And I'll say, why don't you report it? And they'll say it wasn't interesting. Russ: Not publishable, either. Guest: Well, that's the problem, that there's a counting process [?] and a publication process as well. You do this, that, and the other thing and I'll say, yes, why don't you report it? And they say it wasn't interesting. Russ: It wasn't interesting. Not publishable, either. Guest: Well, that's the problem, there's a publishing process and a culling process as well. This stuff makes it through.
52:37Russ: So, we started off this conversation talking about efficient markets, and we haven't talked about a zillion other things that you've studied that are important in the field of finance. One question I'd like to hear you talk about is the issue of a non-specialist. Let's say I'm just a smart, everyday person and I want to be educated out in the world. What are the lessons for me that finance has learned that are important? There are obviously of findings that have stood up, findings that have had to be modified over the last 50 years that has become more empirical that an educated person should be able to understand and use? Guest: I'm obviously going to be biased. I think all of our stuff on efficient markets would qualify. I think there is a lot of stuff in the corporate area, corporate governance and all of that, a huge field--that has penetrated to the practical level. The Black-Scholes option pricing paper in view is the most important economics paper of the century. Russ: Why? Guest: Because every academic, every economist whether he went into finance or not, read that paper. And it created an industry. In the applied financial domain. What else can claim that? So, I think we've learned a lot about risk and return. Some of it is intuitive. But there is a lot of stuff on which stocks are more or less risky. A lot of stuff on international markets. Now, what should an ordinary, intelligent person know? That's an interesting question. Let me turn it over. What should an ordinary, intelligent person know about pricing? Russ: Well, I have some thoughts on that. You probably do, too. Guest: Yes. It's difficult. I know lots of very intelligent business people who need some knowledge of what's going on in finance. But not an awful lot. Because that's not a big part of their business. Russ: Correct. I would worry about what people think they know that isn't so and the things they should know. Guest: That happens to me all the time. I'll be playing golf with somebody and they ask me what I do, and I tell them I teach finance and they say, oh my goodness, they don't know anything about finance. And then they give me a lesson in finance. Russ: What do they usually say? Guest: They tell me all about their smart investments. Russ: Do you smile and just take another strike at the ball? Guest: I do. Russ: Do you say anything back? Guest: No, I don't; but I avoid them in the future. Russ: One of the fascinating things about our profession--it must be true for other professions as well--but everybody's an expert. So, your 50 years of empirical, in-the-trenches work is meaningless because that guy had a good month. Guest: Right. Russ: He doesn't think he has much to learn from you. Guest: Indeed. He's making a lot of money. Russ: He is, sure. He's doing great. He knows. I was really thinking more of practitioners than experts, not of lay-people, so I assume there are some things we know in finance that may not turn out to be so. Guest: Oh, absolutely. Russ: I guess I'm thinking about macro, which I know a little bit more about when thinking about the Great Moderation and the comfort that people had that we had mastered the business cycle; and that turned out not to be true. So, I assume there are some aspects of finance that may turn out not to be true. Guest: Oh, absolutely. What I say to my students is: I'm showing you the stuff that people have done in the last 30 years, but in 20 years, it may all be irrelevant; so the best I can do is to train you about how to think about these things, so you can absorb stuff that comes along in the future that may overturn what's there now. That's what makes this profession fun, I think--the fact that stuff can get overturned. Russ: Of course, if we only have the illusion of understanding, or what Hayek called the pretense of knowledge, we could be doing some dangerous and stupid things under the guise of thinking we are making progress. Guest: Right. Russ: So, you do have to be careful. Where do you think in the near future finance is going? Guest: Oh, gee, I don't know. That's part of the fun of it. You just don't know. I wouldn't have been able to predict 30 years ago the stuff that evolved during those intervening 30 years. No way. Russ: It's kind of a random walk. Guest: I don't think it pays to think about it very much. There's so much serendipity in what happens in research. My best stuff has always been--I didn't start thinking about writing a great paper. I started thinking about a little problem; it just kept working in circles into a bigger problem. Or had offshoots that were related. I've beaten many topics to death, with the consequence I've got a lot of recognition; what started as a little thing developed into something much bigger. That's not a predictable process. Lots of little things end up as nothing. Russ: And? Guest: A student comes to me, a Ph.D. student, and says: I want to write a great paper. You can't start out to do that. You have to pick a problem and hope it works out into something that will get you a job, and hopefully a good one. But if you start saying: I want to come up with a great topic, you won't come up with anything. Russ: You recently wrote a very nice essay, "My Life in Finance," that gives an overview of some of your contributions and some of your thinking along the way and all those little problems. You started out by talking about your thesis topic, where you had five ideas and Merton Miller said four of them weren't very good. Guest: Right. Russ: Did you ever go back to any of those four? Guest: No, actually. Merton was incredible. He had a great eye for stuff that would work and wouldn't work. I went to Belgium for two years to teach, and I came back and showed him the stuff I'd been working on, and I think he discarded like 8 out of 10 things. He was right on all of them. Russ: Such is life. Guest: It taught me that nobody can work in a vacuum. You really need colleagues around you to enrich your work. You get credit for it in the end, but there are a lot of inputs from other people that go into it in the meantime.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2012/01/fama_on_finance.html. http://www.econtalk.org/archives/2012/01/fama_on_finance.html http://www.econtalk.org/archives/2012/01/fama_on_finance.html Eugene Fama Mon, 30 Jan 2012 06:30:00 -0500 David Rose on the Moral Foundations of Economic Behavior David Rose of the University of Missouri, St. Louis and the author of The Moral Foundation of Economic Behavior talks with EconTalk host Russ Roberts about the book and the role morality plays in prosperity. Rose argues that morality plays a crucial role in prosperity and economic development. Knowing that the people you trade with have a principled aversion to exploiting opportunities for cheating in dealing with others allows economic actors to trust one another. That in turn allows for the widespread specialization and interaction through markets with strangers that creates prosperity. In this conversation, Rose explores the nature of the principles that work best to engender trust. The conversation closes with a discussion of the current trend in morality in America and the implications for trust and prosperity.

Play
Time: 1:11:33
How do I listen to a podcast?
Download
Size: 32.9 MB
Right-click or Option-click, and select "Save Link/Target As MP3.
]]>

Readings and Links related to this podcast

Podcast Readings
HIDE READINGS
About this week's guest: About ideas and people mentioned in this podcast:

Highlights

Time
Podcast Highlights
HIDE HIGHLIGHTS
0:36Russ: Intro. [Recording date: January 11, 2012.] Ideas in new book; you frame the book around an interesting thought experiment to help us understand the nature of prosperity. What's that thought experiment? If a society's sole objective was to maximize general prosperity and it could choose the moral beliefs of the people that comprise it, what kind of moral beliefs would it pick? What would they look like? What kind of characteristics would they have? Guest: The reason for doing that is I had become disenchanted with the progress that we have been making as a profession on what's commonly now known as the Development Puzzle. Russ: Which is? Guest: Basically, economics did really well through the 19th century, the beginning of the 20th century, working out the essential logic of the price system. And that was a huge triumph, a great gift to mankind. And I think we basically got that right. But as Thomas Kuhn has pointed out, when you have a new paradigm, you always say that things are great; you start to answer a lot of questions; but over time you start to peter out. The usefulness of the paradigm starts to peter out. And that happened with the neoclassical paradigm. So, what then happened? Well, in the 20th century, institutionalism was re-resurrected, I should say--it was already there to some extent--to fill in the gaps. The basic insight there was while there's nothing wrong with neoclassical economics and our understanding of markets per se, we have to recognize that they exist in a context; that they rest on an institutional foundation, as it were. And once we did that, then a whole bunch of puzzles became solvable. We were able to make some real progress, including but not limited to Development Economics. We certainly made a lot of theoretical progress. That kind of work resulted in Nobel Prizes for people like Ronald Coase, Oliver Williamson, Doug North. I would argue, though, that that has begun to lose steam. We have found that when you drop institutions into less developed countries very often they either do nothing or they are subverted and co-opted and become vehicles of opportunism themselves. So, something else must be missing from the story. Barry Weingast, who is a political scientist at Stanford has a great way of putting the problem. He said if you needed a copy of the U.S. Constitution, you could always go to South America because there's a ton of photocopies of it floating around in the form of their Constitutions. Yet you don't get a United States down there. And you can't tell the standard argument that they don't have the right kind of requisite conditions, because as recently as the late 19th century, Argentina had higher per capita income than we did. So, they have all the stuff that they need, and they even have, superficially, a Constitution, and so on and so forth. So, much of the institutional apparatus is there. Or apparently there. And yet the don't get what we get. Because apparently--they have a court, but maybe it's not quite like ours. They have laws, but legislation doesn't quite work in terms of how it's enforced. Etc. So, there is a puzzle, still, which is fundamentally we don't fully understand why some countries do much better than others. Right. And you are trying to fill that gap. That's what got me interested in this area in a broad kind of way.
4:59Russ: So, this thought experiment is to think about what role moral values might play in helping to create prosperity, and you focus on the issue of trust in dealing with strangers in large group situations because that's necessary for specialization. Is that correct? Guest: It is. The way I approach the whole thing is to say: Look, if we are trying to figure out what kind of moral beliefs would do the best job supporting the development and operation of a market system, the first thing we have to do is figure out what exactly needs to be going on to have a well-functioning market system. That stuff's all well known. Basically, Adam Smith is right about this. The issue of distribution is important but not nearly as important as the issue of having enough stuff to divide up in the first place. Really comes down to specialization. Societies that are able to effectuate dramatic specialization through very large scale production are those that are going to have levels of productivity that are many orders of magnitude greater than other societies. And we've known this for a long time, although it's surprising how few younger economists are really aware of how dramatically different the level of productivity is when you allow specialization. Well, I shouldn't say almost nobody, but many economists don't have the pin factory example memorized, for example. Which I require my Principles students to do because it is such a shocking increase in productivity. But be that as it may, the question then is: That's what it takes to work, but now does specialization present any kinds of problems? Obviously if it was really easy to effectuate tremendous gains from specialization, everybody would do it. But not everybody does do it. What's the problem? Well, when you have dramatic specialization to increase the productivity like that, you are going to invite a problem of localized knowledge that is quite similar to a local knowledge problem that was addressed by Hayek across the whole of society. As you know, Hayek argued that the price system solves a problem and the problem that is solved is reconciling the localization of knowledge. Because we have a price system, we don't have to know what each other is doing or why. All we have to do is pay the market price, and as a result, we'll pay the full social opportunity cost of using that resource. And that effectuates efficient coordination across the whole of society, even though we don't have to know that much about each other--because everything we need to know is already embodied in that price. That was a fabulous argument. But I would argue that when you look inside firms, which is where all the stuff gets created in the first place, we have a similar kind of local knowledge problem. The larger a firm is and the more complex its production is, the more likely it is that there are people who know things that nobody else knows. Or even can know. And as a result, if people in that situation are not able to take full advantage of that knowledge, we are just throwing away a tremendous amount of efficiency, much like we would be if we didn't have market prices across all society. Russ: The problem within the firm: there was a big fad in business schools in the 1990s. I don't know if that fad is still going in the business schools any more but there was a big fad in business schools and management and the business literature about the capital stock of knowledge within a firm--that there was a lot of specialized knowledge and localized knowledge that you are talking about embodied in the individual workers. But they would come and go, so how do you preserve the knowledge that the firm has at any point in time to make that more efficient despite the reality of turnover. I don't know if they made much progress with that; obviously there is one move toward using prices within a firm; I don't think that's been terribly successful. But it's certainly true that at any point in time within any large organization whether it's a business or a non-profit, there is an immense amount of specialized, sometimes localized, but specialized knowledge that isn't written down anywhere. It's just embodied in the heads of people who happen to be employees at the time. And how do you get that to be used effectively is a major problem for any successful organization. Guest: Right. And that's kind of a stock concept of it, and that's certainly correct. But the problem is every bit as daunting in a flow sense, which is what Hayek would have emphasized. That is, things are changing constantly; the problems of the day today are different than yesterday. And they just come at you constantly. And the person who is in the best position to answer those questions is the one who has a great deal of localized knowledge regarding how a particular area of the firm works. What I introduce in the book is that there is a form of opportunism that has never really been codified in the past. It's what I call third-degree opportunism. And that's opportunism of the form that there's an action set and other people in the firm, or the firm owners or CEOs or whatever may know a proper subset of that action set; but a person who is on the ground, as it were--I like to say a middle level manager--knows a much larger number of actions than that action set. And if an action is one that is profitable but not the most profitable is known to the person with local knowledge but not known to the others, and the person who possesses the local knowledge knows this, he might pick an action that is good enough but is not the best. And that would not be consistent with maximizing profits and not be consistent with efficiency. And this is a very daunting problem. I call it 3rd degree opportunism. It's very a very daunting problem because it's a problem that gets worse the bigger firms are. Because the bigger firms are, the more specialized the knowledge, and by definition the more likely you've got a situation in which an individual has an informational advantage over those that he would have to answer to or coordinate with. Russ: You are not talking here about--you talk about these other phenomena, which I'm going to mention, which is shirking, where obviously sometimes an employee can work less hard than his boss might know about and enjoy some leisure on the job. That's not what you are talking about. You are talking about a very specific kind of opportunism, right? Guest: Exactly. I'm talking about a form of opportunism that cuts to the very heart of whether a firm is run in entrepreneurial fashion or in bureaucratic fashion. This is a fundamental tradeoff, because if you aren't able to delegate managerial responsibilities vis-a-vis what we call relational contracts--in other words, contracts that are flexible enough to give those who possess local knowledge--if we can't do that then we are throwing away all of the efficiency gains, what I would call Hayekian gains, that would come from fully exploiting localized knowledge. However, relational contracts that would confer that kind of discretion would by definition open themselves up to opportunistic exploitation that constitutes what Bob Frank would call a golden opportunity. The reason why is by definition if nobody else can know what the optimal action is then there is no way you can be in a sense caught cheating because no one else knows what the counterfactual could have been. Only you know that. So, this is kind of an inescapable problem associated with the efficient use of local knowledge within firms. And I think it's a very deep problem; it's a very fundamental problem; and it cuts right to the heart of production and to the heart of the difference between a bureaucratically run firm and an entrepreneurial firm.
13:35Russ: But it goes beyond that. There are so many transactions that--and you talk about this in the book--you and I are going to make a deal; there's going to be a contract between us. Not a handshake deal; there is a contract. But it's impossible for the contract to specify all the possible conditions, including conditions where I might do something on your behalf without your knowing it's even possible. Because you don't have that localized knowledge. And I always think, when I think about these kind of problems, about selling a house or buying a house, where we have this unbelievably important asset being exchanged for money and we have this unbelievable set of paraphernalia and bells and whistles surrounding it--title and page after page of contractual agreement on all sides, about what we are going to do on each other's behalf. But despite all of that, we leave much of it unspecified because it's too costly to specify everything; and more importantly we can't anticipate everything that could happen. And so inherently at some point there is either trust or there is this random legal action; and of course legal action is really unpleasant. So, obviously the more trust that's involved the better it is because we avoid the complexities of legal action and all of its costs. But--you have to trust the other person to a certain extent. And how do you generate that trust? Especially in this situation, which is the one I want to focus on because it's the center of the book for the rest of the way out, which is: One of the parties knows something nobody else knows, and knows that by either taking an action or not taking an action, good or bad will occur. How do you get that person to do the right thing? And if you can do that, if you can get a world where people do the right thing even when they are not observed or monitored, you can really exploit these potentials for specialization and trade, exchange; and you won't be able to exploit them if that trust isn't there. Is that a good summary? Guest: I agree with that totally. I think that's basically correct. My particular approach doesn't really view it as what do we do to make that happen, although I have ideas, of course. I basically am working backwards. Russ: What's necessary to be true. Fair enough. Let's turn to that. Obviously there are many other ways you can check opportunism generally. There's repeated dealings, there's reputation, there is police rules, monitoring of various kinds. But we're going to focus on the most difficult problem to monitor, observe; because that's really important to keep in the back of your mind as you are listening to this. Because obviously markets and societies find ways to deal with many of the problems associated with opportunism. This particular kind is special. Guest: It's special but it is more frequent and it is more fundamentally important than one might first suspect when one first thinks about these things. Part of the reason why is most of the cost is unobserved. Most of the cost takes the form of economic organizations that don't exist, or institutions that don't exist. So, I would argue that the preoccupation with incentive-compatibility mechanisms is the result of kind of a survival bias. In other words, you study what's there to see and for most of human history, what we have observed are institutions that exist to solve these kinds of like shirking and so forth that are pretty frequent precisely because being able to trust people you don't know is something that has been extremely rare throughout human history. It's even rare today but if you go back 500 years or so, I would say it was completely rare. Nobody had the kind of moral beliefs that would be required to get you to a condition of genuine and generalized trust at the same time. Russ: So, something has changed and part of your argument is going to be, although you don't deal with this in depth in the book: that change helped facilitate the explosion in our standard of living. Guest: That's right, and actually, I'm writing another book now that deals exactly with that issue. That's a huge issue all by itself.
18:31Russ: Let's go back to the moral issue now, which is: What's necessary to create behavior on the part of individuals basically to turn down, reject, and resist the chances to be opportunistic when nobody is watching? What do we need? There are a couple of things that you need. Guest: Number one, the person's predilection to be trustworthy cannot be merely an exercise in incentive compatibility. Which is what most economists want to do. They want to model trust behavior and trustworthiness as an exercise in incentive compatibility. Russ: Explain what you mean by incentive compatibility. Guest: It's the idea that it's an exercise in enlightened self-interest because it's in your own best interest to behave in a trustworthy manner. The most common example is to say: Markets breed honesty and honesty breeds markets. Suppose you've got a guy and he's a car mechanic. If he behaves in an untrustworthy way it gets back to the customers; he has less business. If he behaves in a trustworthy way, he gets rewarded for that by virtue of having more business. And so on and so forth. So, that's an example of the kind of argument that most economists like to make about trust. Which is: It's no big deal, it's easy to explain. It's in your own best interest to be trustworthy anyway. That's all well and good but the problem is if that's all there is to trust then trust is going to fall down exactly where the word is most meaningful. This is such an empty approach that Toshiyo Yamagishi, who is a pretty famous social capital theorist, sociologist in Japan, says this isn't even trust at all. We should call it assurance; that's all it is. Russ: I agree. I don't trust you. I just know you are going to act as if you were trustworthy. Not the same thing. Guest: And Oliver Williamson is very dismissive of a great deal of the trust literature; and he would say that this is what he would call calculative trust, which is a contradiction in terms anyway. So, for a situation in which there is a genuine golden opportunity is possible. Russ: Explain that again. Guest: A golden opportunity is a situation in which the person who may or may not behave in an opportunistic way believes there is zero probability of being caught. In any way, shape, or form. They can do it and they can get away with it, perfectly. Russ: And this terminology comes from Robert Frank. Guest: Yes, Bob Frank first introduced that phrase I believe in 1988 in the book Passions Within Reason. That's the first place I ever saw it. You've got to be able to deal with that. And so, Frank's argument, and I think he was absolutely right although he was kind of dismissed at the time, was that the only way to bust out of that is for trustworthiness to be based on moral taste. If it's in any way an exercise in rational behavior, it's not going to work for a golden opportunity. So, the thing that's producing the trustworthiness has to be in a sense pre-rational, antecedent to the rational calculation problem. So, he said it had to be moral taste. It was a heretical thing to say when he said it and people have largely dismissed it. And I think that's been a huge mistake. Russ: They dismissed it because economists generally don't like arguments based on taste. They prefer to use arguments based on prices, incentives, etc., institutions as we talked about. But this is basically saying you'd better have a taste for being good. Or not doing a bad thing. It had better be part of your makeup, to solve that. And that is an unappealing argument methodologically. It could be true--which is the problem--but it's unappealing methodologically partly because you don't want to be in a position to say: Well, the way we'll make the world a better place is we'll get people to be better people. That obviously--most economists are uncomfortable with that kind of logic. But that doesn't mean it's not true. Guest: This one's also uncomfortable with it. I don't like arguments that are grounded in taste, but nature doesn't care what we like. The explanation just is what it is. If it is indeed the case that tastes carry the day, then it's incumbent upon us to move forward with that as our working theory. Turns out things are not quite as bad as people think, and we can circle back to this later when we talk about culture. But anyway, you were asking what do we need: Well, first of all it needs to be taste. That's where Bob left it. He just said it's got to be taste. I pushed the ball down the field by saying if it's got to be taste, then what kind of moral taste? And then I worked through the thought experiment to discover that first and foremost, if the reason why you think something is wrong is because of the harm it does to other people, which is by the way what I would call harm-based moral restraint, and that is kind of the foundation for why most of us are reluctant to be opportunists. But if that's the only reason why you won't behave opportunistically is because of the harm that's done, then the problem is, if you are in a situation where you think nobody is going to be harmed by your opportunism, you'll still be opportunistic. And just think about it for a minute. That is not a big problem in very small group society, where you live in hunter-gatherer bands or small tribes. The number of people involved is fairly small, so even if we don't get caught, we do know that our actions might measurably harm someone that we care about, or maybe we don't care about him but we don't want to be feeling like we hurt somebody. Russ: By the way, we should mention: guilt is a lot of what we are talking about here. Talk about that for a second. Guest: Guilt is the mechanism through which all of this works; and the question is how do you put guilt to work? You put guilt to work by having moral values that actuate it. The point of my book is that moral values are important also, but even more important is how they are structured, because otherwise you are not going to get guilt triggered in the right sort of way. Russ: And this point about small versus large, I found very interesting, because basically what you are saying is that guilt is going to be triggered by empathy. When I realize that I'm harming someone I'm going to feel bad about that, which is I think a universal truth. We may differ in how bad we feel about harming others and differ dramatically in how we emotionally react knowing we've hurt someone; but the insight you have which I really like is: you might be wrong, but if you don't believe you are hurting anyone, either because you don't perceive it or it's so small--the harm is spread out across many people, as it would be in a large group--the guilt is going to be very small. And you give the example, which I thought was very good, of a false insurance claim. Explain how that would work. Guest: The basic idea is usually when we do something in a small group to behave opportunistically, somebody gets hurt and we feel guilty about it. But the greater the number of people in the group over which the cost of that harm is divided, the more likely it is that there will not be a single human being who is harmed and who we can therefore empathize with and therefore sympathize with and therefore feel guilty about having harmed. Russ: Or, if they are harmed, it's by such a small amount they might not even perceive it. Guest: At some point we don't even have to make that qualification. If I exaggerated my income tax deduction, if I got $1000 more dollars back from the government than otherwise, there is not a single person on the planet who is harmed. There isn't. We don't even need to quibble. We are talking about way less than a penny per person in the United States. People can't even perceive that. It's not even there. Noise swamps it by orders of magnitude. So, no one is harmed. And that's why many people who seem to be nice guys and seem like they would never do anything to hurt you or your family or anybody, very generous, good people, might cheat on their taxes. Russ: Or inflate their expense account at work. Guest: Exactly. And that's a fundamental problem. It's a problem everywhere, but it's an especially big problem in countries outside the West. Outside the West, if people feel like they are not hurting anybody, they really feel like they can just do whatever they want as long as they don't get caught. So, you are only left with incentives to combat opportunistic behavior. So, the point of that is that harm-based moral restraint is not enough to deal with the empathy problem; and the empathy problem is fundamental because it's a problem that gets worse the larger the group size is. And you are going to be an impoverished society if you can't sustain very large institutions, large markets, large firms. Bigness is the key. Smith is right, and getting big means that our hardwired sense of moral restraint is going to fall down on the job. Russ: Because that's a small group thing. Guest: Right. Because we are a small-group species.
28:42Russ: Let me raise Immanuel Kant here for a second. The only thing I understand about Kant--which is I think an important thing, though--is the categorical imperative. In the categorical imperative he says that you should take an action or avoid an action, when trying to decide if it's the wrong thing to do, you should imagine if everyone did it, if it was common practice, rather than just you doing it. And that's his way to solve this problem, right? I always use the example: Sampling all the fruit everywhere in the grocery, or reading all the books in the bookstore while drinking coffee, which most people say: Well, that doesn't hurt anybody; it's no big deal. And to some extent that's true; but if everyone did that instead of buying the fruit or the books and just ate while they were there, there wouldn't be grocery stores or bookstores; and I consider those immoral acts. When I tell people that, they get mad at me. But I think that's correct. And that's one way to solve the problem. But you don't deal with that. Or do you? Guest: No, I do. In the book I compare the moral foundation after I completely work the whole position out to what other philosophers have had to say, and one of them is Kant. I think what Kant was doing is he was giving a rigorous voice to changes in moral beliefs that were already underway. So, in other words, I don't think he's somebody who brought about these changes. I think he's somebody who is simply echoing them. They are already in the culture and he is codifying it and making it rigorous. I think that people who like Kant or know Kant are going to say: the principled moral restraint, which is the thing that I'm going to say solves the empathy problem, makes a lot of sense to me. Principled moral restraint is the idea that I'm not going to do this particular negative moral action not because of the harm that it does but because I believe it's wrong in and of itself. Russ: Even though it would benefit me. Even though it's in my own self-interest. Aside from the guilt. With the guilt aside, say, it's in my financial interest to do this, it's morally wrong; I'm not going to do it and I'm not going to get caught. Guest: Right. And many economists balk at this. Not to pick on Oliver Williamson, but he and I have argued about this over the years a great deal. And I would say to Oliver: Suppose you are at 7-11, and there's only one person working and he has to duck in the bathroom. And suppose you knew the security camera wasn't working, so you knew with certainty you could steal a candy bar and get away with it. You are not going to steal that candy bar. I know you are not. You know you are not. And you know that I know that you are not. Russ: And it's not because: Well maybe it really is working. That's not the reason. It's just you don't think it's right. Guest: I think that's how Oliver describes principled moral restraint but doesn't realize it. Russ: Well, I think a lot of economists are uncomfortable--it comes back to my methodological point. I think everyone accepts that as true. I think there are economic ways of looking at that. I think if the candy bar would save your child's life, even though it might be wrong you might be more likely to steal it rather than just to appease your sugar demands for just a few minutes. I'm willing to accept the idea. Guest: Sure, but there's a qualitative difference between stealing the candy bar to save your child's life and saying I know that stealing it was wrong but I don't care; I'm going to save my child's life versus not believing it's even wrong in and of itself. Russ: I agree with you. Guest: There's an example that can tease that out. Russ: I'm just agreeing with you that people do act that way, they feel that way, they refuse opportunities because they think they are wrong; but that economists may be uneasy about invoking that for methodological reasons.
33:01Russ: So, principles moral restraint is obviously, undeniably a way to solve the opportunism problem; but you have more to say about it than that. Guest: Well, it's a necessary but not sufficient condition for solving the opportunism problem. It solves the empathy problem, but there's another problem. Russ: The empathy problem meaning that you might have trouble feeling that there are actual people being hurt. Guest: Right. Even if you solve the empathy problem, you have another problem, and that is someone could feel guilty about undertaking a negative moral act, let's say an opportunistic act, and they feel extremely guilty about it because they possess principled moral restraint; maybe somebody's hurt, maybe somebody's not, but that's beside the point in this case; but they feel guilty about it, so they have principled moral restraint. There's no issue there. But they may also feel guilty about not being able to take a positive moral act they could have taken if the negative moral act is undertaken. So, this is what I call the greater good rationalization problem. And it is really a huge problem, because this is a device that many advocates use to rationalize their actions in ways that after a while we come to take as reasonable but not so long ago we would have viewed as patently wrong. Russ: So, give an example. Guest: In the United States today the conversation begins far downstream of whether it's legitimate to take money from other people to solve some kind of social justice kind of problem. If you go back to say 1870 and you say: I've got an idea. We should have the government take a bunch of money from these people and then give it to those people because these people have a lot and those people don't have very much, the vast majority of Americans in 1870 would have said: You can't do that. That would have been self-evident. Although it would be nice to do this nice thing, that would be an inappropriate use of government power. It absolutely would not fly. But over time our sense of what's normal becomes a new normal--popular phrase now--and those kinds of things are just taken as the way it is. Russ: And there are a whole bunch of rationalizations for why that's a good idea. But certainly you are right--there is only a small group of people who would view that as immoral. Guest: Now. Russ: Correct. Guest: But the greater good rationalization problem is a fundamental problem for trust because if I believe that you might feel more guilty about helping someone that you could help if you cheated me, even though you like me, I still can't trust you. I have to believe that you are the kind of person who would say: Just because you could cheat me a little and help your nephew a lot, you don't do that sort of thing. You don't even think in those terms. That's not on your radar screen. I need to believe that about you to trust you completely, in other words to genuinely trust you because I've reached a rational conclusion that you are genuinely trustworthy. Russ: Does that play out in the firm example? Guest: Yes. Russ: How would that play out in that example. I understand it where, let's say, you are really wealthy; I'm buying some property from you; I'm going to use the property for some good cause; and I might convince myself that it's okay to cheat you. And I accept that that's a problem. How would that play out in the firm? Guest: Suppose you are a middle manager in the firm, and you are working really hard, and you work really hard because you believe you are going to be well taken care of by the firm. You are going to get your just desserts. The firm is going to shoot straight with you. You can trust them completely. Things might not work out because you might make a mistake; you might make the wrong call about this or that investment, but that's different. It's never because the firm might cheat you. Intentionally. Or the firm might reach the following kind of conclusion: there's a reduction in demand for the product; they've got to let some people go; if they let you go, you'll probably be able to find another job somewhere; you are pretty talented. But there's this other guy who doesn't work real hard at all, not that gifted, certainly doesn't put the kind of time in that you have; but he has somebody in his family that has a pre-existing condition and if they cut him loose, it will be much more difficult for him to get health care. So, it would be nice to that person. So, in an effort to be nice to that other person, you end up being fired. Now, even if in some ultimate moral system that's the right outcome, it doesn't matter. Your willingness to do that as the firm's CEO, to me, affects my behavior and my willingness to trust you and therefore make firm-specific human capital investments in your firm because that could happen to me. That's a quick and dirty example. Russ: That's interesting, but is that third-degree opportunism? Is that undetectable? Guest: Well, it doesn't have to be undetectable. I'm saying this is another issue. There is a hierarchy to the argument; they don't all have to fit, all be in the same stream of subsets. You asked for an example; I gave you a quick and dirty one. Russ: So, let me just stick with that for a minute. Is the worry then that I as the employee--if I can't trust you, I'm not going to make the investments in myself in the firm that I would otherwise make? There's loss of output there. Guest: Yes. That is true; and that's what I said. But that's not the real point. The real point fundamentally is: I'm not able to trust because you are willing to reduce my welfare, knowingly, even though it's not the appropriate thing to do by the rules of the game; we spelt it out; because you think there's a greater good that can be achieved by doing this to me. Russ: So, the basic point of this, then, is that because of this greater good possibility, people may do things that may violate negative prohibitions, because of the greater good. And so what do you have to say about that? Guest: I certainly feel like you've engaged in a negative moral act because I've lived up to the terms of the contract. By any objective reading of the contract that spells out my employment relationship to you and the other employees' employment relationships to the CEO, I shouldn't be fired; he should. I got cheated.
40:23Russ: But you want to find a mechanism for reducing even that. Guest: My point is that you will not have a social norm of unconditional trustworthiness if you don't also deal with the greater good rationalization problem. And the solution to that problem, just as principled moral restraint solved the empathy problem, lexical primacy of the obedience of moral prohibitions over the obedience of moral exhortations solves the greater good problem. Russ: Explain that. Guest: There are two types of moral statements out there. There are those that exhort us to take positive moral actions, to do things that most people would say are good and right and problem. And then there are prohibitions against negative moral actions; we are being prohibited from doing things that harm or are inherently wrong. If moral beliefs don't just list a bunch of moral values but also adduce a logical structure on those values such that the obedience of moral prohibitions comes first and foremost, and the obedience of moral exhortations is only meaningful in the value of a person's morality if and only if they've satisfied the obedience of moral prohibitions--in that case, that person will never trade a greater good kind of outcome against opportunism. So, you don't need to worry about being a victim of their opportunism, because they felt justified in doing so because there was some kind of positive moral act that they felt morally compelled to do because in their moral belief system, that utilitarian comparison compels them to cheat you. You don't have to worry about that because they don't have that kind of moral belief system. They have a moral belief system that says: First, don't engage in opportunism. Russ: So, this is basically: the ends never justify the means. And the emphasis there is never. And if you know you are dealing with somebody like that, that would be really good, because you know they wouldn't exploit you, justifying it in their mind that there's something better coming. This would make politics very different, I would just say as an aside. Guest: Oh, absolutely. Maybe most people aren't that way, Russ, but you do know people who are that way. Russ: I do. I think it's good to be that way. Let me just make an aside on something we haven't talked about yet, which is the--and this is very Smithian--the role of self-deception. For me, once you open up the argument that maybe this is for the greater good, you start to go down a slippery slope of justifying what you are doing that's really for you but you'll tell yourself: It's not for me. Of course not. It was for my nephew. Guest: I discuss that explicitly in the book. Russ: I don't remember that part. Where does that come in? Guest: It would be in the chapter on duty-based moral restraint. Russ: Sorry I missed it. That's to me the danger. Many people would argue for "modern morality" you take in the greater good. That is the moral action. But my view is that's a slippery slope. Guest: Right. I have a section titled something like: When greater good rationalization becomes self-serving rationalization. And I give some examples of how easy it is to happen. Very concrete examples. But I don't remember any of them off the top of my head.
44:07Russ: So, let's summarize here, because we've gotten into some interesting, complicated stuff. Let me try to see if I know where we're at, which is: If we could live in a world where we knew that everyone believed that the end never justifies the means, we would live in a world where we would know that the person on the other side of the transaction, whether it was within a firm or across firms with exchange, especially with strangers, that we could trust them. And that would allow us to engage in transactions we otherwise either couldn't engage in or could only engage in at great cost, because of the other ways we try to solve that problem. And you are saying there are some that could not be solved in any other way--those would be the golden opportunity ones. Guest: Right, but you are only half right. Russ: What am I missing? Guest: You have to have both principled moral restraint and the greater good rationalization to solve the greater good rationalization problem at the same time to produce a condition of duty-based moral restraint, because--let's go to the greater good rationalization problem. Suppose by doing a particular thing that's a negative moral act, on paper, I can do this wonderful thing. That's the greater good rationalization problem. But if I don't possess principled moral restraint, even if I possess greater good rationalization, even if I possess lexical primacy, so I'm not subject to greater good rationalization, if I don't possess principled moral restraint, that action that I would have to undertake in order to facilitate the positive moral act won't be regarded as a negative moral act if nobody gets harmed. Russ: Correct. Agreed. Guest: Both have to be in play in order to have duty-based moral restraint. And duty-based moral restraint is not even enough to give us the moral foundation. But I figured we would wander to the next stage.
46:14Russ: So, at this point--I didn't feel this way when I was reading the book--but at this point in the conversation, I'm starting to think: This is hopeless. This is too high a level of moral foundation to expect in our fellow citizens. Guest: Actually, that's something I talk about explicitly in the book. There's a new movement in our society; it's a cottage industry, in character and morals education of children. And I'm sure you've seen some of this in your own life, if you talk to people in public schools they'll have these character and moral education programs. And, what you'll find is people who teach in these programs create the impression in children's minds that moral dilemmas are everywhere. Everything is complex and hard and there's no such thing as black and white; everything is a shade of gray. Russ: You buy an apple and it's from New Zealand and you've killed the planet. You'd better study it; you'd better look at it; good luck. Guest: Right. And they make these arguments that people like Dave Rose and Russ Roberts are unsophisticated and incapable of sufficiently nuanced reasoning in order to be a truly moral person. My response to that is: Utter nonsense. The problem is, what they are doing is, they have an implicit theory of morality that's actually very, very old. It is just rank utilitarianism. It's a perfectly good approach to morality if you live in a very small group. It gives you the most efficient outcomes if you live in a small group. No doubt about it. And that's what you are hardwired to believe. And that's why they have such an easy time persuading people they are right, because you are trying to persuade people of a particular type of moral belief system that they are hardwired to already be ready to be receptive to. The problem is, all of these nuanced analyses and all of these exceptions and conundrums that they have have the result of bringing a knife to a gunfight. They are taking a very small group sense of morality and applying it to the modern world. What I would say: the moral foundation is a much more complex set of moral beliefs; but people don't have to know the theory behind the set of beliefs in order to abide by the beliefs. Let me give you a simple illustration that I did in the book about this. Suppose you had a guy who was a mechanic; and this mechanic had a set of tools. And the set of tools was like a little kid's craftsman's starter set, but he's working on a 2010 Honda Accord. There's going to be some real problems, because advanced engines are very complex and they require many specialized tools, and so on and so forth. As a result, the only way you are going to get that car repaired is if that mechanic is extremely smart, clever, and creative, and with bandaids and duct tape can somehow get these tools to get the job done. Because the tools are not up to the job. The tools are simple and therefore it requires a very brilliant and thoughtful mechanic to deal with the complex car. Instead, suppose you had a guy who was trying to repair the same car, same repair, but he has the full complement of tools that are provided by the factory--really advanced stuff, lasers, and you name it, the whole nine yards. It would be a mistake to infer that the car is not complex because it's so easily repaired by the appropriate tools. The fundamental problem is, and these people are making the argument--and you are making the argument--that the moral theory is too complex; what I would argue is actually what's going on is their theory is simple and it's applied to a complex situation. This theory is adequately nuanced itself to deal with the very society that it gave rise to, so as a result the actual execution of the theory is actually quite simple. In other words, the rules of thumb one needs to abide by in order to abide by the moral foundation are actually very simple. Russ: I agree with that. Guest: The fact that it's a demonstration that the theory works has nothing to do with the execution of it. Russ: This comes back to my philosophy professor, Dr. Smyth, who in trying to summarize pragmatism and the thought of Charles Pierce--and it's a very Hayekian insight--the way he summed up one aspect of it was: Your grandmother is right. Meaning your grandmother has a bunch of rules of thumb about right and wrong--don't do this, do this, do that--and if you ask her why or why not, she doesn't have an explanation. She just says: That's always the way it's been and that's the right thing. You are suggesting that if we live that way, or the fact that we have lived that way for a long time is part of the reason we are so successful as a culture. And as an economy. Guest: Yes, and that way, what is required to live that way, doesn't require twenty hours of schooling. It requires many years of continuous reinforcement in order to build the character to produce the moral conviction behind a belief, but the beliefs themselves are pretty simple. Don't do stuff, don't do negative moral actions. Just don't do them; and just because nobody gets hurt, that doesn't mean you can do it, either. Because it's not about the person who is getting hurt or not hurt; it's about you. If you steal, even though nobody gets hurt, you are still a thief. So don't do it. Period. Don't even consider it. Don't even run it up the flagpole. That's not that complicated. And then secondly, if somebody says to you that you should do something that you know is wrong but it's okay to do it because there's this other good thing over here that you can make happen if you do otherwise, you need to realize that that is the language of a charlatan, that that is inappropriate, that you are being sucked in. We don't do things like that. Russ: Some of us try to raise our children that way; some of us do not.
53:17Russ: Let's move away from the morality. Let's talk about the implications for growth, development, and our standard of living. If this is correct, and much of it seems correct to me, there are two implications. One is: Societies, cultures, that have successfully inculcated the view that stealing is just wrong, don't do it, you never want to perceive yourself as a thief--and that's either done through religion or other cultural means--those societies find it easier to specialize and grow. Societies that don't inculcate that or haven't--again there's no thing called society that tries to, but societies with individuals who have not adopted those beliefs are going to find it much more difficult to grow and be successful, because specialization and exchange in large groups is going to be much more difficult. Two questions. Number one: What's the evidence that this is true? It has an appealing casual truth to it. Might there be some specific evidence that it's true. And the second question I would have is: It seems to me, and we've talked about this informally in the last few minutes, that there's been an erosion of that moral imperative in the United States at least over the last 30-40 years. Do you think that's true and do you see any signs that it might make a difference in how we behave towards each other? Guest: Well, as far as evidence, we do have empirical work on measured trust across the world, and measured levels of trust do co-vary well with economic performance and general quality of life in societies. That suggests that however it is they are able to achieve this trust, if they can, it does pay off. And so that doesn't cinch the argument, but it's certainly consistent with the kind of evidence that we would need to see. Russ: Aren't there people who have done experiments--this reminds me of these experiments where you take a wallet, you leave the wallet in the middle of the street, and in some cultures, you find a wallet that isn't yours, you stuff it in your pocket as quickly as you can and hope nobody is looking or notices and nobody says: Hey, what have you got there? You just take the wallet and you get home and take the money and dump the rest in the garbage. But there are other cultures, and we know this happens, where people find that wallet and they return it to a stranger with the money in it. Guest: And if a person was asked to come up with a list of societies where they think most people would act the latter way, they'd probably be right. Their preconceived notions are basically right. And most of those societies are well-developed and prosperous societies. But my point gets behind that point. My point is that in order to get to that condition, moral beliefs have to have a particular kind of structure. If they don't have that kind of structure, you won't have the unconditional trustworthiness and you therefore won't have an environment of trust. Because it will be unsustainable. People will not extend trust if they are continuously punished for doing so. If it's not rational to extend trust, you don't. Russ: Like a sucker, and after a while you'd rather not be a sucker. Guest: Right. Russ: The second question was: Do you sense an erosion in these attitudes in civilization, in Western society. And one thing you might talk about is: where do those views come from? Do they come from folk wisdom? Religion? Does it matter? And where are we headed. Guest: Robert Putnam has documented a pretty-much across-the-board reduction in measured levels of trust. He's focused on social capital, but he does measure trust directly. Eric Uslaner has also done this. From 1950 until the present, it's pretty grim. In the United States, the downward slope is clear. Measured level of trust and trustworthiness are both going down through time. Russ: I was going to interject--I don't believe in the Great Stagnation, which we interviewed Tyler Cowen on this program about it, but this could be an underlying cause of that, if you believe that. It does raise the question: we've been a pretty successful economic society since 1950, so you have to explain despite that erosion why we've done so well with large scale specialization in organizations. Guest: Well, Adam Smith once said: There's a lot of ruin in a nation. Russ: True. Guest: Charles Murray has made an argument kind of similar to this, that in Scandinavia things are moving in the wrong direction. But they've built up a huge pile of cultural capital. They are going to have to make a lot of withdrawals from their cultural account before you get close to the margin. But in my view this reduction in measured trust does comport well with changes in moral beliefs in our country. I've detected it over the course of my own life. The kinds of things that people would say now or say five years ago that would have been laughable even when I was a kid. Let me give you a quick and dirty example. When Jesse Jackson was caught moving funds from the Rainbow Coalition, that he directed, to a woman that he had impregnated--and he was caught dead to right, there was absolutely no way of defending the behavior, he got nailed--many people said: Well, but you've got to look at the whole picture and all the good he's done, give him a break. I really do believe that in 1950 if someone had said that publically, they'd have just been laughed by virtually everyone. Are you kidding me? The guy basically engaged in overt fraud.
1:00:09Russ: I don't know. It's an interesting thing. This is part of the challenge of this kind of research agenda; I don't say this as a criticism because I think what you are trying to do is extremely ambitious and it's very interesting. But there is still a remarkable amount of moral sanction and shaming and other activities for people who are fraudulent or who cheat. Just look at baseball. Very few people say--there's some variance on how people respond to the steroid issue, but so many people just say: Well, they cheated; it's wrong; end of story. Well, everyone else was doing it. Doesn't matter; it was wrong. Well, they didn't really enforce it. Doesn't matter; it was wrong. Guest: You are conflating two very different functions of the brain, though. You are conflating conviction born of a deep belief with a habit of mind. Are you familiar with Kohlberg's stages of development? Russ: I am. I don't like them. Guest: But many people who are just very mechanical about their moral beliefs really are behaving in a simple-minded kind of way. Cheating. But what if? It's just cheating. That's observationally equivalent between having somebody who abides by the moral foundation in a self-aware way and it's unyielding and has deep conviction to the possibility that a person is just--whatever the rule is and for whatever the reason, they accept it and they simply employ it. Let me give you a counterexample to what you are talking about. There have been numerous studies of high school students and college students cheating in college, and high school. This has been looked at over and over again. The amount of cheating has never been zero, of course, but it has gone up dramatically in the last 25 years. Moreover, in the past when you asked students why they cheated and they explained why they cheated, they almost never excused the cheating; they never downplayed the moral import of it. They would say it was wrong but they had to do it. Today, though, increasingly--I don't remember the proportion but it's a shockingly high proportion--most of them report cheating at least once; and a shockingly high proportion of those who report cheating at least once say: What's the big deal? In other words, they make an argument that is very consistent with the absence of principled moral restraint. Because their argument is: I cheated; so what? Nobody got hurt. I didn't take anything from anybody. Nobody's worse off. Teacher's not worse off; I'm certainly not worse off; nobody in the class is worse off; what difference did it make? And the answer of course is, at that margin it makes no difference at all. But my point is that it's indicative of a shift in moral beliefs themselves, the way we organize our thoughts, and it's very frightening. Russ: But you are suggesting--what your book suggests is that this change in our view of what is right and wrong, assuming that is really actually happening, and I think it could be right, is going to affect our economic activity because of the change in trust. Guest: Well, yes. And I think it already has to some extent. Look at the kinds of loan behavior that was going on in the financial crisis. I know people in the real estate business both on the mortgage side of it and in the house sales side of it, and it was just amazing what was going on. Many people knew what was going on was wrong. And they just shouldn't be doing it. But they thought, well, nobody's dying because of this. Russ: Or what about that the ultimate people who are going to pay for this--it's going to be spread out over a large group, a corporation will lose the money or it might be taxpayers; in fact it's good because I'm putting a person in a house. I'm thinking about the person who convinces somebody to take out a loan, doesn't require the documentation that would be necessary or the credit rating; both parties wink and say: Hey, this is good. Guest: And that con worked okay and almost nobody ever got hurt as long as all the house prices kept going up. The standard argument was, well, worst comes to worst, you can't handle it, you sell it. What's the big deal? But prices go down and there's the big deal. Russ: The fundamental question of this approach--of course, these kind of things happened in the past, the question is have people changed the way they feel about them? Did they feel differently in 1880, 1920, 1960 versus today? And the answer is: Maybe; I don't know. Guest: Well, there are tricks--obviously we can't go too far back--but there are tricks to teasing out these things. With survey data that matches up to trust experiment data; and I'm working with some economists around the world to develop variations on well-known trust experiments that can be put together with data that's generated from self-report information about how people feel about various kinds of moral statements, they order them and categorize them. What we can do is we can infer from how they would categorize these things in a survey instrument, we can infer how close they would come to the moral foundation, and then we can match that up to how they performed in the trust experiment, and see if indeed people who give us self-reported information about how they valued things relative to one another and therefore have moral beliefs that comport with the moral foundation actually are more trustworthy.
1:06:53Russ: Let me ask you about one more empirical possibility. Some economists have been surprised over time at the way people behave in various experimental games that economists and psychologists have created, dividing the pie, other ultimatum games, that people didn't behave--I always like this--rationally. That is the claim. And then there have been attempts to decide why they really did and what was going on, what people were thinking. And it's obvious, to me at least, that one of the reasons people don't behave with what narrow-minded self-interest would predict is that people aren't narrow-mindedly self-interested. They are not going to enjoy hurting somebody else, or taking money from someone, and they might feel guilty about it. I don't follow that literature closely. I assume that those experiments have been done outside of the United States and Western Europe. Guest: There's a cottage industry in doing those experiments outside the United States, and just as you'd expect, there's a great deal of variation depending on where you are. I have two reactions to those experiments; and I do talk about that in the book fairly extensively. Point number one: Most experiments-- in fact all that I know of, I don't know any exceptions, but let's just say most to be safe--are inherently framed in a small group context. You are playing a game against another person or against two other people or against all the other students in a classroom. Very rare that an economic experiment in a trust game involves more than 25 people. So we are already in a small group situation. That frames the issue in a small group way and therefore actuates all of our small group mental models. So, it doesn't tell us anything about large group trust. That's one fundamental problem with these experiments. This is something that can be fixed; it's not a big deal to change it; but nobody's even known to ask, even try. I'm going to help people figure out how to do that to test these other hypotheses. The other issue is when people behave in a way that's too generous, too trustworthy, too kind to be rational, according to what an economist would say, there are two possibilities. One is there is some kind of moral guidepost that's affecting their behavior; they are not just playing the game for the sake of the game. That's certainly true. But even if that weren't true, there's another problem that I call a reluctance--well, basically that a person has an aversion to false positive golden opportunities. It seems to me that we are hardwired, that we should be hardwired, to be suspicious of what appear to be golden opportunities. Suppose you sit down and play a game and a guy says: Here's the game, here's how it works. What are you going to do? Well, you are an economist, but even if you weren't, you might think to yourself, who is to say there's not going to be another level to this game where they are going to take how I play now into consideration. Russ: True. Guest: So, I don't know if I'm going to go all the way with this, and no matter what they say you don't believe them. And I do think that it's the mark of maturity and careful thought to be incredulous about things that appear to be golden opportunities. Russ: I don't know. We like free lunches; and a golden opportunity is a variant on a free lunch. We do have a taste for free lunches. Guest: We have a taste for free lunches but only if they really are free.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2012/01/david_rose_on_t.html. http://www.econtalk.org/archives/2012/01/david_rose_on_t.html http://www.econtalk.org/archives/2012/01/david_rose_on_t.html David Rose Mon, 23 Jan 2012 06:30:00 -0500 Taleb on Antifragility Nassim Taleb, author of Fooled By Randomness and The Black Swan, talks with EconTalk host Russ Roberts about antifragility, the concept behind Taleb's next book, a work in progress. Taleb talks about how we can cope with our ignorance and uncertainty in a complex world. Topics covered include health, finance, political systems, the Fed, your career, Seneca, shame, heroism, and a few more.

Play
Time: 1:13:56
How do I listen to a podcast?
Download
Size: 34.0 MB
Right-click or Option-click, and select "Save Link/Target As MP3.
]]>

Readings and Links related to this podcast

Podcast Readings
HIDE READINGS
About this week's guest: About ideas and people mentioned in this podcast:

Highlights

Time
Podcast Highlights
HIDE HIGHLIGHTS
0:36Intro. [Recording date: December 19, 2011.] This book is in process, you estimate it's roughly a year away. So, we are here to have a conversation that is in progress. I did my first EconTalk on the day of the release of The Black Swan. So nice, so fun. I know a lot of listeners out there are very jealous because I've had the privilege of reading the manuscript-not the final book. It's in process. But for those of you who are out there, excited, this will have to satisfy you for maybe about a year. Nine months. Well, that's a good gestation period. Now you start off with a very provocative idea. The title of the book is a little bit strange. I don't think it's a word in the English language: antifragility. You start off by asking: What is the opposite of fragile? And of course we think we know what that is. The opposite of fragile is robust, you say; it may be unbreakable. But you argue that's not right way to think about it. It doesn't capture the essence of fragility. So, why do we need another term? Because if you send a package by mail to your cousin in Australia and it has champagne glasses, you write "Fragile" on it. If it is something that is robust, you don't write something on the package. You don't say you don't care, you can do whatever you want. So the fragile, the upper bound comes back unharmed or [?] and of course the worst is completely destroyed. So, that's the fragile. The robust has an upper bound of unharmed and a lower bound of unharmed. The empty fragile would be a package on which you'd write: Please mishandle. Because a lower bound would be unharmed. And the upper bound would be improved--you'd get, instead of sending 6 champagne glasses, 8 would arrive. Exactly. Like in mythology. Or they'd be better glasses, stronger somehow. Like the Hydra--you cut one head, two heads grow back. So the robust would be more like the Phoenix--you shoot it and it comes back. So the upper bound and the lower bound are both unharmed; with Hydra, the Hydra wants harm. When I first read that idea I thought: Okay, that's interesting, true; but why is it relevant. There are not that many Hydras around, life doesn't consist of many Hydras. But much of the book convinced me and the reader that actually antifragile is a very powerful idea. So, where is that important, where is it relevant in our lives? The first thing, the reason I had that word--I had an equivalent word for something like volatility, but it was not powerful enough to capture it. And it was called long volatility or love volatility, but it didn't quite capture the idea. But one day I read this book by Guy Deutscher on language, and he reports in a book something that was discovered by the U.K. Prime Minister Gladstone, and that was to the shock of everyone, about 140 years ago--that the Greeks did not have a word for blue. The color of the sky. The wine-dark sea. Homer did not have a word for blue; he did not have the full spectrum of colors. And these developed much later; and ancient Mediterraneans, the Greeks, the Hebrews, the Semites, didn't have a word for blue or for many similar words. They were not color blind. They were biologically okay. They were just culturally color blind. So, I realized you just give light on something by coining a word; and that turned out to be "antifragility." And once I wrote it down, I realized, I started seeing it in places I never suspected. It had this property. Give us some examples of things that are anti-fragile. We understand what things are fragile. Actually, I am even going to go beyond. Half the book is about things that love volatility, love stressors, love uncertainty--political life. But we'll get to that in a minute. The human body, the bones. The bones need stressors, constant stress. They communicate with the environment with stress. If you spend Christmas vacation in a space shuttle, you'll come back with diminished bone density. Which is weird. Because you'd think it would be great to be in the space shuttle because your bones will get to rest. What could be better than getting them unstressed? Actually, a complex system, a paper that really changed my thinking, by Gerard Karsenty, a 2003 paper in Nature, and of course he had a lot of follow-ups; and in it he showed it's not aging that causes weakness in the bones, the reverse is equally true. You have a complex system with feedback loops that are not as obvious as in a linear, ordinary system. And therefore the idea that weak bone mass makes you older. And vice versa. Weaker and older. You can see the bone density of females in African villages who carry jugs of water on their heads, between 100 and 200 pounds--they have excellent posture and excellent health. And even male reflective [?] abilities are affected by bone density. Which means if you go to the gym you are wasting your time because you need weight-bearing stressed, not these [?] machines that waste your time. We'll go into that in more detail later; you bring it up in the book and it's a very interesting idea: that certain things are good for our body, exercise and weight lifting, actually are not. We've talked a little about this with Art De Vany, who I know you are a fan of. Art gave me a lot of ideas and suddenly everything flashed together, when I made the distinction between two types of systems, the organic and the non-organic. The organic has the property that the difference between the living and the dead, the living and the non-living; the living, between living and a machine for example, requires stressors. That's how the complex systems communicate with their environment. You need a stressor. As with the bones, with your muscles, a lot of things. And usually overcompensate for the stressors--there is a mechanism in biology called hormesis. This table I have in front of me will never get better if I bang on it. Use it and lose it. On the other hand, the human body gets better if it is exposed to the right amount of stressors. Of course, you have to define the stressor and the quantity of stress. But then that makes a difference between two worlds--the organic and the engineered. And now, if you can apply that to economic life--is economic life in the first or second category? If it's in the first category then we should have bailouts, top-down engineers, everything. If it's in the second category then sorry, you know, it doesn't work that way.
9:05You use a metaphor that I also use myself, which I find deeply provocative and educational, which is the forest fire. So, if the goal of fire policy is to have no fires and you are constantly putting out every fire as quickly as you can--which is to me what the bailout policy of the last 30 years has been about--it's true that in the short run it looks great because there are no fires. There's no damage, everybody is fine, it turns out okay; and people even brag--we didn't have any out-of-pocket, all we did was guarantee these loans; we didn't even have to pay anything because the guarantee never was invoked. But the problem is, is that the brush starts to build up--in the natural case--and then when the fire does come, it's the fire of all fires. It is incredibly destructive. Exactly. So, what you are doing is you are not lowering volatility. You are increasing fat tails. Which means that most of the contribution to the damage will come from a small number of events or one single event. It's the same thing in economic life with Greenspan, or anybody. If you put someone in a germ-free environment for 15 years, then invite him to take a ride in a New York subway at rush hour, I think he will last a few minutes. The Greenspan example is--you are fine-tuning and steering and averting every possible bad event; and then suddenly there comes a bad event you can't overcome any more. Exactly. Because we had something I noticed in 1997 with barrier options--if you take variations, when you spend a long time without variation, you have a lot of exposure built that would be harmed by it. And it's linear with time. So if you go 5 or 6 months without a new low, for example, and you make a new low, you have a lot more blowups. You see? So quiet periods aren't very healthy for financial markets. And I noticed it in dynamic hedging, by showing how the number of barrier options start building up below the lows. It was a metaphor that kept in my mind for 15 years and here it popped up when I started talking about the economy, how it causes it to get weaker. Let me now make one statement about antifragility that's quite important. Is what benefits from the following phenomena: volatility, stress, uncertainty, error, chaos, variation, time--because time is volatility and things like that. Now these categories I've just enumerated are qualitatively and theoretically different. Volatility and stress are different things. But the phenomenology is the same. That is what is quite central to the book; had to explain that something that gains from volatility tends to gain from stress. And something that gains from volatility gains from time. So, this is quite central in the book, to explain it early on. This kind of analogy can be very dangerous. There's a temptation to say--I've fallen prey to this temptation myself; I think it's true but it is a little bit risky--the temptation to say: Well, this works in nature and because economic systems are organic, then the same phenomenon is happening here. The question is: Is that really true and what are the underlying causes of that? And I think what you get at that is so interesting is really the fundamental nonlinearities in these organic, unconstructed, unengineered, emergent systems. The way I think about it is: there is no reason that Federal Reserve policy should really be like fire policy. It's really interesting, amazing, that it could be the same phenomenon; the question is, is it? I think the reason it is gets at the nonlinearities you talk about, which is that if I have a bad event happen ten times, it's not the same as a ten-times worse single event. That massive large event, because the damage is not linear, the effects of the damage get dramatically worse as the size of the damage occurs. You talk about this in many different ways in the book. You talk about it mathematically in terms of convexity and concavity; but the simple way that I understood it is: if you have a bunch of little financial errors, even though they could add up to a relatively large number, they are not very harmful. But one financial error that is equal to all those little ones by itself can be unbelievably harmful in terms of the systemic effects. So, this seems to be the essence of what's going on in these organic systems. Yes, that's one thing. Whenever you have nonlinearities, then you have a certain effect, and it so happens that that effect translates into either fragility or antifragility. Nonlinearities implies one or the other. And actually, this idea to detect risks that Taylor has of stress-testing, I am collaborating with him on a paper on Taylor risk, seeing if you have nonlinearities in exposure--for example, these stress tests that we do, they are nice; they work sometimes; sometimes they don't. Why? Because the number you have to come up with for a stress test is arbitrary. Why are we stress-testing 10% and not 11%? So, someone who has nonlinear exposures and you stress-test him at 10% and he passes the test, as many European banks did before the last rout. But then if you test them at 11% or 12% and see the risk increasing then you realize you have a huge exposure to error from that nonlinearity. Now that one, this phenomenology is identical to the one that allows me to detect physical fragility. Let me give you the idea. You take a car; you drive it against a wall at a 10th of a mile per hour, a hundred times, a thousand times. Are you going to be harmed? No. The car will have some damage, but not you. Now drive the same car once at 100 miles an hour. You are dead. The definition of fragility, universal systemic physical fragility, model fragility, has to have some nonlinear term or what we call short gamma in option trading. It's quite universal. This coffee cup I have on my desk now has suffered a lot of shocks, with zero material fatigue. You can't see me do it, but if I let it fall to the floor it will break, it will shatter. It's not a shock that it gets every few hours on the table. What you have is that if you are harmed increasingly, if 10% harms you disproportionately more than 9%, 11% disproportionately more than 10%, you have accelerated harm, then you are fragile. And vice versa for antifragile.
16:57Let's talk about the antifragile side, because that's the less intuitive side. We understand this idea that if I bump a coffee cup a little bit against the side of the table, I can do that a thousand times and there's no damage. There might be no cumulative effect, even. It might be relatively harmless. But one large shock, like dropping it three feet rather than an inch 36 times is totally different. It's not just a little worse--it's over, it's dead. Now how does that work on the antifragile side? The argue has to be, to carry it over, it gets stronger and stronger and stronger, so that in fact, the bigger the bump, the better, as long as I stay below some threshold. Exactly. Of course, the second derivative flips in sign at some point. But a very simple example: you go to the gym. What's better over a week--to lift a tenth of a pound a thousand times, or to lift 100 pounds once? So, that's my body. You have fast twitch fibers in your body and these are very antifragile. Fast twitch fibers require strain, even more pronounced. But you have low twitch fibers that benefit from say an earlier--it has some convexity that stops very early. So, there's a chapter in the book on health, which listeners know I'm very interested in, recently I've started to eat differently and work out in a rigorous way. But it's much more important than just about your health. A huge part of the book is about both career advice and about policy advice. Let's talk a little bit about career advice. You point out, it's a provocative idea, that the tails are very different from the middle. Essentially again a nonlinearity. So, a person who is working at a minimum wage job, you argue, in a certain dimension is very antifragile, and a person who has a nice steady job at a bank, who is say a clerk, is very fragile. And yet that's not our common sense. Talk about those differences. There is something I call the barbell in the The Black Swan where I showed that a portfolio that has 90% in Treasury Bills and 10% in extremely risky securities was more robust because your measure of volatility--I mean, provided of course adjusted for inflation or if you have inflation-linked securities for 90%--would be a lot more robust because it doesn't depend on computation. It doesn't have model error. It was very risky, you know it's very risky; so that's a lot more robust than a regular portfolio. Likewise, if you walk and sprint, as De Vany says, it's vastly better for your health than jogging. Right. And then I continue: if you want, a company should have a certain amount of its energy in the things that make money, but should have dual strategy of very safe and then very speculative. Just like monogamous birds--the strategy in female kingdom, even in monogamy, is you have the accountant, and once in a while is you get pregnant by the rock star. That's the barbell strategy. Another barbell strategy--I notice that the great writers did not work as journalists. They had a cushy job that had a barbell; and then when they wrote it was very speculative literature. Like Kafka didn't write a journal article a day. It's not like he was a journalist. That's very common in the French literature--when their parents are rich they become diplomats; when the parents are poor, they become postal workers. And you write on the side, rather than have that middle. Einstein was a clerk; and then did his theories at night instead of being an academic. Faulkner worked in a boiler room somewhere when he was writing his best books. But why is that relevant? Why is it bad to work as a journalist? That seems okay. Things in the middle sometimes--some I can explain, some I can't explain. But when I go to a restaurant, I like to have my steak and salad first and then the dessert later; I don't want to mix the steak with the salad and the dessert and bring them to me at once, you see? You want a separation of function, a separation of things. In a lot of domains it confers some robustness on the grounds that to get antifragility, first you have to remove fragility. It's not symmetric. Antifragile is what has a right tail. Fragile is what has a left tail, but the antifragile requires no left tail. In other words you have to clip your left tail; you have to have so much safety and then be very speculative, a lot of volatility. And underlying that idea, which is very beautiful in the book, is this idea of an option, where the downside comes, but you are not subject to it. You can refuse it. And then you can embrace the upside. Exactly. And I took it to epistemological grounds by saying that in finance you may pay for the option because nobody will give it to you for free and typically an option is highly overpriced because people are scared of them when they are labeled as options. But in real life, people don't notice the options. Optionality situations [?]. And I took it to epistemological grounds by showing how if trial and error is a rational option--in a sense you keep what you like, nature, actually, thinkers, and we discovered only 40 years ago that nature knows it can't make a perfect baby, so you have spontaneous abortions 50% of the time without anyone knowing about it. So, trial and error is embedded in my idea of the convex economy. Most mutations are not productive and they get weeded out. They don't get to reproduce; they are failures and they are just thrown out. Exactly. There are fractal layers of antifragilities. There's a gentleman who read my draft, top notch physicist turned geneticist; and he uncovered the mechanism within your cells that causes, why premature aging comes from not stressing your system because there's a competition between molecules in your system. So, what you have as a resolution is an antrifragile process. It likes some volatility, otherwise you don't have selection bias. There is selection. Likewise in your body you have competing things, and you want to always accelerate the weakness of the weak in order to get rejuvenation of cells. And there's a mechanism called hormesis that was known by the ancients--if you give someone a little bit of poison he becomes immune, a process called mithridatisation. Mithridates was a king who became immune to poison that way. But they noticed also that it went beyond, was actually stronger with very small doses of exposure. It's not what you think. It's definitely not homeopathic. It is something actually that has a lot of domains. Small dose of radiation protects you from skin cancer. It's universally observed in science. It's very difficult to find a counterexample. The expression in everyday life is: The dose makes the poison. Meaning in a small dose it's good for you; in a large dose it could kill you or will kill you. We see it constantly. The discoveries about the benefits of alcohol; obviously in small doses it appears wine is good for your heart. In large doses it destroys you. That's true, but you have to be careful. That's what Paracelsus, one of the pioneers of homeopathy, discovered. I'm not talking about homeopathy where it's a matter of dosage. I'm talking about something that's evidence based process by which some amount of exposure causes an overreaction on your part. And actually, when you go to the gym, what you have is an overreaction. I lift 100 pounds today; my body will project that I am going to have a stressor slightly worse next time. So it prepares for 105 pounds. Provided you have enough recovery. Homeopathy is something where you have very small things. The same applies to both, but I would be careful. I don't want my ideas to be used by people in homeopathy to justify their methods, because their methods have not yet shown any scientific empirical validity. And you are not suggesting you should be sprinkling arsenic in your food. You are saying that the right level of stress in small doses--what doesn't kill you, makes you stronger. Yes. And also but you have to make sure that you don't have selection bias as well. And I wrote about some illusions we have about things that get people stronger when in fact it's just selection bias. For example? There are a lot of things in antifragility that are counter common wisdom. You talk about that because of selection bias it looks like it's making it stronger but in fact it's just weeded out some of the weak ones. Exactly. Which is effectively how it works within the cells. It's more a destructive process within the cell than a strengthening process. And it can do the same with populations, you see?
27:52Let's talk about via negativa, which is a phrase you use to capture addition by subtraction. Part of this is a reaction to some of the criticism you got from The Black Swan, where people would say: So, every once in a while there's this really bad thing that happens, so how do I predict that really bad thing? And your insight, which is so profound, is that the whole point of the black swan is that you can't predict it; so rather than figuring out when it's going to come so you can be ready for it, the best thing is to create an environment where it can't hurt you very much. Exactly. And shifting to non-predictive methods. When I started writing this book I had a lot of bitterness in me because people didn't understand my Black Swan. They were buying it; it sold several million copies. And most of the people didn't get it. I'm not talking about I'm trying to prevent people from exposure to position errors. And nature is not predictive. And via negativa, is what I call negative advice, acts of omission. And when people ask me what should I do, I tell them: Don't get exposed to negative black swans. It's very easy to remove negative black swans from your life. If you are a bank, sell tails; if you are in a business don't do these things; if you are an individual, don't smoke, don't have fructose sugar. So people didn't understand; they said: I want advice. And they couldn't get the point that the rookie tries to win; the professional tries to make the other person lose. Or for example, via negativa, by removing things than by adding in. People didn't want to hear it. By preventing people from smoking you save more lives than by producing insulin cumulatively. Likewise all these things--people are looking for the miracle drug or the miracle cure or the silver pill or anything to make people live longer. The philosophers don't realize that starvation is the most effective way, and we have enough evidence of that. We even now have evidence and another paper last week that if you starve people for four months, you reverse diabetes and they can gain their weight back and they will still be normal. Reverse--by subtraction. Remove food. The ancients knew that. So, the via negativa is--I've got a little more aggressive with via negativa by showing that removing does not have side effects, or no long term side effects. You see? Whereas in a complex system, every time you add something you have side effects. And you can't predict what they are, by nature of complex systems. So via negativa is not. People ask me what would you do in economics; I tell them: just remove Geithner to start with; everything will be okay. Then we will have less control by certain crowd. Democracy works by via negativa. The idea is not to find good rulers but to be able to remove the bad ones. The American Constitution, when it was put in place, was designed to talk about what government can't do, and instead government has become more concerned about what it can do.
31:44You talk in the book very provocatively about our bias toward intervention, which this is all a part of. I want to know the vitamin pill I should take. I don't want to hear about what I shouldn't be doing. I want to be proactive. We have this incredible psychological bias toward being proactive rather than passive. Which again is a nice example of your opposite. The opposite of proactive isn't reactive. It's doing nothing, it's passive, doing nothing. Letting things happen. That doesn't mean nothing is going to happen. It sounds terrible. Fabius, the Cunctator, [?] whose big achievement resisting and making sure Hannibal destroyed himself before attacking. Big general; he was not a coward. He just said: My asset is time. This ties in a little book, well to me a lot, where you have a nice diagram in the book. You have a giant cube, which is the real world. And then you have a little tiny cube, which is what we know about the real world that is scientifically rigorous, experimental, tested through rigorous techniques. And unfortunately it's a fact that what we understand rigorously is a very small part of what we'd like to understand. But we can't help ourselves. We want to believe that that real world is a lot more understood than it actually is. How do you explain that? This is where I have the character Fat Tony where he didn't have knowledge of the small world but he had rigor in the large world. And what matters is rigor in the large world. Last time we spoke I was talking about this fantasy we have. Procrustean bed. This fellow as bad and he would abduct travelers and feed them; and put them in his bed. And if they were too tall, he would amputate their legs; and if they were too short he would stretch them. The bed was always a perfect fit. We have a tendency in a lot of things to try to put people in a Procrustean bed. Fat Tony had the rigor of thinking outside the bed, or outside the box. But it's not trivial, because there are rules outside the box. And these rules--you can actually catalog them; you can actually change the small world by coming from the large world rather than doing the opposite. The artistic [?] whatever you want to call it. Analytical, scientific. [?] Like trying to impose logic on [?]. Logic works but seems a lot more ambiguous. So, via negativa is a central idea. Harnessing antifragility [?] by trial and error and focusing on payoff, which is non-predicted, rather than focusing on probabilities which have predictive thing in it. Probability is predictive, has a predictive aspect to it. So it has a different paradigm when you work in the large world. And of course we have the invisible what I call logic of rules we have inherited from the elders. And typically, just like you mentioned, the American Constitution, you have the heuristic work, heuristics, inherited from the elders. And typically these are all the negative rules, what not to do. I think that's probably almost always true. Yes. Like debt. The Babylonians had an interdict against that; so were the Hebrews. The Greeks did not like debt but didn't have a strong interdict. [?] had a fatua about that. "Neither a borrower nor a lender be"--Shakespeare. And then of course Islam bans debt. But the language used by [?] is vastly stronger than the language used in Islam against debt. So you learn. There's no reason you don't understand the logic. There is something in risk management--the largest n you find, you are going to find it in nature or in history. So, if you are talking on statistical grounds. Big sample. And yet we always think we just need to manage it. Debt is bad of course, but I don't need to worry about it because I've got a theory, I've got a model, I can make it work. I've used the very same convexity effects to show why you need stochastic, why of course hormesis, what you were calling benefits of small doses of something are less harmful, and all the other things. There is the same convexity effect. Size and debt, and overspecialization, fragilization. And leverage. They fragilize. A redundancy makes you robust. And actually necessary even for becoming antifragile is to have large redundancies. It may seem strange, non-optimal, but we have inherited, as I said last time, we have two lungs and two kidneys. An economist would never design a human being with two lungs and two kidneys. It's wasteful. Deadweight loss. So, the opposite of spare parts would be debt. And nature doesn't like debt. Nature likes redundancies. This mechanism of overreaction is redundancy. Let me give you a little hint here. When you take a trader or risk manager at a bank, they look at the past for the worst-case scenario. And actually making a mistake does not recursing. They say: Well, the worst day was 22% in the stock market, so let's use 22%. The human body doesn't do that. The human body doesn't think that the worst harm is going to be the next worst harm. The human body builds a margin on top of that. It thinks the worst day was 22% in the market? The human body would say, let's calibrate and adjust and manage for 27%. Or 50%. Not that much. If I lift 100 pounds, my body will start coding for an ability to be able to lift 105 pounds. And then if you lift 105 pounds, it will code again for a little more. There are limits of course, structural limits, but they will go to these limits.
39:28The other side of this, which again is incredibly fascinating--it helps you see the way the world is working these days--is that in today's world, because of policy we've imposed already, we allow fragile people to impose--they become antifragile and they push their fragility onto others. You have many examples of this in the book. Talk about some of those and what that means. I went into ethics in the last section of the book, what I call Book V, because I discovered at some point that I had a lot of books in the book. So I call them Book I - Book V, because of their separate topics after the first section where I present antifragility and the last one I call "Skin in the Game: The Ethics of Antifragility." What happens is that some people in society have the option, namely the bankers, the managers of businesses, they have other people's skin in the game, the left column. No skin in the game other than they keep the upside and transfer the downside to others. You can see this, the stock market has lost about $5 trillion over the past 10 years, comparatively because a lot of stocks were at a higher level compared to cost of funds. Managers of companies made $400 billion. Why? Because you have the upside and no downside. So they actually own the option and they benefit from volatility. So, no skin in the game--in that category I put bureaucrats, journalists, corporate executives, bankers of course, and other people I call Fragilistas. Now, people with skin in the game are citizens, people who have the upside and downside of their actions. If they don't pay their mortgage, they lose their house. Or, if I make a mistake, then you have skin in the game. And of course my rule of ethic is what I write about, is to have the corresponding position in the market, so I don't really care about right or wrong; what matters is the payoff. Anyway, so this is the middle column, people with skin in the game. And of course the right column is an interesting column of people who actually don't have upsides. They are there to take the downside of others. And they have the highest status in society, traditionally. Compare a banker who has upside and no downside, because they don't have negative bonuses, to someone in the military. He doesn't have a bonus and he has his life on the line. It's a very beautiful insight. Honor is bestowed on those who take the bullet for others. Exactly. These don't have to be a saint, a knight, a warrior, a soldier, a prophet, or a philosopher in the pre-modern sense. Or a maverick. You can be just like the babysitter who pushes herself and lost her life because she had a responsibility for the baby she was holding. And you argue that modernity is pushing more and more people into the left column, the Fragilistas who impose their downside on others, and we don't spend as much time on that right column. Our culture doesn't do that. In fact, we look at those people sometimes as fools--they could have avoided that harm; they are idiots. Exactly. And in fact it's the first time we have power for people who don't have courage. It's the first time in history in which the people on top have power without courage. First time. You cannot find that in any society. Take the knights. The knights were people who, their trade was that they were risking their lives. This is why they or lords were supposed to die first. And of course the United States was supposed to be first in battle. Not someone pushing a button. It changes the incentives. So, the only way you can have a safe society is by moving the first column, the left column, moving these people out of there, making it more accountable. It's hard to get there, though. You can, with the legal system you can in various ways. But I think society will explode because then you start having a growing wedge between what is ethical and what is legal. And I name names in here; I don't know if you want me to name them. It's your choice. I'm willing to take a lawsuit. It's your book. I name people who to me--for example, some academics can cherry-pick; they can give contradictory advice and retain the one, because they don't have skin in the game; they don't go bankrupt from the bad trade, so to speak. They are always going to be there. The problem is a Nobel Prize in economics. People are not penalized for being wrong. You cannot have a proper functioning. I just wrote a paper in a policy journal in which I show that without accountability, risks will keep going because people will hide them, and we had a system in ancient societies for that. That's Hammurabi's Law. Hammurabi understood risks very well. And it was as follows: if the house collapses and kills the owner of the house, the architect is put to death. Why? Not because to punish people. As a deterrent, because no inspector, no regulator, nobody will ever know more about what's in a foundation than the architect himself. So, you can hide risks from society, you can cherry-pick, you can do a lot of things unless you have a direct responsibility for the results of your action. When I put it in the New York Times, it seemed too simplistic. I put that proposal there by saying capitalism is not about incentives; it's about disincentives. People said it would be too easy; can you implement it? Of course. Society can only survive when everything is based on very simply heuristics, not 2800 page documents. No appendices with lots of Greek letters. No.
46:37It's a deep idea because it really gets at this interface between what I would call effectiveness and ethics. I had a conversation this past week with someone; I was suggesting that the Federal Reserve, the Chair over the last 15 years, has encouraged imprudence. Has honored and rewarded malfeasance; has insulated people from recklessness. Relentlessly. And maybe there are some bad incentive problems with the way the Fed was structured. And her reaction was: I don't like to think that about the Chair of the Fed. I think they are trying the best that they can. That's nonsense. No society has ever put someone in a position of responsibility without accountability. I said that's nice; it could be true; but when has there ever been a person who had that much power who didn't succumb to the dark side of it? It's nice that there might be such a person, but like you say they don't really exist in history. So the counterargument is their reputation: their reputation will protect us from their malfeasance. But the problem is it's very hard to evaluate. It's true. When you don't see the link between action and consequence. So, when I talk about fragility in my central chapter, chapter 5, on political systems, I talk about localism. Talk about Switzerland. People think that Switzerland doesn't have a government, or it has a government at a very localized level, it's a collection of municipalities and the noises washes out. So their political system is remarkably intelligent; it's just that it's small. So the mistakes are made small, and things aggregate up without the mistakes. The other element in it, concerning ethics is if you make a mistake in forecasting or make a mistake, any kind of mistake, it's not like Alan Greenspan who has never done wrong to you or other victims. You encounter these people Sunday at 10 o'clock at church. So you have this biological skin in the game, that doesn't exist when you--at Russell's for example, when you can have this loss of ethics at the level of [?]. Shame. Shame plays a role in everyday life. If the only people you see are the people you are helping. Exactly. This is why in my column to the right I have the artisans. The artisan, the last great artisan we had was Steve Jobs. Where people have their ego in the game. They have their product. You know, Steve Jobs had the inside of the computer, he was just like cabinet makers, unlike these commercial shelves you buy, they look great on the outside but ugly on the inside because their inside is not meant to be displayed, to be seen. It's the same thing with Steve Jobs--he had the inside of the computers look good. Although you can't open them. Which is kind of crazy. That's an artisan; he is not in the game except for to do a little authenticity [?]. That is artisans. You will see that with politicians at a local level. This is one of the great arguments. Now Sweden, you think has some 60% of the GDP in government. It's not the same as the United States because the bulk of the money is spent locally. It makes a big difference. A huge difference. I'm not sure that's the only difference between the countries. Size has a lot of effects. I use the same argument--size is visible everywhere. Forecasting errors grow with size. I have a very sinister theory of the size bias, which is--you point out Switzerland works very well, that small mistakes are relatively harmless, they just stay small, they don't aggregate up. And then you look at the euro, the European Union, and you think it's obvious that the European Union (EU) is not going to work well; it's too many people, there's the accountability, and the feedback loops aren't there. And yet the people who want to run the EU are going to tell you it's so much more efficient. Well, of course it is if it could be run by God, but when it's run by human beings it doesn't work that way. Exactly. They themselves have a certain principle, this subsidiarity [?] principle, that any problem should be dealt with at the lowest possible level. Only necessary things should go up to Brussels. But given that you have a lot of bureaucrats in Brussels, these people make their job look--of course they are going to create jobs for themselves, and you know, metastatics, bureaucracies have always been metastatic. That's what destroyed ancient Egypt, by the way, the first centralized nation-state. Metastatic autocracy. Doesn't work very well.
51:55Let me ask you something--I'm going to take a shot at you; and then I'm going to defend you; and I want to know if maybe your defense is different. But this is the way I defend your ideas. Some people have said about your work--I would consider this your third work in a trilogy. It starts with Fooled by Randomness, it goes to The Black Swan, and it goes to this one. And some people say it about your first two books--they may say it about this one, too, but it doesn't really matter--they say: There's nothing really new in there; we knew it already; we knew there are tails; this is uncertainty; people understand that probability is hard to assess, that we get fooled. And I have a very different take on your work. Basically I see it as: it's all the same book, and I view that as a plus, not a minus. There's nothing new under the sun, to take a very old insight. What's new is how we think about them. And it gets at your distinction between the inventor and the implementer. People love the inventor; they don't give much honor to the implementer. But the real issue is insight isn't worth anything unless you absorb it. So, if I tell you don't put all your eggs in one basket, and you write it down; but if it doesn't get into your bones, it's not going to change your life. And the power of your ideas is that they get in your bones, the way you write, the use of metaphor, the use of humor, the use of characters; and you go deeper and deeper into these ideas; and they are very deep. Both your criticism and your answer confirm one thing to me, is that what I'm saying is not wrong. That's a plus. Exactly. The point is that when people tell me that what you are saying is not new, and they find it completely in predecessors [?], it makes me smile, because what I am saying is exactly the opposite of what they consider not new. Traditionally we have put the most trust in small probabilities, the most risk in small probabilities. And I am trying to stand this argument completely on its head: this is where we don't understand anything. And it was never written before that small probabilities are completely uncomputable. You see? In proportion to how small they are and in proportion to p, the probability itself. And this is what they are not getting; but the fact that they are saying it is not new means that they are agreeing with me. So, what I am proposing here is a system; and it took me a long time to develop it. I know I'm saying the same thing; I hope I'm saying the same thing--because as I said in the Introduction, I'm not writing close-ended books on closed topics with an expiration date. I am going deeper and deeper into the central element of daily life, or of life--what you do when you don't know what is going on. That's a great way to describe it. We face a government, an individual, a corporation, a dentist, anything--what do we do when we don't know what is going on? That's the most important question that I am obsessed with, and I am trying to answer it. Now, the best compliment I can ever hear is when someone tells me it's not new, because I know it's not written elsewhere, or maybe some portions of the derivation exist elsewhere. But this notion that the smaller the probability, the less we know what's going on, is exactly in reverse of the common understanding of such a problem. And that's because...? It's because of convexity effects, because small probability is very convex to error. Meaning the consequences are so different. No, no, no. It's the probability itself. Take the Gaussian distribution. And actually in a separate paper I finally proved something that has taken me three years. Take a very thin-tailed distribution such as the Gaussian. Thin-tailed, the normal distribution. You have two inputs, one of which is standard deviation. Standard deviation is very much your error. Now, if you take a remote event, say, 6, 7, 8 sigmas, you increase the standard deviation away from the mean; you increase the sigma by 10%, the probability of that is multiplied by several thousand, several million, several billion, several trillions. So, what you have, you have nonlinearity of remote events to sigma, to the standard deviation of the distribution. And that, in fact if you have uncertainty, the smallest uncertainty you have in the estimation of the standard deviation, the higher the small probability becomes and at the same time, the bigger the mistake you are going to have about the small probability. So, in other words, most of the uncertainty in parameterizing the model, most of the tails. So, you take an event like Fukushima, you see, where they said it should happen every million years; you perturbate probabilities a little bit and one in a million becomes one in thirty. Or the financial crisis. Or anything. So, what I meant is, what I managed to derive is the following: Any small probability is derived with an error rate. You have an error rate. Because only God doesn't have an error rate. God doesn't have probabilities. You have an error rate, and that error rate has an error rate. And this in turn has an error rate. You continue. Then you end up with power loss. Depends on the regime, of course, depends on how big the error of the error of the error is going to be. And in the power lies a very fat tail. And of course how to privatize. And of course that was how--you can derive the power of fat tails with some counterfactuals. But what is essential here, what I am saying is essential, in my work, is that you can have certainties; you are never going to get into big trouble in the body of the distribution. Where you are likely to get into trouble is in the tails. And the benefits of being right in the tails are very small. It's a small imprecision, multiplies a 10 sigma event by several trillion; you shouldn't be talking about 10-sigma events.
59:13But I want to come back to the way you formulated a minute ago, because I think it's very deep and very important. You said: What do you do when you don't know what's going on? And I would add, which I think comes right out of your book: and most of the time, you don't know what's going on. It's not like it's a special case. I think about it a lot of the time with economic policy, because when I suggest that maybe we should do nothing or if maybe the government should get smaller, we should reduce debt across the board, people say: How can you do that? You've got to have some positive. The reason, say, Hayek, says it doesn't matter--I don't think it's a fair criticism of Hayek, but people say: He didn't want to do anything. And one counter is: You don't know what you are doing. You have no idea what you are doing. You claim you have a scientific basis for it. I may have some more solutions here, based on this convexity effect. It's not all pessimistic. I know, for example, from convexity effects, that I pretty much can map the extent of the unpredictability. And let me give you an example. A specific, big convexity effect or fragility, is in traffic. You put 80,000 cars on a street, you have no traffic. You move 90,000, now traffic time goes up 10%, 90,000 cars. You go to 100,000 cars, and traffic times doubles. Those are those little perturbations, that each person is struggling to keep up with the person in front of him, and that slows the person behind him down; and congestion is very nonlinear. So, we have an idea. You can apply the same thing to the size of corporations. Nature applies it to the size of animals, and the size of an elephant is speculative--there are negative convexity effects. You can pretty much use it with speed. We do the same thing with speed. We actually do it. We limit speed to 55 miles per hour. Because accidents at 55 miles an hour aren't a tenth as dangerous as accidents that take place at higher miles an hour. So we can do things using this concept, the convexity effect, in other areas. And how much redundancy do you need? How many mean deviations do you need to be away from your accelerated harm? Heathrow, for example. Those who built Heathrow Airport didn't realize that the smallest perturbation causes 4-, 5-, 6-hour delays. Which means you have to reduce it by a certain amount. And actually, I'm talking a lot to the Cameron Administration to use these methods to control size. So, the analog, in the financial system: Would you favor limiting the size of banks? Or limiting the size of leverage? Or both? Or neither? I don't know if we can limit as a society. It happens that companies destroy themselves. Unless we save them. Exactly. So we should not save them, and we should have a pact. And what I proposed to the Cameron Administration and they like the idea. On paper. No, no, they like it. They called me to go there, visibly, because they want to really do something. They want to go after size. Size is their big enemy. Before that they had romantic arguments about small is beautiful, before these convexity effects. And I said: It's very simple; you take the convexity and you certify whether company sales--you don't know if it's going to fail, but you know, should it fail, the taxpayer has to bail it out? Yes/No? If you think the taxpayer would need to bail it out, if it fails, then automatically the employees can no longer can no longer get bonuses. De facto, potential civil servants. And you can't play the long option game at the expense of taxpayers. Remember, my ethics problem is someone who owns the option at the expense of taxpayers or someone else. That would automatically force companies to be of such size as they won't be bailed out. It's a very nice pact you make with a company. You say: You can do whatever you want, you can pay each other as much as you want, we don't care. Provided we don't deem that you are to be bailed out. Now, of course, it's a gray area, a large gray area. For a lot of companies we know it's very visible. We know we are going to bail them out. Therefore they are civil servants. And now by putting caps on how much banks can pay in bonuses, people are moving to hedge funds, the risk is slow into hedge funds, and these are not to be bailed out. Great; let them go. Exactly. So, I am not asking to regulate society. So, government can use something to protect citizens from large corporations. Not exactly a rent directly in proportion to their size. It's an interesting way to limit their size organically, in theory at least. It's a way to discourage them from growing because they realize that if they do they will lose their opportunities for the upside. Exactly. They no longer can use the option, it's the option of society. Or do what I call the Bob Rubin. Bob Rubin had $5 million in bonuses, retroactively financed by the taxpayer. We have to eliminate the Bob Rubin problem.
1:05:08When you are talking about modernity, your insights into our culture and the clamor by experts for solutions they claim are scientific--it reminds me of "The Second Coming," by Yeats, where he says: "The best lack all conviction, while the worst / are full of passionate intensity." It saddens me how overconfident so many people are who have no grounds for it, and how cautious or lacking in conviction are people who really understand the limits of our knowledge. But you see, at some point, things can change, because you can have--we think that systems can survive for a long time while being weak like that. They can't. Fragility will get you eventually. Can I mention something, do I have time to talk about modernity? Go ahead. Modernity, to me--I love modernity and a lot of things--the rise of the nation state. That's the first thing, top-down government. In the past, we had some top-down governments, but the government did not have the means to reach around the place. France, even Colbert, could not reach provinces. Only a few cities along the tax routes. This is why France had 400 [?] and about 72 dialects. The good old days. So, modernity is the rise of the nation state, military state-nation states. Rise of the expert, the predictive methods, pseudo-science, the rise of social science; and of course the no-skin-in-the-game. Diseases all. All dangerous. And of course the bailouts. And of course the thing will destroy itself. And what will replace it? I feel the future very positively. You will have more and more artisans. At no point in time, we've never been that rich yet we've never been more in debt. So, when the dust settles, we'll have more robust systems. More and more artisans in the sense of people really liking what they do. That's sort of my definition of an artisan--it doesn't have much to do with scale. Again when I talk about scale, scale is specific to the industry, specific to the type of function. You see? You have the death of the nation-state, which we are witnessing; a rise of local government; and of course, the end, the utopia for me, is what we are starting to see in Europe right now. They are all talking about golden rules and the golden rule, Rabbi Hillel's golden rule, is: No government deficits. That's a good heuristic. No government deficits makes things a lot less fragile. Very simple heuristic. Again, solutions can only come from very simple heuristics. That's what we've been doing now since civilization started. And of course the codification [?], the first one we have is Hammurabi's Law.
1:08:56Here's a little postscript. You wanted to say something else about Seneca. Go ahead. Most people don't understand what Stoic is. They think that a stoic wants to sort of be robust, no positive nor negative emotions, get rid of. The attachment from the world. Exactly. Become a vegetable. That's the impression that for a long time, about 2000 years, of the Stoics, because nobody really read them. People kept commenting on comments. But when I read the best expository of Stoicism, the best two expositors, Marcus Aurelius and Seneca--and probably also to some extent, Cicero--I realized these are not that type of people. Very different. And now, recently I saw some papers confirming my idea. That was what Seneca was, was about being long in options. He wanted to keep the upside and not be hurt by the downside. That's it. It's just how to set up his method. Seneca was the wealthiest man in the world. He had 500 desks, on which he wrote his letters talking about how good it was to be poor. And people found inconsistency. But they didn't realize what Seneca said. He was not against wealth. And he proved effectively that one philosopher can have wealth and be a philosopher. What he was about is dependence on wealth. He wanted the upside of wealth without its downside. And what he would do is--he had been in a shipwreck before. He would fake like he was a shipwreck and travel like he was a shipwreck once in a while. And then he would go back to his villas and feel rich. He would write off every night before going to bed his entire wealth. As a mental exercise. And then wakes up rich. So, he kept the upside. In fact, what he had, my summary of what Stoics were about is a people who really had, like Buddhists, an attitude. One was to have the last word with [?]. And my definition is a Stoic is someone who transforms fear into prudence, pain into transformation, mistakes into initiation, and desire into undertaking. Very different than the Buddhist idea of someone who is completely separated from worldly sentiments and possessions and thrills. Very different. Someone who wanted the upside without the downside. And Seneca proved it. And the way you get there, Seneca is suggesting, is through mental exertion. Through renunciation--some of it's action, but some of it is the way you look at your life and what you prepare yourself for and how you affect your expectations. Exactly. He understood the hedonic treadmill that Daniel Kahneman rediscovered 2000 years later. He understood it very well. And he understood wealth, debt from others or from fortune. And he wanted to write off debt from fortune and he wanted to remove his dependence on fate, on randomness. He wanted to have the last word--was randomness. And he did. Not a bad goal.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2012/01/taleb_on_antifr.html. http://www.econtalk.org/archives/2012/01/taleb_on_antifr.html http://www.econtalk.org/archives/2012/01/taleb_on_antifr.html Nassim Taleb Mon, 16 Jan 2012 06:30:00 -0500 Dean Baker on the Crisis Dean Baker of the Center for Economic Policy and Research talks with EconTalk host Russ Roberts about the financial crisis. Baker sees the crisis as part of a broader set of phenomena--rising inequality and declining unionization. Baker is highly critical on both economic and political grounds of the policy attempts to stimulate the economy as well as the governance structure of the Federal Reserve. The conversation closes with a discussion of potential innovations to lower the budgetary cost of health care.

Play
Time: 01:03:49
How do I listen to a podcast?
Download
Size: 29.3 MB
Right-click or Option-click, and select "Save Link/Target As MP3.
]]>

Readings and Links related to this podcast

Podcast Readings
HIDE READINGS
About this week's guest: About ideas and people mentioned in this podcast:

Highlights

Time
Podcast Highlights
HIDE HIGHLIGHTS
0:36Intro. [Recording date: December 21, 2011.] Mess the economy is in, how we got here, and how we might get out of it. How did we get here? What went wrong? I see our economy as having been seriously unbalanced in some ways dating back to the 1980s, that you could tell a story of a virtuous pattern of growth, 1950s, 1960s, into the 1970s, where you had productivity growth, very good in fact, that was passed on in wage growth pretty much up and down the income ladder, that led to increased consumption, increased demand; therefore increased investment, more productivity growth, etc., etc. That really broke down in the 1980s, you could trace that to a number of factors, I think a big part of that is the fall in unions. We saw a big fall in unionization rates in the 1980s. It had begun earlier but it accelerated. Also the power of unions was weakened substantially because following the Professional Air Traffic Controllers Organization (PATCO) strike there was a willingness to fire striking workers, hire replacement workers, so that meant that there was much less effective tool. I'd say that globalization played a big role, the way we structured it certainly, in the 1980s in particular; you got a big run-up in the dollar which had a big negative impact on manufacturing workers in the United States which had been really the center of the unionized workforce. Anyway, long and short, you had a situation where following the beginning of the decade, the beginning of the 1980s, wages for most workers no longer moved in step with productivity growth. This, in effect, created some of the demand gap that had some impact in the 1980s, much more so in the 1990s. And the demand gap was in effect filled by the bubbles. So, in the 1990s, we had the stock bubble that ended up pushing the economy to, you know, in many high levels of employment now put, but of course that couldn't last; the bubble eventually burst; we got the recession 2001; and the recession proved hard to get out of. It's always hard to get out of a recession caused by the collapse of an asset bubble. And when we did finally get out of that we started to see healthy growth and job creation--that wasn't till 2003, by the way, the fall of 2003. It was on the back of the housing bubble. And of course that bubble was even bigger than the stock bubble, at least in its effect on the economy. When the housing bubble collapsed in 2006-2007, that led to the economic collapse for two reasons. One hand, it was directly driving construction; we lost 4 percentage points of GDP in annual demand because of falloff in construction, about $600 billion a year. Then on top of that you had the consumption demand being driven by the housing-wealth effect, we had around $8 trillion in housing bubble wealth had been at peak of the bubble; pretty much all that disappeared. The result of that has been a big rise in the savings rate; it had been over 5%, it's down a little bit over the last quarter or two but it had been over 5% compared to pretty much zero at the peak of the bubble. That translates into a loss of about an annual $500 billion in demand. So, you saw a big falloff in demand in residential construction; there was also a bubble in non-residential that burst as well a little bit later, a falloff in consumption demand; we are looking at a shortfall in annual demand of a little bit over $2 trillion. And we simply don't have the ability to fill that at the moment. We could do that with government spending, but the private sector is not going to step up and fill it simply because there is no dynamic that would cause the private sector to step up and fill that gap. So basically we are recovering from a collapsed housing bubble and we aren't at least prepared at this point to do the measures with the government that we could; and the private sector is not going to do it on its own or at least not any time soon.
4:48First, I want to talk about the union productivity issue. Data on this is pretty good. It's not great. But I think it's hard to sustain the argument that the 1980s were somehow a watershed. The PATCO strike is one aspect. But hasn't unionization been declining in the private sector pretty steadily from 1950 on? Mainly--partly because of the change in the composition of jobs, right? Maybe for other reasons as well. Yes, no. Unionization rates peaked about 1955-1956--I'd have to double check exactly and of course our data from that period is not that great in any case. But they definitely peaked in the 1950s. They declined in the 1960s. I would say that they definitely did decline more rapidly in the 1980s, and we could look through the data; again, it's not perfect data. But I think there are two things there. One is that you had a continuation of the rate of decline that certainly had begun earlier; but the other part of this story was, even being in a union, you suddenly had much less ability to bargain effectively in a context where going on strike could cost you your job. That really wasn't true in the 1950s, 1960s, and 1970s. So, when you had, following the PATCO strike you had several major private sector employers--Greyhound, Eastern come to mind, but there were others--that did the exact same thing: they fired striking workers, hired replacement workers. That wasn't done in the 1950s-1960s-1970s. I'm sure there were smaller places here and there that did it, but it was considered really, you know, unusual practice. Basically the story was: You shut down your operation or maybe you operated it with a skeletal workforce until you reached a settlement with your workers; and the question was who would go longer: the unions without a paycheck or the company without being able to produce anything. Once companies availed themselves of the option of actually firing workers, you really did change bargaining power significantly, and there were certainly fewer strikes in the 1980s. Workers were very cognizant of the fact that if they went on strike they did risk losing their jobs; and even in cases where they did have strikes, it was often the case that the company would say: If you are not back by x day, we are going to start hiring replacement workers. Didn't real wages grow, real income grow dramatically in the 1980s, despite that lack of bargaining power? No, they didn't. You have to be careful how you look at this. If you take average real wages --I should say average compensation--they more or less kept in step with productivity. But if you look at median or wages of production workers, which tend to track roughly the bottom 70-80% of the workforce, those fell quite a bit behind productivity over that period. Depends how you measure inflation, of course--the Consumer Price Index (CPI) measures. It doesn't matter how you measure inflation because the point is it's shares. So, I'm talking about shares, so it doesn't matter what your denominator is. Explain that? Shares of what? Shares of output. So, typically to measure productivity we use the GDP deflator, standard measure. Right. Whereas if we are looking at real wages, most often we use the CPI. But you could use the GDP deflator as the denominator to measure real wages for the purposes of this comparison. You'd still find, for the typical worker, or the median worker, production workers, their wages did not keep pace with productivity growth. That's interesting. Measurement issue in productivity and compensation--the business sector--the impact of falling computer prices has led to much bigger increases in productivity than it has led to decreases on CPI, which I think is part of that. Right. But if you use the same denominator. Right, that's what I'm saying. I'm agreeing with you. I think that solves that problem. Of course, the other problem you have is when you have the median, you are going to have problems with composition in the workforce as it changes over time, not holding the population constant. So, I've pointed out that in the late 1970s, as the divorce rate starts to rise, the household income, for example, and to some extent median wages of workers, is going to be distorted by just in the change in the number of households. You could have the median fall even though every person is still doing better. And I think we haven't fully disentangled those. Yes, you could beat up the data. I think you'd be hard-pressed to find a story, though, where most workers are doing as well in terms of productivity growth in the 1980s and 1990s--a little different story in the late 1990s, which we can get to. But you'd be pretty hard pressed that they are doing as well as in the 1950s -1960s. If you control for education, you find that workers with high school degrees, workers who have finished high school, workers with say two years of college, a B.A. degree--pretty much anyone who didn't have a college degree you find that their wages are not--you can control by age, you know, break it down men/women--you find that pretty much across the board. So you'd have to beat up the data pretty bad to make that result go away, that wages are not keeping pace with productivity over that period. Yes, it's an interesting question. I think most of the comparisons are looking at a cross section at points in time. If you follow the same people over time, you get a very different picture. Yes, that's right. And part of that story is--life cycle effects. Yes, so again. If you control for age, a 40-year old in 1990, how did they do relative to a 40-year old in 1975? There again, I think you'd be hard-pressed to make a case that their compensation increased with productivity over that 15-year period.
10:53Now, one of the stories you are telling is the role of bubbles. Where in your narrative do those bubbles come from? So, you mention the stock market bubble and the housing bubble. Why did those happen? Are they natural events? Are they monetary events? Where do you put the causal change? Well, I think that you are always going to have some erratic movements in financial markets. And the question is: Do they become self-perpetuating and build to the point where they really move the economy? And certainly both of those did. I think I lay the problem here a lot at the foot of the Federal Reserve (Fed). Part of the story, if we look to the 1990s, what you would have seen if we'd gone back, say, 20 years earlier, you would have had more concern about inflation. And of course Alan Greenspan was concerned about inflation. He did raise interest rates in 1994, 3 percentage points from early 1994 to 1995. But then he backed away from that--because he rightly said he didn't see any inflationary pressures to the economy. No reason not to let the economy grow more and let the unemployment rate fall. Which is in fact what he did, over the objections of many mainstream economists, including Clinton appointees to the Fed. And he was right that we didn't have to worry about inflation. But it did create an open door for the bubble to keep growing. And there's no doubt about it. While low interest rates don't necessarily mean you'll have bubbles--we had low interest rates in the 1950s and early 1960s, certainly--we didn't have any notable bubbles. And they were low and steady, rather than low and falling. Well, how much falling. Well, they weren't actually falling. They did fall from the peaks of 1995 to the late 1990s, but they weren't lower than they were in the early 1990s, so if you look at the Federal Funds rate, that was 3% in 1992, I think that was where Greenspan first lowered it to 3%, and then he raised it to 6% in 1994, 1994-1995 raised it to 6%; and then he knocked it down a little bit, but it was still somewhat higher than the 3% it had been in the early 1990s. The long term rates fell some in the mid and late 1990s. I won't say they plummeted, but again that was part of the story. Active policy there, hoping those would fall. But I won't say that every time in long-term rates, or short-term, whatever you want to put the causal element there, I won't say that leads to a bubble. I will say that it can lead to a bubble. In the 1950s and 1960s it did not. We had very good growth, good investment growth, and that's kind of what you want to see. Low interest rates should mean that's conducive to economic growth, and it certainly was in that period. In the 1990s, we had a very different economy, and it was much more conducive to bubbles. And to my mind it was the Fed's responsibility to prevent it, and Greenspan just looked the other way. As a matter of policy. I mean, we know this now. We have the minutes, the transcripts. They saw the bubble and just said: Well, we'll let it run its course. And then after the bubble burst you began to see--actually the run-up in house prices began in the 1990s. 1995. Yes, that was when you first started to see a divergence between I mean the rate of growth in house prices and inflation. And when the stock bubble burst in 2000, 2001, unlike Japan where you had the two bubbles growing side by side and they both collapsed side by side, what happened was that actually fed the growth of the housing bubble I'd say was for two reasons. One was that in the wake of the collapse of the stock bubble, of course we had very low interest rates. Greenspan lowered the Federal Funds rate to 1%. Sure. So, one was you had low interest rates, and that was conducive for growing the housing bubble. And the other was just that the psychology of many people was just that they felt really burned in the stock market, so they thought housing was safe. Go back to that time and there were a lot of people saying: Well, you can always live in your house. I never quite understood the logic of that. It's a true statement. Why it implies you should use your house as a vehicle for--it's like buying a really expensive car because you can always buy your car. Yes; people would say this like they had said something very profound, and I'd just be scratching my head, and: What does this have to do with anything? And it's tax deducti ble. That was the other bizarre--the interest is tax deductible.
15:29So, you fault Fed policy in that period, and I do as well. And I think there are other things you fault the Fed for, and we'll get to that in a little bit, in the 2008 crisis. But just in general: What's your take on Fed policy and where you think it ought to be in terms of governance and structure? You know, there are people--I think it's a very mainstream view--that we need to learn more. We had Scott Sumner on last week. Scott Sumner says: We've learned some, we've made progress; yes, we've made a lot of mistakes; Scott's very critical of the past three years of monetary policy. So, what do you think? Are we going to get better at it? Have we gotten better at it? Are we going to get something radically done to how we treat money in the United States? Well, I think we've been horrible at it. Again, I think the Fed hit all it needed to prevent this disaster. Whether, how much we've learned--I guess I see two different stories here. One is: Are they doing the right things to get us out of this? And then the other one is: Is there any reason to believe that we won't be here again? That they have things under control, so that if we start to see another housing bubble or whatever bubbles, that they will take steps. Dealing with the first one: I mean, I think Bernanke has been better than, say, the European Central Bank. The Fed's been better. I think what basically the Fed should be trying to do is everything it can do to boost the economy. And Scott Sumner's idea, targeting nominal GDP, I think that's a reasonable thing. Paul Krugman has a different version, saying we should target inflation, a higher rate of inflation, a 3-4% rate of inflation, which of course Bernanke himself wrote about when he was a Professor at Princeton University. Those end up to my view being largely the same thing, at least for the time being. I'm not saying that under all circumstances they'd be the same thing. But where we sit now I think they would end up looking pretty much the same. Better. Probably. So, I absolutely would love to see the Fed adopt either of those. There are other ways you could frame it, but I think either of those would be better than where we are now. Whether for political reasons, I'm just thinking the policy of the Fed--could Bernanke get that through, probably not. Because he's already had resistance from the Fed. Three of the Fed Governors complaining about concerns on inflation. Which I guess we are changing who is voting as of January 1st, so maybe--I haven't looked closely enough to see who is coming on--but maybe there will be a little more room there. But I'd certainly like to see more aggressive action; and you know, again, by comparison with the European Central Bank, he's doing good; by comparison with what I think the Fed should be doing, I think he's not doing particularly good. They could certainly be more aggressive. But structurally, would you support some radical change in how the Fed is run? Because no one views it as: We just need to learn more. I could take a more Public Choice oriented view which is that the Fed is not particularly designed to help you and me. It is designed to help people with more political power than we have. Its independence is a bit of a sham. And I don't expect much of it. Plus, there's the general problem that it's hard to do. Yes. Well, in terms of its structure, I think it's an abomination. How do you justify having a regulatory agency where 12 of the 19 members of its main body are depending on--how do you put it--5 of the 12 voting members here, I'm talking about the Open Market Committee--are actually appointed by the industry being regulated. Yes, it makes capture really not so difficult to do. And then you have the New York Fed, which is, to me, even more bizarre and abominable: the people sitting on the Board of that coming from the banking industry directly, so the people you have dinner with, chat with, you call when you don't know what to do. This is a bad idea. I agree completely. I understand the history, how it was set up. I don't understand how unjustified that. I've often said it's as though we had the Food and Drug Administration (FDA) where we had Pfizer and Merck appointing two of the five commissioners. I think everyone would agree that's not right. Even where you don't have that, we are always going to have enormous problems with regulatory capture, but the way the industry puts the people on, that I cannot see justification for that. What might we do differently? At the very least I would like to see basically that the people who are running the Fed, whether you keep the current governor structure, any which way you shape it, that those people are actually appointed by the President, approved by Congress, and answerable to Congress. I don't have illusions that it suddenly makes all the problems of industry capture go away, but at least there is a clear understanding that this is an agency of the government and it's answerable to democratically elected officials. Though I think that would be a part of the story, we do have more openness and I think we have made some progress in that. That was one of the things in the Dodd-Frank Bill that wasn't originally part of it, but through this kind of left-right coalition, you had Alan Grayson, one of the most left-wing people in the House joining up with Ron Paul, one of the more conservative people in the House; and they managed to get through a bill or amendment to Dodd-Frank that requires a lot more openness in what the Fed is doing; and on top of that the suit by Bloomberg, so they have to disclose now who gets lending through the discount window. I forget what the time lag was. But I think you need more openness, we need more accountability. Again, none of that is going to solve all the problems, because we can look at the other regulatory agencies, the FDA, the Federal Communications Commission, whatever you want to look to--all of those has serious problems with industry capture. But certainly you are better off with not having the industry actually appointing people, and also having things more out in the open than has been the case historically with the Fed.
21:49Let's move to 2008, because you've written about that, and although you and I don't agree on everything, we're going to agree on this, which is: What do you think the Fed did wrong and policymakers did wrong in 2008 dealing with the financial crisis, spanning from, say, March, with the rescue of Bear Stearns through October of 2008, Lehman, and the Troubled Asset Relief Program (TARP)? What's your take on that period and what kind of grades do you give the Fed and others? I'd say I'd give them a D. I mean, we didn't want a financial collapse; I think it was good they prevented a financial collapse. But they basically left everything in place. So all the banks that got us here--obviously with the exception of Lehman--the same people are running the banks. They were left at the helm. And yet it was a situation where much if not most of the banking system had driven themselves into insolvency. We had an interest in preventing a complete meltdown, a continuation of a chain reaction following Lehman that I think you would have seen had we not done anything to keep AIG alive; I think there was an interest in doing that. But it should have been accompanied by a total overhaul of the banking system. Basically, these banks would not continue operating as they are doing; that we would be looking to downsize them, replace their executives, those being the main points. Instead we just kept them alive and gave them enough money to keep them on life support until they are more or less--because who knows, the Bank of America still might be insolvent. I find it very strange that a Democratic Administration with that opportunity pushed through a reform bill that's really disappointing on the welfare subsidy side of the equation. And this again, I think is a place where left and right are coming together: that the banks are, it's disgusting. Yes, it was completely unjustifiable. This was a mess they had gotten into by their own folly, mistakes, whatever term you want to use. And the fact that you would have the government just step in with basically unlimited amounts of money and say: Ok, we are going to keep you in business and essentially hold you harmless. Certainly the country wasn't held harmless. To my mind it's really unconscionable. There's been a continuous effort now to sort of cover this up and say we've made money on this. We gave these banks money at a time when liquidity carried enormous premiums, the idea that somehow--the analogy I make is I gave you a 30-year mortgage at 1% interest and you paid it off and then I walked away and said, Hey, I made money on it. That's not the way we would ordinarily do accounting. The part I find strange, and I'd love to get your reaction, and maybe it's not true, but the impression I have that there's a consensus among many, many economists that's very different from your assessment and mine of the role of the Fed and public policy generally. There is, I think, a common view, that they saved the country. As you said, you can save the country in different ways. But most of our colleagues don't seem to give a D. They give more like a B, B-, B+. Yes, there are people who say we should have put some strings. But I find the lack of outrage among academic economists and policy [?] economists rather strange. Do you think I'm overstating it? No, I see the same thing. I don't know that these people are all dishonest, but I think at the very least there's some disingenuousness in the sense that they are willing to sort of look the other way. And in other circumstances they wouldn't be. I'll give you a very concrete example. There was a study done by Alan Blinder, Mark Zandi, both very smart guys, good economists, where they did a counterfactual and they said: What would have happened if we didn't have the bailout? Their study shows the unemployment rate goes down 15-16% and stays there for a number of years. What just struck me as absurd about this is their implicit counterfactual. Not just that we don't have the bailouts, but that we don't do anything. So, this isn't the way we would ordinarily talk. That's not typically the way we think about policy, that by not doing this we are somehow committing ourselves to not doing anything, even after--so you get the bad case, you get the collapse; I agree we want to avoid that; but even after the collapse, 6 months later we don't do anything, a year later we don't do anything. That's really not a serious counterfactual. And these are both very smart guys. I think they know better that for a policy they didn't like, if someone modeled it that way, I think they would say that's just being silly. Because that's not the alternative. Yes. I think it's easy to invoke political constraints. Certainly there are limits to what strings could have been attached to the money or the way the money could have been handed over. It's easy to talk about that. But the fact is that we have a system in place for dealing with this: the Federal Deposit Insurance Corporation Improvement Act, FDICIA. Which was passed in I think 1991, early 1990s, on the grounds that we had created a moral hazard with past rescues, and we needed to have a way to force large financial institutions and their decision-makers to pay a price. And when it came time to invoke that statute, it was I think invoked once. I forget whether it was WAMU or Wachovia--it's creditors did take a haircut. But every other creditor, with the exception of Lehman, and I have political reasons for being skeptical about this one--every other creditor, Bear, AIG--got 100 cents on the dollar and was told by the government, Tim Geithner in particular: No, no, no, no negotiation, everybody gets 100 cents on the dollar. I understand why there is outrage by the general public. I just don't understand why there isn't more outrage by our colleagues. Embarrassing. And part of it is looking the other way; part of it is this claim I make that there's over 100 economists in the United States that think they are in the top 10 of economists, right? So they think they are in the running for Chair of the Fed or the Council of Economic Advisers or the National Economic Council, and so they hold their fire. I think we are a little bit captured. I think there is a lot of truth to that. People are always looking to move up, and obviously if you make big criticisms of Ben Bernanke, you go through a list of people here, going after a lot of the big names, and I think you are exactly right--people are going to be reluctant to do that for the most part. Certainly the people that think they are next in line. Most of them. But they all think they are, I think. I'm spared that. I'm not next in line, so I can be honest. But on the other hand, it's easy for me to sit here in Fairfax, VA without any historical legacy on the line as someone like Alan Greenspan or Bernanke has and take potshots in hindsight. So that's the flip side of this. It's really easy after the fact to tell a different narrative, explain all their mistakes. We're not sitting there; we weren't in the office, on the chair. It's a very hard job. But I don't think they did it very well. Certainly I'm inclined to agree. For better or worse, these were things I was saying at the time. Now maybe had I been sitting there, had access to information I don't have; so I do have to recognize that. It would be nice for them to share it with us. I like what you wrote, and I said the same thing. One of the most irresponsible aspects of this--and John Taylor's written this as well, and a sprinkling of people across the political spectrum. When the TARP bailout was put on the table, at first blush we were told the world is going to come to an end--tomorrow. Not: it's going to be dangerous. It was: This is it. It's going to be an apocalypse. It's irresponsible, because in and of itself that can be harmful. But to say that without any evidence, and again with Bear Stearns, to say we had no choice but to sell Bear Stearns off for $2--later it became $10--to a single suitor over the weekend who was guaranteed $29, later $32 billion worth of assets because "they were too hard to figure out"--what kind of a democracy is that? It's not right. These are huge, huge deals; and here you have Congress in big fights over something that might be a tenth that large. This was just done over a weekend with no public input at all.
31:02Let's move on to the 2009 period, the stimulus. In the aftermath of the 2008 financial crisis, and various policies we've just been talking about, we passed, in February 2009, a $787 billion--later became measured to be at $825 billion--Stimulus Package. What's your assessment of how that worked, whether it worked, and whether we should have done something differently. I think it did work for what it was designed to do, which was create on the order of 2-3 million jobs. They originally said 3-4 million jobs, but we ended up getting, if you looked at what was stimulus in there, it was closer to $700 billion spread some of it over those first two years, some of it spent 2012 and later years. My reason for saying that is just to pin down what actually got spent as stimulus in 2009-2010; it came down to $300 billion a year. And again, based on--this is in hindsight, you can go back and read their documents, the Obama Administration's documents from the time--they were predicting that had they gotten fully what they asked for, they would have gotten 3-4 million jobs out of it, and they'd get considerably less, say 2-3 million. There have been some efforts, and I tend to like this study by two professors at Dartmouth, James Feyrer and Bruce Sacerdote, that finds the stimulus finds pretty much along the lines of what was projected. I'm inclined to think it worked, it did what it was assigned to do; the problem was it was no where near large enough. That we created 2-3 million jobs; we probably needed on the order of 10, 11, 12 million jobs. It simply wasn't large enough or long enough. So, it didn't deal with the immediate problem. Now, there's also as you, was it the best way to spend the money; could it have been better targeted? One of the issues that they were very concerned with, they here being the Obama Administration, was that things be shovel-ready, get money out the door quickly. There's a logic to that of course that you want to create jobs quickly. On the other hand, given that we are looking at a downturn that was going to last a long time or did last a long time--I think it was reasonable to expect it to last a long time because it was a big gap in demand that we needed to fill--I think it would have made more sense to have some longer-term projects, to focus on some long-term infrastructure. And what they put in by way of long-term infrastructure was fairly limited. So, I think that's unfortunate. We should have had a more directed stimulus, much, much more. But I think we are better off for having it. I am glad we created 2-3 million jobs, whatever the exact number might be. I'm very glad we did that. But it simply was not big enough to get us out of the downturn. And again with most of the stimulus ending in 2010, it created a situation where we actually had a drag on the economy in the last year associated with the end of the stimulus, basically withdrawing the stimulus. The same thing as cutting the budget, cutting spending, raising taxes. That's contractionary for the economy. But, we haven't done very much of that. Well, we certainly cut back the spending. Not the total. The spending that was cut back was the aid to stimulus to state and local governments, and the result of that is we've seen a sharp falloff in spending at the state and local level. The total of Federal spending has done anything close to go down over this period, right? As a share of GDP, total Federal spending has fallen somewhat--I'd have to double-check that. Not in absolute terms. No, not in absolute terms. Share of GDP is up.
34:53Let's look at this job creation thing, because I'm a skeptic of it and you are a supporter of these arguments. I'm interested to try to dig down a little bit and see where we disagree. That Dartmouth study you mentioned, is that the one that goes state-by-state? Yes. The problem with that, it's a strange study. Wouldn't you expect government spending in states, even if you were skeptical about stimulus, wouldn't you expect the states that get the money to create the most jobs? The question is what happens in the states that don't get the money, and the hidden, unseen, and complicated effects of expectations and uncertainty and tax burden. You can't really look at those by themselves, can you? Well, it's hard for me at least to see those as being big negatives. So, the simple story is it would raise interest rates and therefore crowd out other investment. I think you'd be hard-pressed to make that story. I mean, obviously the Fed was being accommodating as well, which is of course appropriate. Had they not been, how much would interest rates have risen? My guess is not a lot since we have something on the order of $1.6 trillion in reserves sitting around. But again, we don't know the exact counterfactual. Did it create uncertainty? If you look at private sector investment, it's largely recovered. I'm focusing here on equipment and software. I had a little back and forth with someone a little while ago on that and they were bringing in structures; and my reason for excluding structures is, well two things. Residential--it's a problem. But same thing in non-residential. There was a big surge in non-residential construction, 2005-2008; and if you look at commercial real estate, hotels, office space--there has been considerable overbuilding in most of those areas. So, if you pull those out, look at equipment and software, we are almost back to the pre-recession level. I think we are at 7.5% as a share of GDP, pre-recession, with 7.8, 7.9% in 2007. So, I'm hard-pressed to see that there is a big role for uncertainty there, given that we still have huge amounts of excess capacity in large sectors of the economy, certainly manufacturing. I actually think investment is fairly strong right now. So I just don't see much of a case here that uncertainty is really holding it back. As a classical-oriented economist, I don't see the interest rate mechanism isn't really the right look. I'm more interested in the fact that resources are not in excess supply uniformly. So, to take an example out of my neighborhood, I live in suburban Maryland, and there's at least two brand-new elementary schools getting built in my neighborhood within ten miles of my house. Gorgeous, beautiful. This is in Montgomery County, MD, which is an incredibly wealthy county despite the recession. Sort of insulated to some extent by government spending generally and employment. So, things are coming along, dirt being shoveled. Big shovel activity; and the Beltway has got tons of work going on. There's all this earth-moving equipment. And by the way--it didn't all take place in 2009; it's still going on. So, you look at that and you ask: Is that going to really put back to work the Nevada carpenter? Yes, some construction workers are finding work in these different kinds of construction projects, but a lot of this is just not going to get to them. Now, in the Keynesian view, I guess the extreme view, it doesn't matter. It's all just purchasing power. But I look at the resources that aren't scarce, which I suspect are some of those higher skilled machinery folks, and so you increase the demand for them, you increase their wages, and you crowd out people who would have done other things with those skills elsewhere in the private sector. Does that affect your assessment of the measurement at all? Do you think those effects are small, not important? Well, I'm inclined to think those effects are pretty small. There are two reasons for that. One is if you try to look at occupations, you are really hard pressed to find any occupation where there is any evidence of real wage growth. Well, economists. We are doing great. It's a banner year for us. Are you saying that seriously? I'm saying that seriously. It's a good time to be an economist. There is an increased demand for our services. I don't know literally whether wage growth is positive or not. That's interesting. Don't you get more phone calls than you used to? Yes, that's for sure. I don't know if my income is keeping up. Well, I hope it is. But, yes, I'm getting phone calls. But anyhow, I don't think you find a lot of occupations where real wages are rising. The evidence on that doesn't really show that we are crowding out, of that sort. There was a study done, and I'm forgetting who the authors were. One was at Ohio State. Anyhow, they were trying to look at the impact of this sort of crowding out, and what they were trying to show was that in states where you had the most spending, you had a decline in private sector employment. They really weren't able to show that. That had a narrow category of jobs. I'm not saying they were cherry-picking. I'm just saying how they had done it. They had a category of employment where they could have a negative relationship; even that was only marginally significant. And if you just did private sector employment--and I did ask; we had some back-and-forth on this--it came up altogether insignificant. So, if we are looking at Montgomery County as an area where you had a lot of spending, there was no significant decline in private sector employment associated with the stimulus there. Now, again, there's no simple way to do the test. It's hard to do. A lot of the public sector employment, or public-paid-for employment, is going to be private contractors. So, there's not a simple story there. But I just don't see the evidence for it. Not to say you couldn't find it.
41:32What I'm suggesting--let's put the crowding out aside for the moment. Even if you don't have that factor, it's not obvious that paying folks that are already employed to do more stuff than they used to--if that's really what's going on--you have to argue that there is this Keynesian multiplier effect that is working through just their spending levels. They are spending money and that's going to put other people to work. And I'm a skeptic on that. What evidence do you think we have that that mechanism actually works, as opposed to might work? Wait--there are two separate issues here. One is that we are employing some number of people. Now some of those are people that would not otherwise have been employed. But the point is how many? I'm suggesting that in many cases it may not be very large. Certainly, for example, the stimulus as we've talked about along the way, a lot of it didn't go to shovel-ready stuff. It went to, a third of it roughly went to a one-time temporary tax rebate that put purchasing power into people's hands; they may have spent it; there's not a lot of evidence that they did. So I wouldn't expect that to have a big bang for the buck. We gave a third of it to state and local governments to keep their employees employed, and a lot of cutback on other things they were doing. I don't know if that had much bang for the buck. And another third of it, we actually spent more money; but some of that stuff that I know of--and of course, I'm cherry-picking here; I'm telling you right now--I looked at the stuff that went to education, and I'm thinking it's nice that they are funding more research on Parkinson's Disease at Washington University in St. Louis, a wonderful medical center that I used to be associated with in economics in the business school. But is that really going to put people back to work? And the answer is: I don't think so. I think it just gives some grants to some nice people who are doing some important work, and that's fine. But I wouldn't expect that to create a lot of employment. And I don't think we have much of an idea of how much of the stimulus was that kind, versus stuff that really put people back to work who were unemployed before. Well, I think all of these are mixed bags. The tax cut story, you know that's not my first choice; we did some beating up on that. It's a little hard to try to get an assessment because you have a story where there's basically a collapse of consumption, 2008-2009, associated with the plunge in house prices, the wealth effect. You know, so you are trying to control for that. We put in various controls, our estimates, I'm not going to say it's viable, somewhere between $.50 and $.70 on the dollar was spent. I know there are other estimates out there. I feel reasonably comfortable with that, primarily because we did beat it up. In other words, we were trying to control for that in ways that we felt were reasonable, and I didn't approach that with strong priors because, you know, tax cuts aren't my preferred way of doing it. I didn't have an axe in it, a stake in this one. So, I feel $.50-$.70 on the dollar was spent; to me that's very good, better than not doing it. Is money given to state and local governments? State and local governments are operating under tight budget constraints. They have to balance their budgets. When they have a shortfall, they lay people off. They've been doing that. Did it one-for-one translate into increased employment? Probably not. But I think it certainly kept a lot of people from losing their jobs. I agree with that. So, I'd say positive; could it have been more positive? Sure. But it was the right way. The third one, when you get to more projects, again, it was a mixed bag. Money spent on health care research might be, as you say, it might be good research. Not an area of high unemployment. Construction work at the time, 20% nationwide unemployment among construction workers, and that's pretty much everywhere. I'm not saying it was 20%, but you know, you had high unemployment among construction workers even in Montgomery County. There had been a lot of building in this area; it went to zero. I just don't think they are operating a larger piece of earth-moving equipment to rebuild the Beltway--I still think they are waiting for that housing sector to come back. But maybe I'm wrong about that. Well, it's mixed. There are different types of skills. So, some of those workers, the skills in residential construction are not yet--there's some overlap, some differences. So, it's not as though we re-employed everyone that lost their jobs when the residential construction sector collapsed. So, most of these cases that say it's somewhere between 0 and 1; and I'm inclined to think closer to 1 in the sense that we are employing someone what would not have otherwise been employed. It's not 1. I don't mean to say it's even 0.9. I understand. But I think in a lot of cases we are employing people that would not otherwise have been employed.
46:21So, you mentioned that the stimulus wasn't big enough. Back in February 2009, the Obama Administration, I think it was probably the first serious piece of policy action that he took. I think it was passed in February. And he had a Democratic House, a Democratic Senate. There was a reasonable amount of love for the man among the general populace, the general public. Why do you think he couldn't have gotten more? What do you think were the politics of that? And I agree with you that certainly today, although there are many people who are advocating large increases in government spending financed by deficits now, that's dead on arrival, both because there is a Republican House, but also because the American people are not so excited about it. Why do you think it failed then, and why is it hard to make the case now? What are some of the political issues? Well, at the time of course remember the big issue is you have to get 60 votes in the Senate. And they had 59 Democrats. I forget--you had the Al Franken election in Minnesota was contested and I forget exactly when he took his seat, but it wasn't at the beginning of the session. It was some time in February, if not March. I think he was there in February. But anyhow, you had to get to 60. And he [Obama?] had to pull on at least one Republican, and he had at least one Democrat--I believe it was Nelson from Nebraska--who was holding out. Smart man. I'm sure he got something good for it. In any case, that made it difficult for him to get a bigger stimulus through, and he had to whittle it down. To my mind it's really unfortunate--the things that got whittled down most in negotiation was the aid to state and local governments, which I thought was a good thing because part of the story here is that you want money to be spent quickly and there's no quicker way to spend it than to give it to give it to state and local governments who otherwise would be cutting back, cutting off workers, cutting back spending in various areas. So, he had to make those compromises to get what he got through. Here's what I think was a big mistake: People argue over whether he could have gotten more had he asked for more; so instead of asking for his original $787 billion, he should have asked for $1.2 trillion, which is what Christina Romer, his chief adviser, had recommended. I don't have the answer to that; I don't know. I don't know if the concern was that you'd have people in Congress who would have just flipped and said that's crazy; and walk away with nothing, or maybe less. But what to my mind is indisputable is that once it was passed, he knew it wasn't enough. He knew that wasn't going to get the economy back anywhere near to full employment, certainly not any time soon. But instead of saying that, he turned around on deficit reduction. We solved that. And that just totally undermined the case. He couldn't say now we are going to focus on deficit reduction and then come back a year or two years later and say: Hey, that wasn't big enough. Of course, he was touting the stimulus. He was talking about green shoots of recovery. That was March, certainly no later than April. Summer. He did this horrible overselling. And it was a combination of really bad economics and certainly in retrospect--I'm not the finance person, the political adviser--it looks to have been really awful politics as well. It looks like he is going to pay a double price for it as well. Although there is some sign of green shoots of recovery right now. Maybe that will be enough to give him something to sell that's more attractive in November of 2012. Hard to say.
50:05Do you have any worries about the long run fiscal health of the United States that would discourage you from advocating a larger stimulus now? Let's forget 2009. Let's say right now you had some direct say in this. Would you be pushing for a spending increase right now? Absolutely. When I look to the long-term problem, I see it overwhelmingly as a health care story. We have a broken health care system and the projections just show health care costs--and this is coming from the private sector--are going to keep going through the roof. So, currently we spend more than twice as much per person as the average for other wealthy countries--Germany, Canada, England--and that gap is just projected to rise in the decades ahead. If that were to really happen, it's going to be devastating on our economy and of course have a devastating impact on the budget, because more than half our health care is paid for through the public sector and through programs like Medicare and Medicaid. So, to my mind we have a health care problem that we have to address. And that's independent of the budget. Of course, as you say, it affects the budget hugely over the long term because we have those programs. But I don't see that as a reason not to do stimulus now. I think the main thing, get people back to work, is--the argument that I get from people on the other side: We are going to have to tough this out. Well, we have jobs. It's easy to say. The people that don't have jobs, they are not going to get these years back, they are raising kids, the kids are 4, 5, 6 and we are talking about them being unemployed 2-3 years--they are not getting the time back, if they don't feel they can raise their kids properly, give them the education, make sure they have decent housing. That's loss. Definitely an enormous price. So, I don't, to my mind I don't think it's a close call. The fiscal issues--are we going to be in a situation we can't pay our debt? I mean look at Japan, with a debt-to-GDP ratio of over 200%. We are nowhere in that ballpark. And they are still borrowing at 1% interest. I know there are a lot of differences between the United States and Japan, but still. Some of them work toward not being worried. Having the world's dominant currency makes it easier to run large deficits, at least for a while. You always run the risk that you are going to find out that that period is over, and I think we are running in that direction. My feeling is just that I'm not sure it works to spend real resources on things--I'm talking about infrastructure, bullet train in California, other large projects that may not have much of a payoff--seems to be punishing our children as well. Toughing it out is a horrible piece of advice. I have a job, I have better than a job--I have tenure, which makes it even easier for me to be the other way, you could argue. But I worry about my kids, they are getting adolescent age; I have one in college, one getting ready to go to college. I worry they are going to have trouble finding jobs. So, the real problem to me is efficacy. I don't think we know as much about what works as we like.
53:18What's your view on the longer run fiscal challenge that we do face with health care? I've argued, many people have argued, that attempts to fix that in the short run in the middle of a recession did add to the uncertainty we were talking about earlier. Especially when it was done in a way where the legislation--it's not even set now, we don't really know how a lot of it is going to work, seems like an unwise policy. Do you think that was a good strategy? Do you think we should be doing something different? Well, I think it was a step forward in the sense that if it actually goes into effect, and that's independent of the outcome of the 2012 election, you have extended health care coverage in a significant way. And actually I think the most important part of that story is something that a lot of people don't fully appreciate and the Obama Administration doesn't push it--and that is that it will mean that people have health care insurance, in many cases for the first time, genuine health care insurance, who think they have it today. And what I mean by that is: I, and you are probably in the same situation, we get our health care insurance through our job. And my situation is that if I were to get seriously ill, I would at some point have to give up my job. And at that point I give up my health care insurance as well. What that means is that I'm sort of insured for the day-to-day things, normal things I have to go see a doctor for, even some things that could be fairly expensive; but if I were to get some chronic, debilitating illness, at the end of the day I'd find myself uninsured. I'd have to depend on Medicaid or whatever sort of care I could get other than through insurance. So, I think that's a huge step forward. Now, the uncertainty it created--again, this is one of these things where you look at the data, you have a hard time seeing a case that that's cost jobs. Because there are a few things you should expect to see. You should expect to see a rise in the average hours worked. You don't see that. The hours weekly hours is still below what it was prior to the recession. You expect to see more temporary employment. Temp employment is still way down. People don't have to get insurance for temporary workers. And the general fixed costs of turnover there are much smaller. That's right. I just don't see the evidence for that. Now, long term, we have to fix the system. I don't think this does it. What I support, and I'd be interested in getting your reaction--I actually support a more market solution, in the sense that I'd like to see more trade in health care. There are a few different ways you could do that. One is you could let people who are on Medicare, who by definition almost--they aren't all retired but most of them are--let them buy into the health care systems in countries that have lower costs. So, let them buy into England's or Germany's and pocket half the difference. So, if the difference, and you look at the projections, 10-20 years out, differences are making cases over 10, 15, or 20 years depending on which country you look at. Suppose you said: Let people pocket the difference. How would we do that? How would that work? Well, we'd have to negotiate a deal with these countries. They are subsidizing their own people; they are not going to want to subsidize us. No, no, no they are full cost. Oh, because they are cheaper. They are full cost to cure. Or even higher--110%. Yes, give them a premium, absolutely; you'd make it worth their while. So, let's just throw some numbers out. Let's say it cost $6000 a year to give a person over 65 care in the United Kingdom, and let's say it cost $15,000 here. So, we'll give them $7000. A thousand to pocket. $8000 left. So, someone goes to the United Kingdom to get their care, they get $4000 and the U.S. taxpayers save $4000. That's going to be hard to implement, obviously, because most people don't want to go to the United Kingdom for their health care--for a bunch of reasons. Understood, but a lot would. Because you'd let them pocket the difference. That's clever, interesting. I would certainly want to encourage people to spend their own money. When you say things as you did earlier--and it's a common argument that health care spending keeps rising and will continue to rise--that's not a natural process. Part of it is. Part of it is innovation, people find new stuff. But part of it is the fact that we are spending other people's money, and as long as we do that, and certainly through our employer--which is a crazy way to do it and I'm sure we agree on that--we keep subsidizing them. It's going to get more expensive that way. Again, I have a hard time saying that. Obviously insurance is your money, too. But the problem you get into is are people in a situation to distinguish between care that they really need and care that might be speculative. I've had my own experiences. Fortunately I've never had a major illness, but I have had my own experience dealing with doctors, and I've had to argue the opposite. I do the same thing. And we're not experts. We are both relatively well-educated in the scheme of things, but you have your doctor saying: Oh, you need x, y, and z. And how many people are going to challenge this? It's true. Fascinating thing. I'll say: I'll pass. And they look at you like you are crazy. But sometimes there is a reason to pass just because there are these side effects they don't worry about. They are more worried about the side effects of not doing something and being legally vulnerable, I suspect. But part of it is it's someone expert. They have a hammer and they are always looking for a nail. Let's remove that. I'm saying: Let's see how it goes for a while.
58:47You and I look at the world differently, but there are a bunch of things we have in common. I want to just let you talk about what you'd do differently in terms of the solution. One of the things we both agree on is that the regulatory process is often captured by special interests, and seems increasingly so for one particular sector of the economy--the financial sector. If you go back to 1984 and the rescue of Continental Illinois and its creditors, you see a long steady pattern. You get lots of free market rhetoric, but the fact is, in terms of practice, there's a lot of socializing of losses and privatizing of gains. That sector has gotten a lot bigger; it's gotten a lot more politically powerful; and the wages and profits that go to that sector seem way out of line. And to me seem to be related to its political power and what its contribution to our way of life. So, I think we pretty much agree on that. The way I want to fix that is to make government less powerful. How would you fix it? I think you take a different approach. So, what would you advocate, given the political realities? Well, I would love to see breaking up of the large banks; that we would bring them down; we could quibble over what the exact size might be, but require that J.P. Morgan and Citigroup and Bank of America get down to a size where they aren't too big to fail, where they are component parts. So, presumably we are talking about breaking a J.P. Morgan into maybe 5, 6, 8 banks. The component parts are not too big to fail; we can let any of them go under without serious repercussions to the economy. I'd also like to see them downsized by having a modest tax on the industry. I think part of the story here is that because of computerization, you've seen a huge increase in trading volumes, because the cost has just fallen through the floor. So, you could both trade the same assets more frequently; and it's possible that more complex financial instruments than would have been conceivable if you go back with the technology we had 30 or 40 years ago. So, in effect I see a financial transactions tax making up some of those losses. Also, just in terms of if we think of that being unfair to the industry, this is an under-taxed industry. Most of the taxes that apply for getting a car, getting clothes--sales taxes; if we were to look to Europe, value added taxes--those don't apply for the most part to finance. And I can't see a rationale for that. So, this is my way of sort of equalizing. They are special. That's why. Well, that is what they say. A little perplexed: why is it you are special? So, I think there are a lot of ways to make them less powerful, less politically powerful, less economically powerful. Glass-Steagall, again I'd like to see that sort of separation. And of course the rationale to my mind is you have a sector, the financial industry, that is insured by the government. You are taking government-insured deposits. And the quid-pro-quo is, well, you aren't going to take big risks with my money. I agree with that to a point. I'm not sure Glass-Steagall is as important as people say it is. But the fact is, as you say, we have explicit insurance and then we have implicit insurance, and they both allow them to take risks with my money. Where we have the explicit insurance, there have to be clear conditions that here are the risks you can take; and we don't want implicit insurance. The irony of this, for me, is that the justification for Glass-Steagall being removed, or any of these other maneuvers, Triple-A changes, allowing things to be leveraged that look safe but aren't--the argument is: Well, it's more efficient. Which is something I'm very sympathetic to. But the fact is, it makes it more efficient at using my money. And that's not good. As long as that's there hanging over it, I don't care how efficient it is. I want something different. Yes, I agree with you. And the argument of Glass-Steagall making it more efficient--it's almost contradictory by its nature because they always said they would maintain a strict separation between commercial banks and the insured deposits, and then the investment bank components. Strict separation--where's the efficiency?
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2012/01/dean_baker_on_t.html. http://www.econtalk.org/archives/2012/01/dean_baker_on_t.html http://www.econtalk.org/archives/2012/01/dean_baker_on_t.html Dean Baker Mon, 09 Jan 2012 06:30:00 -0500 Sumner on Money and the Fed Scott Sumner of Bentley University and the blog The Money Illusion talks with EconTalk host Russ Roberts about the state of monetary policy, the actions of the Federal Reserve over the past two years and the state of the economy. Sumner argues that monetary policy has been too tight and helped create the crisis. He disputes the relevance of the so-called liquidity trap and argues that aggressive monetary policy is both possible and desirable. The conversation closes with a discussion of what we have learned and failed to learn during the crisis.

Play
Time: 01:06:48
How do I listen to a podcast?
Download
Size: 31.1 MB
Right-click or Option-click, and select "Save Link/Target As MP3.
]]>

Readings and Links related to this podcast

Podcast Readings
HIDE READINGS
About this week's guest: About ideas and people mentioned in this podcast:

Highlights

Time
Podcast Highlights
HIDE HIGHLIGHTS
0:36Intro. [Recording date: December 21, 2011.] Broad topic, my ignorance: I have trouble figuring out what's going on in the area of money and monetary policy. You seem to understand it, so I'm coming back to you to ask some of the same questions I've been asking for a while to see if I can get a little bit smarter. Let's start with a little bit of a review. In your perspective, what does monetary policy have to do with the mess that we are in right now? Basically, I see monetary policy as driving nominal spending in the economy, nominal income. By nominal you mean just the dollar value, rather than corrected for inflation? Right. So, if your listeners were to imagine their own income, and then add up everyone else's income in the entire United States, that would be total nominal income. And so that's the variable that I think is the key to the business cycle. Now, I don't think it's a key to long term economic growth. In fact, I don't think it really even matters much in that area. But in terms of the business cycle, I think fluctuations in nominal income or spending are really the key. I want to stop you there again. So, when you said it doesn't matter in the long run--you mean, for example, if we doubled nominal income, our wages doubling, but we didn't produce anything more, we'd have twice as much measured income, but we wouldn't be any richer. Right. Prices double, and then your real power of purchasing would be unchanged. So, that's an example of where the government could affect, say, nominal income as a whole, but in that example, we wouldn't be any better off. I think in most people's minds, this is one of the great sources of confusion in macroeconomics. "Well, but I'd have to double the income." Famous Mark Twain passage. People have trouble perceiving that your income--it depends what it can buy. If you can't buy any more, you are not any richer. Right. And I think one of the big confusions in macro is that people confuse two issues, the real and the nominal. So, some people talk about what can the Federal Reserve (Fed) do? There's one question which is: Can the Fed boost nominal spending or nominal income? And there's the second question, which is: Would more nominal income boost real output? And those are two very distinct questions. I think most economists believe that at least in the long run, monetary policy can target nominal variables or control them in some sense by controlling the quantity of money. There's somewhat more disagreement about how that plays out in terms of real variables--whether they are affected in the short run or not at all or over a fairly extensive period of time. But, when you see a lot of the debates about Fed policy, you see people mixing and confusing the two issues. What does it mean to say the Fed is out of ammunition or not able to do anything? Are you talking about nominal spending or are you talking about real output? Two very different questions. A good example would be Zimbabwe, which produced spectacular growth in nominal spending, but almost all through inflation, so there was no growth in real output. To the point where inflation was sufficiently high that real output would fall because the normal channels of exchange were so uncertain. Exactly. And of course, they had other supply side problems, too. So, that's one issue. My view is that there really should not be a serious debate about whether monetary policy can drive nominal variables. It's just a question of how determined the Central Bank is. They can print almost unlimited amounts of money. I think the real debate, in my mind, is: What is the proper path of nominal spending or inflation or whatever nominal variable you wish to target--could be the money supply, as Milton Friedman proposed. There's going to be some nominal variable that's going to be the anchor for the monetary system. Another example is the gold standard, where it was anchored to a fixed nominal price of gold for many years. So, you have a monetary policy that in some sense determines nominal aggregates--and I happen to think nominal income is the best one to stabilize. And then the second question is: If you do that, what sort of real outcomes in the economy do you get? And that's where I distinguish between the business cycle and long-run growth. I think monetary policy can help smooth out the business cycle by having a stable path of nominal income growth, but it can't speed up the real growth in the economy. That's due to structural factors, government policies, incentives, all sorts of productivity, etc.
5:47So, what went wrong, do you believe--there's two parts to this question. What went wrong to get us into the mess, and what has gone wrong with getting us out with respect to monetary policy? We debate in the policy sphere about every aspect of policy. We debate fiscal policy, we debate monetary policy, the structural things, side-issues about what to do with the housing market. But basically you focus a lot on monetary policy. So, what went wrong with monetary policy, both to get us here and to fail to get us out? First of all, if you just look at the path of nominal GDP over the last 5 years and knew nothing about the rest of the economy--you didn't know there was subprime bubble and crash and banking crisis and all that stuff, you didn't know who was elected President in 2008--you would predict a fairly severe recession, just based on the path of nominal GDP. In 2009 it fell at the fastest rate since the Great Depression, and it's grown very slowly since, much more slowly than in a normal recovery. So, that's one level of causation. But then of course people will say: But that doesn't really explain anything. Why did that happen? When we have a recession, isn't nominal income going to go down? No. For instance, in 1974 we had a very severe recession, and nominal income rose fairly briskly because we had high inflation. That was the famous oil shock case. So, real Gross Domestic Product (GDP) falling is actually the definition of a recession. So, if I were talking about real GDP I would have just stated a tautology. But nominal GDP, I do think there is a causal relationship between a fall in nominal GDP, which as I say I think is controllable by the Fed, and the impact on real output. And then the next question is: What caused GDP to fall? Certainly the Fed probably didn't want this to happen. There I think it's kind of a complicated story where parts of it have to do with the financial crisis sort of unintentionally made monetary policy more contractionary than the Fed wished or desired. And second, in late 2008 the financial crisis was a big distraction, so I think the Fed wasn't really focusing on the fact that its monetary policy stance was inadequate to promote nominal growth. And another thing is I think there is a tendency to confuse symptoms and causes. When you have a severe crisis, all sorts of things happen to an economy that look like causes that might very well be symptoms. For instance, almost every crash in nominal spending is associated with a financial crisis of one sort or another, throughout history. And there is a tendency at the time for people to blame the problems on the financial crisis because that's much more visible than the fall in nominal spending. So, that was the original view of the Great Depression--that it was caused by financial problems. Later, Milton Friedman and Anna Schwartz started to convince economists that it was actually monetary policy failure. I could point to examples like Argentina about 10 years ago where their deflation and all of nominal GDP led to the severe financial crisis. And then of course more recently--well, what's interesting about the current situation is you had, in both the United States and Europe, very real problems that had nothing to do with monetary policy. In the United States, it was our subprime fiasco. And in Europe it was fiscal policies, especially in places like Greece. So, those are outside of the story I'm telling. But what happened was that when nominal GDP fell in both places, each of those crises spread and became much larger than the original problem. So, you so of started with some bad loans made for a variety of reasons, and then you had this fall in nominal GDP. And instead of just having a subprime crisis in America, we had a huge debt crisis that spread into commercial loans, and municipal loans, and sorts of other things. And then in Europe instead of there being a Greek debt crisis, there became a Eurozone debt crisis because of the fall in nominal GDP. So people view the financial crisis as the problem, whereas I see it more as a symptom of a deeper problem, which is inadequate nominal income, which makes it tougher to repay loans. After all, most loans are nominal loans. They are not indexed to inflation. So, when nominal spending falls, it's much harder for people or governments to repay loans.
10:44Let's digress about that for a minute. My presumption remains, after many conversations, some on this program, that the real danger of deflation is a simple danger. It's not as frightening in and of itself as people make it out to be. The reason it's dangerous is that it's rare. It's often unexpected. And if I have made a promise to repay you $1000, which is as you say a nominal promise--meaning it's just a certain amount of money, that's all we mean by "nominal," it just means dollars, some absolute numbers--so if I promised to repay you $1000, if there is a deflation and I have trouble and my wages fall for example, all of a sudden my ability to repay that has changed. And you are expecting to get that money and do something with it. I might not be able to keep that promise. However, if we had expected deflation then we would have had a different interest rate implicit in that loan and things would have been very different. So, it's unexpected deflation that can lead to contractionary problems as people struggle. I think that's right. But let me just make one little addendum there. A good example was in the late 1920s when we had a little bit of deflation--maybe 1% or something per year. I'm not sure the exact number. But real GDP was growing strongly, so people's nominal incomes were going up maybe 3% a year, something like that. Because monetary policy was relatively neutral, you are saying. Relatively neutral. So, people sort of expected back in those days that there might be a little bit of deflation. So that didn't really create any problems for the economy. It did very well in the late 1920s, until the end of 1929. But what tends to happen is that when you get a severe deflation, it's almost always unanticipated. So, in the 1930s, we had this big drop in prices. And the reason why it's almost always unanticipated is: It's hard to have anticipated deflation at a rapid rate, because that would do is make the real return from holding cash become very high; and that's not like just an equilibrium solution to an economy. It's sometimes called a liquidity trap. So, if you had 10%/year deflation, people holding cash would earn a real rate of return of 10% on just sitting on cash in their wallets. And the economy isn't really capable of generating that kind of real rate of return on a safe asset like cash. So, instead you get a liquidity trap developed. What do you mean by that? I don't really mean "trap" in the sense most people use it. I don't think it's a barrier to expansionary monetary policy. All I mean is that you get a situation where people sort of hoard currency, and interest rates on other assets, like government bonds, fall close to zero. But that sort of environment--because that's not an equilibrium condition for the economy, to have that sort of real interest rate on cash, what would tend to happen is if you tried to run a deflation that was very rapid, you'd probably end up in a depression, for various reasons. But mild deflation which still allows for a positive interest rate is still a feasible solution, and we saw that in the late 1920s. Now, in our modern world unfortunately we are expecting not a 1920s situation but a positive rate of inflation and also positive real GDP growth. So, most people are probably expecting about 5% nominal growth, and they made their plans on that basis. They made wage contracts, signed debt contracts on those expectations, and when they didn't pan out--nominal income fell about 4% from mid-2008 to mid-2009, that fall was 9% below what people expected based on trends. So that really made it a lot harder to repay debt, and it pushed a lot of marginal debts over the line into problem debts. It still is true that much of the debt problem was bad decisions, but the amount of actual distress you have depends also on the ability of people to service those debts, which is national income basically.
15:12I want to come back to this parallel between our subprime crisis and the European crisis and how people see them as two different things, and you see them both being exacerbated, made worst dramatically by a failure of monetary policy. We'll come back to that. Let's stick with your observation a few minutes ago. You said the Fed, very focused in 2008 on the financial crisis, for whatever reason failed to note or failed to respond to this drop in nominal income and dropped the ball, made things worse. So, as a casual observer, I would be puzzled by that; and here's the obvious question. Help me understand it. Around that time, the Fed was doing some of the most aggressive monetary interventions of our lifetime. They were injecting a trillion, two trillion--I don't remember the numbers, you probably do--trillions of dollars in what's called high-powered money. That is not like literally printing money and dropping it from a helicopter, but entering it into its books; buying up assets from various banks and entering it into the books of those banks. Reserves, which they would now be free to lend. So, you are suggesting that the Fed was being negligent in being insufficiently aggressive and having too tight a monetary policy. But on the surface, it's the most aggressive, expansionary monetary policy in recent history--maybe ever. So, reconcile those two broad points. Let's be clear what we are talking about here. You are presenting what would be the liquidity trap view, that they pushed all this money out there and it didn't do anything. I'm not presenting anything. All I know is you look at the balance sheet. I have a mild horse in this race; we'll get to my horses later. Let me put it this way: I'm characterizing your view . In other words, there are two issues here. One is, would more nominal spending boost real spending; and the other is, would expansionary monetary policy boost nominal spending. And we just know from the data that we haven't gotten a lot of nominal spending in the last three years. So, the real question is why haven't we gotten much nominal spending given this big increase in the monetary base. And I think there are several reasons for that--probably three reasons I could cite. One reason is when they started doing this in late 2008, they simultaneously instituted a program called Interest on Reserves. They'd never done this before--paying banks interest on the reserves the banks held. And so what actually happened is almost all of this new money the Fed injected into the economy went into the banking system and sort of sat there as what's called excess reserves. Meaning cash that sits on the bank balance sheet but they are not doing anything with it other than collecting interest from the Fed. The Fed requires that they keep a certain minimum amount, and they are well above that minimum. Most banks. Usually what happens is required reserves would be like $50 billion, say, and excess reserves might be $1-2 billion. Now we have required reserves still being around $50-60 billion, across the whole system, but the excess reserves have gone into the trillions. Or maybe between $1-2 trillion. And that's from $1 billion or $2 billion. So, we're seeing an increase of a thousand fold, order of magnitude increase in excess reserves. It's almost all gone into the excess reserves category. I think there are two reasons for that. One is that the Fed started paying interest on reserves. Now, this might really surprise you, because people don't really remember it this way, but during the big crash in nominal GDP, which basically took place in the second half of 2008, the Fed's interest rate target was not yet at 0. It was running around 1-2%. And the Fed decided they wanted to put a lot of money into the banking system, a lot of liquidity to sort of bail out the banks, prevent the system from freezing up; but they didn't want a highly expansionary monetary policy. So, the reason they started paying interest on reserves, surprisingly, was to prevent interest rates from falling to zero sooner than they actually did. Now, in the end, in the middle of December, interest rates were finally cut close to zero. But during that big injection of money in the middle of 2008, the Fed specifically wanted it to stay in excess reserves and paid banks interest on that in the hopes that it would stay there and prevent interest rates from falling too fast. In other words, the policy was basically contractionary in its intent. And that's pretty generally accepted. Now, it was offset by the fact that a lot of money went in there. It didn't do anything. A term we use in monetary economics is that it was sterilized. It was made so that it didn't really have any effect. They paid banks to just sit on the money. Hang on. We are getting close to getting rid of some of my ignorance, because this is one of the deepest and strangest parts of this whole episode. Currently, banks are earning about a quarter of a percent on those excess reserves. Yes. And those who sneer at the implications of paying interest on those reserves say, well, a quarter of a percent on $2 trillion. Say, between $1 trillion and $2 trillion. People say that's such a small amount of money. But of course it was higher initially, as you point out. It was close to 1% initially. They changed it several times in late 2008, but it was somewhere around 1%. The other thing you have to look at. I'm not sure that right now that's a big problem, but even a quarter point is more than banks can earn on, say, Treasury Bills or certain alternative investments. You have to look not just at the amount that is paid but also at the banks' alternatives for other safe investments.
22:20All right, but so here's the question. You state it as if it were fact when you say why the Fed did this. We don't really know what's going on in the mind of the decision makers at the Fed. Ben Bernanke's the most prominent, but there are other people with influence. It's somewhat of an emergent decision. It's deeply puzzling, why at a time when the American economy, when unemployment stinks, when the economy is recovering at a tepid pace, very disappointing to everybody across the political spectrum--why would the Federal Reserve discourage its activity from having an impact? It does nothing. Let me state it in a way that's not at all controversial, and give you something that's in the public record. Two days after Lehman Brothers failed in September, the economy was clearly worsening. The Fed had a meeting and they decided not to cut interest rates. They left their target at 2%. Here's my question. If in the fall of 2008, the Fed was doing all it can to revive the economy, why would it not have cut the Fed target from 2% to say, 1.75%, 1.5%, 1.25%, 1%, .75%? This is certainly what I favored at the time. I think we compress history in our minds, and we remember the Fed getting more aggressive in early 2009 when it started the first quantitative easing program. But I think we tend to forget that in the last half of 2008, when the actual collapse in nominal GDP occurred, the Fed was actually pretty passive. After Lehman Brothers failed they issued a statement saying that "we see the risks of inflation and recession as being equally balanced." In other words, from their point of view, the economy was right on target, but there was some risk that there would be too much spending in 2009, and some risk that there would be too little spending in 2009. Those risks were balanced, so they said: On balance, we're not going to cut interest rates. At the same time they wanted to push a lot of money into the banking system. Other things equal, that's clearly expansionary. My point about interest on reserves is that it essentially neutralized that injection. The injection of all the money was expansionary; then the decision to pay interest on reserves sort of tied up the money and made it non-expansionary. So, if you net the two out, it's simply a passive stance by the Fed. So, I've suggested--it's a depressing suggestion--that the policy of paying interest on those reserves was simply a back door subsidy to the banking system. Again, people say: Well, it's only $5 billion at the current rate--$2 trillion in reserves at a quarter percent is about $5 billion. At 1% it's about $20 billion. And you can argue whether $20 billion is a lot or a little bit of money. I think for some banks it was a great deal of money. You can't just look at the entire system and say: Well, for the overall system it's a trivial subsidy. I think for certain banks it may have been the difference between survival or not. That's certainly possible. That's the empirical question I'd want to investigate. It's possible they had these twin objectives--they wanted to put money in there to help the banks, and they wanted to not have interest rates fall to zero. As you probably know, if you inject a lot of money into the system, the free market interest rate will tend to fall, normally, because you are increasing the supply of money, so that depresses interest rates through the liquidity effect. That's how monetary policy normally operates. So, this huge injection, late 2008, normally would have pushed interest rates immediately to zero if the Fed had not done the interest on reserves. So, why did--let's give the Fed the benefit of the doubt--why was that an unattractive outcome for them? To push interest rates to zero right away? Yes. As I said, believe it or not, they said that the risks of inflation and recession were equally balanced. They were sort of looking through the rear view mirror. Inflation had been high in the previous 12 months, but the futures markets, or more specifically what's called the TIPs spreads, which is the difference between interest rates on regular bonds and indexed bonds, those financial market indicators showed that investors expected about 1.2% inflation per year over the next 5 years. Very low. That's below the Fed's implicit 2% target. So, I've argued that actually the Fed should have worried about inflation being too low, not too high. But they were sort of like driving a car by looking in the rear view mirror, and trying to notice when it was going off the road; and they weren't looking at the market indicators, looking down the line to see where the economy was headed. And if they had done so, they would have seen that inflation was probably going to come in below target. Now, let me hasten to add--these are just futures indicators. They are often incorrect. It just so happens that the one I cited the day after the meeting the day that Lehman failed did turn out to be fairly accurate--we've run about 1.2% inflation on average since that meeting. Although it's been highly volatile. Deflation in 2009 and much higher inflation in 2011. But on average we've had about 1.2% inflation over the last 3 years. That was one of their mistakes, to have a backward looking policy and not take market indicators into account. I think if they'd done so they would have been more aggressive. I think if they could go back in a time machine, seeing what's happened I think they now realize they made a mistake in late 2008; and some of the aggressive moves they've done which have not had much effect, which I'll get to in a moment, would have been more helpful back then. The problem we are in now is once interest rates get near zero, even eliminating interest on reserves may not be enough to get the money circulating in the economy. Because with interest rates near zero there is almost no opportunity cost for banks to just sit on money. What you really need then is a more aggressive policy of targeting some variable, like inflation or nominal GDP, at a level that will raise expectations of future nominal growth and make the price of assets go up and the demand for credit go up and boost spending in the economy. And the Fed is unwilling to do that. So, they've missed their chance to play around with conventional policies like cutting interest rates, which they could have done after Lehman failed. Now they are in a more difficult, unconventional world where they can't cut interest rates any more because they are near zero; and they are simply afraid of using, for whatever reason, unconventional policies that would be effective. Although they've tried some ineffective unconventional policies. Let me be more precise--not completely ineffective, but not effective enough. I would say that all the things they've done probably have prevented the economy from being in a deeper depression right now--I'll concede that--but not enough to promote a rapid recovery like we saw from the 1980s recession, for example. Which was also a fairly large one. Another deep recession. And that one had a very fast recovery, along with very fast nominal GDP growth. Again, to me in a way there's no mystery about the weak recovery. If people say: Where are the jobs? There's no jobs because GDP growth is slow in real terms. Why is real GDP growth slow? No mystery there either--nominal GDP growth is very slow. So, in the 1983-1984 recovery, nominal GDP growth averaged about 11% annual rate for six quarters. In this recovery, it's been a little over 4, 4-4.5%. What does that mean? It means that in a world of low inflation, you are only getting about 3% real growth, which is barely above trend. And that's why we've had such a small reduction in the unemployment rate. We're growing in this recovery over the last few years just barely above trend.
31:18But all of this presumes that somebody's in charge of nominal income and nominal spending. If we went back to that 1983-84 recession, can you point to things that the Fed did rather than things that just turned out that way? Well, they had an easier job, because all they really needed to do was just cut interest rates to promote a more rapid recovery, and they did that aggressively. They started high. Now, in our situation--and by the way, it's not just the Fed. What I found looking around the world today or looking back through history, is every single time, I believe, that countries get into this zero-rate situation, monetary policy tends to be less expansionary than expected. You tend to stay in this slow nominal growth phase for often an extended period of time, and we went to low interest rates in the early 1930s and they stayed that way almost all the way into the early 1950s. Japan went to near-zero interest rates some time around the mid-1990s and they are still there. Europe and the United States have gone into a low-interest rate environment in the last three years and are basically still there. And even more interesting is the fact that twice in Japan and twice in Europe they tried to escape from it by raising rates, and they did so prematurely; and each of those four occasions, the Central Bank had to do an embarrassing about-face very quickly and cut them right back down. It occurred in Japan in 2000, in 2006 where they raised rates--the economy slowed and they quickly had to cut them again. And in Europe, the European Central Bank raised rates in mid-2008 and then had to cut them soon after; and they did it just this year in April, I believe they raised rates from about 1 to 1.5%; and then the European economy slowed in the latter part of this year and the European Central Bank has recently cut them right back down. So, those are four very embarrassing about-faces for central banks, all because they were anxious to get out of the zero-rate trap but hadn't created the robust nominal growth that would support higher interest rates. So, they did it prematurely, essentially. But where's the cause and effect? If you ask a person, somebody running a business, and say: Interest rates are really low. This is your chance to go out there and really do some great projects. Why isn't that happening? The standard answer you hear is: Banks are uneasy about lending because the future is uncertain, and businesses are uneasy about investing, because the future is uncertain, and that's why interest rates are low. Is that true? Excuse me--that's why we don't see a lot of investment. It depends on what you mean by uncertain. There's kind of two arguments on this, the liberal argument and the conservative argument. And they are both probably true to some extent. The liberal argument is that the low interest rates haven't helped because there's not much demand in the economy. Not much spending. So companies are operating factories at, say, 75% of potential; they don't need to borrow to expand their plant, equipment because there's not much demand for their goods. Or, in the housing market, sure there are low interest rates, but since house prices keep falling why would someone want to buy a house now? So, there's not much demand for credit. And so the interest rates reflect a weak economy. The conservative argument is that a lot of bad government policies scare businesses, deter investments--taxes, regulation, and so on. And that may be true, and I think it is true to some extent. But the liberal argument here is really all you need. I don't think it's a complete explanation of the recession, and I've argued to some extent against liberals on some issues like unemployment insurance and other things that I think are increasing the structural rate of unemployment in the economy. But on balance I think that when you have very weak nominal spending, the free market interest rate will tend to fall to zero even in an economy that doesn't have a lot of structural weaknesses. It's not an assumption you need to explain what's going on here.
35:49But then what's the implication of what we ought to be doing? The left-of-center approach is, say: We just need to spend more. We need to get nominal income up--they agree with you. Nominal income has been falling or is not rising at a fast enough rate, so something needs to fill that gap by spending more money. That's their standard argument. Why are they wrong? They are arguing for government spending, which I think first of all won't really help very much. And second, monetary stimulus. The best way and probably the only way to promote faster nominal GDP growth is to get a more expansionary monetary policy. So, I think the mistake on the left is to put too much faith in fiscal stimulus. Fiscal stimulus is relatively weak, and it also tends to be offset or neutralized by monetary policy. But let's say monetary policy stayed as it is; the President and the Congress got the Keynesian religion; they listened to Paul Krugman and they increase government spending in the United States by over a trillion dollars this year, which is what many people are advocating who are Keynesians. They argue interest rates are too low; the Fed has no bullets left. So, they can't lower the interest rate any more; so the best thing to do is have government spend. Government spending a trillion dollars--isn't that going to increase nominal income? Here's the tricky part: When you said, let's leave monetary policy as it is, you slid over a very subtle and complicated question, and that is: What is monetary policy? And I find when I talk to people, everybody I talk to seems to have a clear and definite idea in their mind about what we mean by holding monetary policy constant. But they don't equate with each other. So, for some people that means the Fed keeping the money supply constant. For others it means keeping interest rates constant. Which is a very different policy. And I think both of those are wrong because it's not what the Fed is actually doing. What the Fed is actually doing is adjusting monetary policy to conditions in the aggregate economy. So, they'll do some quantitative easing (QE), then they'll back off; they'll do some more. Or Operation Twist. Or they'll promise to keep interest rates low for two years. And these policies are not highly effective, but they are probably effective in slightly nudging the economy a little bit faster, a little bit slower. So, what the Fed is doing is these on and off policies as it reads the incoming economic data. If the data gets stronger, the Fed does less. When the data gets weaker, the Fed does more. What that means is fiscal stimulus does succeed in promoting a little bit faster growth; the Fed will react by doing less quantitative easing and other policies of that sort; and it will very likely neutralize most of the effect of the fiscal stimulus. Now, I'm not trying to stake out an extreme position here. If the Federal government did an enormous amount of fiscal stimulus, yes, I think it would boost nominal GDP. Whether it would be a good idea would be another question. But obviously, if you took it to the extreme like the spending in WWII, it would definitely boost measured GDP in the economy. But for the amounts that are politically realistic, I really don't think--let me put it this way: The original stimulus bill was originally around $800 billion, in 2009. Ended up being $825 billion. I think it was a mixture of spending and some tax rebates. About 1/3 each--1/3 tax rebate, 2/3 spending, and of that 2/3, 1/3 on payments to the states and 1/3 on various so-called expansionary activities of various kinds. And that was done in early 2009. About the same time the Fed was getting very worried about the economy. It wasn't "done" in 2009. The legislation authorizing it was enacted. It took a while to spend it; it spent out over 2 or 3 years. Right. But importantly, by the way, a lot of modern theories say the effect on demand should come with expectations; so it should start even when the program is not enacted. You've got that program, then. The standard way of looking at it is to assume the Fed is just this passive bystander. But everything we know about Ben Bernanke, throughout his career, tells us very clearly he had no intention of allowing a Great Depression II on his watch. He's a scholar of the Great Depression. He passionately believes the Fed blew it by not being more aggressive. He's also insisted all along the Fed has lots of ammunition they haven't used. He's talked about things they could do, things he recommended the Japanese do that he hasn't done yet. So, the Fed has a lot of ammunition left including the most powerful tools, which they haven't pulled out yet. Which are? Setting a higher inflation or nominal GDP target is the most powerful one probably. If they could. That would be politically controversial, especially if they did it in terms of inflation. I prefer nominal GDP. But here's my point: Suppose Obama did nothing in 2009. There's no way the Fed would have just sat back passively and watched the economy collapse. What would have happened is with less fiscal stimulus there would have been a lot more monetary stimulus. I don't know exactly what it would look like. I'm not saying it would have exactly made up for the lack of fiscal stimulus, but my point is this: Any estimate of the effects of fiscal stimulus are probably really wildly exaggerated by not taking into account the reaction function of the monetary policy makers. And that's the big flaw in the way we think about fiscal stimulus. And no matter how many times I make this point, I find it's very hard for people to absorb it. They want to think in terms of other things equal--like, okay, there's the monetary policy; now let's see what fiscal policy can do. It doesn't work that way. If fiscal policy does more, monetary policy will do less. That's how things work.
42:21I agree with your idea--I've always felt it's an interesting psychological insight--that the greatest living scholar of the Great Depression is Ben Bernanke. Nothing could be more embarrassing than for his legacy to be that he allowed it to happen under his watch. For one thing he's a great scholar of the Great Depression. For another, there's this famous conference where he, in the presence of Milton Friedman, who is not with us any longer and who I'd argue would be the number 1 scholar of all time, but fine, Ben Bernanke's second but now he's first because Milton's gone--but at that conference while Milton was still here, Ben Bernanke said: Don't worry, Milton, we won't let it happen again. Now, as you said earlier, maybe he's achieved that level. He did enough to avoid a Great Depression. He didn't do enough to avoid a Great Recession. But why would he even get this close? Why would he, when he saw that that $787, now $825 billion of stimulus wasn't doing very much, why would he counteract it? You are suggesting he counteracted it, and that's why it had no effect. Is that what you are saying? Yes. The way I would put this is: He didn't go out and say: Aha, I'm going to go out and counteract this now. If you asked him, he would deny counteracting it. No doubt. In his own mind he would not believe that he did that. But I believe that if you really think through the logical implications of what the Fed would have done in the absence of fiscal stimulus, that in essence it was sabotaged. I know that's a very counterintuitive and controversial statement, and almost nobody agrees with me. But I think that's because they are not thinking about the issue clearly enough. It's not that the Fed would ever set out to hurt the economy intentionally or anything of that sort. I happen to believe the Fed underestimated the amount of stimulus that was needed. If there had been no fiscal stimulus, their estimate of what was needed on the monetary side would have been substantially higher, and that's the logical point I'm making. Now, if you word it in a certain way, it sounds very appalling, like the Fed is sabotaging fiscal stimulus; and that's not it at all. But that's really kind of what it amounts to when you think about it logically. Let me give you an example of how the way we're thinking about these issues is so unlike the orthodox view. Can I take one minute to read a quotation--and I bet you cannot guess who said this, in 1999. This is about Japan.
What continues to amaze me is this: Japan's current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do - even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe.
So, this is my view, interjecting. Continuing:
Meanwhile further steps on monetary policy - the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance - are rejected as dangerously radical and unbecoming of a dignified economy.
So, he's amazed that people are suggesting that Japan do deficit spending when they already have this big debt and asking why aren't we doing the conventional monetary stimulus. Now do you know who said this in 1999? I'm going to guess it's Ben Bernanke from the way you are talking. No. Paul Krugman. That was my second guess! So, here's Paul Krugman saying exactly what I'm saying now, and I feel like my view of monetary and fiscal policy was the standard view, and in a sense the only reason we're even having this conversation right now is that in some strange way, the conventional view became very unconventional in 2008 and 2009. As you probably know, I'm not a particularly well known economist, at least prior to getting into blogging; and so the only reason we're having this interview is once I started blogging, I found that my view, which I thought was the conventional view, was in fact a fairly radical view and it got a lot of attention. A lot of people sort of thought of it as a very provocative, unconventional view. This is what I find so strange about what is going on. We have this situation where the standard view somehow twisted around from being monetary policy as the natural way of preventing a depression, which is the story that came out of the Great Depression, supposedly, to the view that it's actually fiscal policy that needs to do this. Now, some people will say it's different now because we're in a liquidity trap; but Japan had zero interest rates in 1999, roughly, when Paul Krugman made this statement. It's not really different. I'll just read you one really quick quotation out of the number 1 textbook in money:
Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.
So, that's what we are teaching our students, right out of the number 1 textbook; and I found in late 2008 almost none of my colleagues believed this. They were all saying: Monetary policy can't do anything right now; we have to use fiscal stimulus. What textbook is that? Frederic Mishkin, Money and Banking.
48:03So, one thing that Krugman's been saying a lot lately is that people who worried--this would be me, and others--that the injection of $2 trillion or so of reserves into the banking system is going to cause inflation--look how stupid they were. They were crazy. They were wrong. It didn't happen. When people ask me why didn't it happen, I quote Allan Meltzer. He said, on this program maybe two years ago: That's because they are not spending it. Then you come to the question of it's not in the economy; of course it didn't cause inflation. They are sitting on it. So, the question I think it comes down to is I think Krugman would justify his current position by saying: It's true that in theory monetary policy could do something, but when the banks aren't going to spend the money you give them, then you are stuck and the government has to step in. And you are suggesting that that's partly because of the bad policy on the part of the Fed of paying interest on reserves, and partly because of other things. Here's one other point he would make, and where I partly agree with him. He would say: What Japan really needed to do was to set a higher inflation target. That is, create expectations on the part of folks. To lower the real interest rate. So, if the nominal interest rate is stuck at zero--let's say you have a 4% inflation. I think that's the number Krugman recommended. Then the real interest rate becomes -4%. In other words, it doesn't really cost anything to borrow money because you are paying it back with cheaper dollars in the future. This is something Ben Bernanke recommended the Japanese do as well. Do what? Raise their inflation target. To 4% rather than its current appearance of zero. I don't know that he mentioned the number 4, but to do what's called level targeting, which means make up for the deflation. So, Japan has had some mild deflation, and what Bernanke said was they should have some inflation now to sort of catch up for the previous fall in prices. I can't remember the number, but I think it may have been numbers like 3-4% mentioned in his article. This is something he wrote I think in the early 2000s. But interestingly he's rejected that for the United States and his argument is that we don't have outright deflation like Japan, so that's the reason he's able to reconcile these positions. It's hard to know. Given the way that the Department of Labor calculates housing prices into the Consumer Price Index (CPI), they've made some arbitrary choices; they might be right; it's a bizarre method; I'm sure the measurement of it is flawed. They have all kinds of problems with quality control, holding quality constant. One quick example that's really striking: According to official CPI data over the last 5 years, housing costs are up about 7.5%, total. That's a little weird. According to the Case-Shiller index, they are down like 32%. That's a 40% discrepancy between Case-Shiller and the CPI on housing, and housing is like a third of the CPI, roughly. In other words, I'm not trying to argue that we are really in deflation this year. This particular year, probably inflation is a little bit positive. But what I would argue is that in general the CPI is unreliable, and that's why I tend to focus on nominal GDP. And if you look at nominal GDP, it's just unambiguous. Instead of the normal 5% a year growth in nominal GDP, for the last 3 years it's been going up about on average I think 1-1.5% a year. And that's barely above population growth. So, basically what we are doing is we are not providing enough income, where we could have a fast recovery even if our economy was perfect. In other words, even if we had none of these flaws that you and I don't like about the regulatory system, the tax system, and everything. It's very unlikely that this amount of income will allow for a fast recovery, because to get a fast recovery we'd have to have rapid deflation, and you just don't tend to see fast recoveries during periods of rapid deflation. At least in a modern economy where probably wages are stickier than they used to be.
52:30So, let's have a little fun. Let's suppose on December 31, Ben Bernanke writes a letter to President Obama and he says: I've always wanted to spend more time with my family, so I'm resigning. And to the surprise of many, the President, desperate for a healthy economy over the next 9 months, 10 months, for obvious reasons, puts in place Scott Sumner of Bentley University; he's approved, and on January 1st he takes control of the Fed's Chair. What would you do? What might you do? What would be your announcements and actions that you would think be the best in this situation? That's a good question. I'll give you a week if you want, but we are recording it now. You've got ten days, but let's pretend it's now. I can give you a quick answer, but it may not be a simple answer. First of all, any Fed policy has to be a strategy. It can't be just a tactic for the moment. So, I can't really know what's best for right now unless I know what the long term trajectory is. If I had to choose, I might just default to what the Fed was doing prior to the recession, which was promoting about 5% nominal GDP growth, maybe a little bit lower. Maybe 4%. That would be the long-term target. How do you get to a target like that? What would be your actions or words? Okay, but the second part is I think we need a little bit of catch up in the next two years because we are so far below trend. I don't think we should try to go all the way back up to the old trend line. I'd like to see us promote maybe 6-7% growth for the next couple of years, and then whatever we decide on. Let's say I pick 4% thereafter. Now, how do we get there? The ideal policy would be to create nominal GDP futures contracts. And peg the price of them. That is, issue enough money until the market expected nominal GDP to grow that fast. So, you would just keep injecting money until you got the nominal GDP futures contract showing the amount of growth that the goal of the policy was. How would you do that? How would you inject a sufficient amount of money given that the past injections have had no effect? First, if you want to make them more effective, you'd stop paying interest on reserves. That's a start. Now, let's suppose banks continue to sit on the money even at zero interest rates. You could always make the interest on reserves negative. You could charge them. That would be a fairly radical move. Now, I happen to think that's not necessary. That's a fairly radical option. That doesn't seem so radical. Well, it would probably for instance destroy the money market mutual fund industry, because people would be better off keeping money in safes in their house at zero interest--cash--than they would sitting in money market mutual funds at negative interest rates. I don't know if you see what I'm saying. I don't. There would be some distortions to the financial system. That would be really bad. I would prefer that instead of going to negative interest on reserves that the first option would be to simply buy as many assets as necessary. The Fed hasn't even scratched the surface for what they could buy. There's a lot of assets out there. But I think the more important point is that people tend to look at this problem backwards. What the Fed has been doing is injecting money and promising that they'll pull the money out again before we get a lot of inflation. Or anything of that sort. Mop it up. So, it's a temporary currency injection. Those are not going to boost GDP very much, or spending or inflation. To have an effect, it has to be more permanent. So, what the target does is it tells you the Fed is going to leave enough money out there permanently to try to hit this track that you've laid out, this trajectory that you are targeting for nominal income. Again, the optimal solution in my mind would be for the markets to determine how much money and what interest rates for this futures contract technique. Essentially the Fed just targets the price of the futures contract and passively adjusts the money supply as needed to make that target price stick. In other words, the analogy would be like the gold standard, except instead of pegging the price of gold, you'd be pegging the price of nominal GDP futures. In both systems the quantity of money in circulation is determined by how much the public wants to hold, given that trajectory for nominal GDP. Now, people will say: What if no amount of money gets you there? You can't really seriously argue that because in the reductio ad absurdum, the Fed would buy up all of planet Earth. And pay for it with currency. Obviously that's not an equilibrium outcome. Long before you got to that point, inflation expectations would start rising and you'd have to stop the injection. I would even go further, though. I would predict that if my policy were put into effect, the monetary base--that's the money created by the Fed--would actually go down. In other words, we have plenty of money in circulation right now. Too much to hit that target. The reason we are not having faster growth is that there is too much demand for money, partly because of the interest on reserves and partly because of the low expected nominal GDP growth. If we had a robust, more expansionary policy people and banks wouldn't want to be sitting on reserves. They would move the money into places where they could earn higher rates of return. And it would turn out we could actually need much less currency to achieve our target than we currently have in circulation. Or base money, to be precise. When I talk about the monetary base I mean including both money in the banks that they are sitting on--the so-called excess reserves--and also the cash in circulation. That you and I hold. What would happen is the banks would probably stop sitting on all those excess reserves. The public certainly doesn't want to hold $3 trillion in cash. So, what would happen is at some point the Fed would have to pull some of that money out of circulation that was injected during the emergency, because in a healthy economy you simply don't have that much demand for liquidity. So, I'm not really worried that the Fed wouldn't be able to buy enough assets to make that happen. I would expect once they started buying assets, expectations would increase sharply, and that very quickly they would have to reverse course and start pulling money out of circulation.
59:50So, you attended the University of Chicago, as I did. Did you ever by chance take a class from George Stigler? Yes. I did as well. I don't know if he talked about it when you learned with him, but he would say, he would contrast his theory of regulation with what he would call the Ralph Nader theory. The Ralph Nader theory is: the reason we have lousy regulation that doesn't serve the public, that serves special interests, that serves corporations unfairly is because we have the wrong people in the job. We just need better people. If we had the right people in the job it would turn out okay. So, the George Stigler theory is: it really doesn't matter who is in the job. There are these fundamental underlying incentives and that's what you need to look at. And once you understand those, you know how they are going to behave. It doesn't matter who is in the job. And a variation on that is Milton Friedman's observation that you don't want the right people in office; you don't want to create a system where you have to get the right people in office to get the right policy. You want a world where the wrong people can get in office but they are encouraged to do the right thing because of the nature of the political system. So, I look at the Fed, and you could have argued--I think many people did argue in 2006 or 2007 or 2008--that there couldn't be a better person than Ben Bernanke for this job. Because of what we talked about before--he was aware of the risks of monetary contraction and he would never let that happen on his watch. Now, you've suggested through a variety of forces, again nothing sinister, that that's actually happened. And you've written recently about other decisions the Fed has made, and made the point that they've been contractionary at times when they should have been expansionary. Where does that leave us with what the Fed is good at? It seems it's an institution that for political reasons--I argued recently that it's some unfortunate political forces that encourage the Fed to be nice to some of its friends who are not my friends, meaning the banking system, the financial sector. Why would we ever--and I don't think Scott Sumner is going to get picked on January 1st--and even if he did, George Stigler would say maybe he wouldn't be like Scott Sumner any more. He'd be more like any other Chair of the Fed. So, where does that leave us for where we ought to go as a society, as a nation, with respect to the Fed? Seems to me they have done a horrible job, and they are incapable of doing the fine tuning and textbook corrections that we teach our students. It seems to me that we need something more radical than just a different kind of policy, a better Chair of the Fed. What are your thoughts on that? I kind of have mixed feelings on that. I think for the banking system they probably do get a little too cozy with the banks and start to think that what's good for the banks is good for the country. So, that part of Stigler's argument, I think there's some merit to. But for macroeconomics I don't think it works very well. Certainly you couldn't really use that sort of argument for the Great Depression, if the monetary theory is correct. One possibility is the Great Depression is completely not due to bad government policies. But if you buy the Milton Friedman argument that I accepted, that tight money played a big role, the damage of the Great Depression to all classes of society was so great that there's no plausible special interest argument for why the Great Depression happened. No, it's just incompetence. Yes, incompetence. That falls under my theory too. If you look at the current situation, most economists are basically comfortable with what the Fed is doing. So, I wouldn't expect the Fed to do anything different from the consensus of economists. So, I'm not necessarily shocked by what the Fed's doing. I'm shocked by what my fellow macroeconomists believe that I thought they didn't believe a few years ago. And I was pretty naive, obviously. I'm out there trying to change opinions. Not to be too fatalistic, you could argue that we do make incremental progress. It's possible that if we hadn't had some of the insights from Milton Friedman and Anna Schwartz and so on, maybe this crisis would have led to another Great Depression, not just the Great Recession. I know that's not a very--it's certainly a weak defense. That's not trivial. Obviously as Adam Smith said, there's a lot of ruin in a nation. Anybody who focuses on economics is always going to be dealing with big problems of one sort or another. There's just lots of big problems out there. So, I don't think one can just look at the fact that there are big problems and necessarily come to the conclusion that the entire system is in some way flawed. Maybe it is. But maybe we are just making little incremental progress, once step at a time, and we have to make a lot more progress. Do better next time around. I happen to think that based on what we know now, if the same thing were to happen again, the Fed would not do the same thing. They would have been much more aggressive. I'm on record saying that if Europe collapses and faces another Lehman moment, the Fed won't behave the same way. They'll do something not necessarily my nominal GDP targeting, but something fairly dramatic and analogous that is much more effective than what they did in 2008. I hope it isn't tested; I hope Europe doesn't collapse. I do feel the Fed has sort of learned some lessons out of this, and in a weird way I think the popularity of my blog is evidence that other people seem to think I have something useful to say about the crisis that was missed in early 2009 when I started blogging. And so I'm hoping we've learned some lessons from this. But obviously we won't know until next time around.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2012/01/sumner_on_money.html. http://www.econtalk.org/archives/2012/01/sumner_on_money.html http://www.econtalk.org/archives/2012/01/sumner_on_money.html Scott Sumner Mon, 02 Jan 2012 06:30:00 -0500 Tabarrok on Innovation Alex Tabarrok of George Mason University talks with EconTalk host Russ Roberts about his new book, Launching the Innovation Renaissance. Tabarrok argues that innovation in the United States is being held back by patent law, the legal system, and immigration policies. He then suggests how these might be improved to create a better climate for innovation that would lead to higher productivity and a higher standard of living.

Play
Time: 01:08:44
How do I listen to a podcast?
Download
Size: 31.6 MB
Right-click or Option-click, and select "Save Link/Target As MP3.
]]>

Readings and Links related to this podcast

Podcast Readings
HIDE READINGS
About this week's guest: About ideas and people mentioned in this podcast:

Highlights

Time
Podcast Highlights
HIDE HIGHLIGHTS
0:36Intro. [Recording date: December 14, 2011.] Ebook available at Kindle. TED talk related to book. Want to start with the problem the book is proposing to fix or improve, our innovation situation in the United States. I think most people still see the United States as a very innovative place. Maybe not in 2011 because our economy is not doing very well, but it's still considered a place and source of innovation. So: Why is there a concern about the current levels of innovation and entrepreneurship in the United States? Well, innovation is one of those things that more is better. So I think we'd certainly like more. I do take for granted in the book what my colleague Tyler Cowen has called the Great Stagnation. Whether you call it a great or modest stagnation, it is true that since about 1973, the rate of productivity growth in the United States has been below its trend--its trend from about 1947 to about 1973. And we've been falling below that. And as you know, productivity is the single most important factor in creating a high standard of living. When we can do more with less, that is better than anything else. And so when our productivity levels are less than what they might be, that's going to be a subject for concern. I certainly agree with that, with part of that, that more is better. I wish we had a better economy. I think--my problem problem with Tyler's analysis and to some extent yours, although you don't rely on many things that Tyler relies on--if you just look at the raw productivity numbers from 1947-1973, it's not like it slowed down in 1973. It's that it suddenly changed its slope dramatically. So, there's a puzzle there that I suspect has something to do--possibly with slower productivity, although that's a little hard to understand given that the last 20-30 years have been extremely innovative, at least given our everyday lives. We look around, we see lots of innovation. We also see a big change in our economy over those 60 years we are talking about. We've had a steady decline in manufacturing as a source of employment and steady but still very productive manufacturing sector because of the innovation that's taken place. So, I'm a little puzzled by those numbers. I don't think--it's one thing to say it's slowed down; but if you see an abrupt change like that, you have to look for things around 1973. I see things being pretty innovative post-1973 relative to pre-1973. If it's not in the data, maybe the data are not measuring some of the gains that are out there. And of course as we've moved to an increasingly service-sector-oriented economy; those innovation gains are going to get smaller. It's part of the problem. That's possible. I think it is very difficult to get an intuitive sense of how much innovation is a lot and what we might expect. I do like this intuitive idea of thinking, if we go back 60 years, 1950, we think about 1950; and it's basically a modern world. It's less advanced than our world, but you have television, radio, airplanes; you even have a few large computers. Cars. Now, you go back another 60 years, to 1900 or something like that, 1890--totally different world. There's no airplane, no radio, no television, and the world from 1890-1950, that looks like an impossible change. That looks like science fiction. That doesn't look like extending out 1890. So, I do think that there's also an intuitive argument for the idea that the rate of innovation has not been as high as it was in previous years. If you go back over that time period. But my focus, however, is: We can do better than we are doing now. So, let's look at the problems that we have now and where we can do better.
5:23And certainly, if there are barriers to innovation, which you identify in the book, then we should get rid of them if we can. So, let's talk about those. You identify a whole bunch of different problems, and opportunities that aren't being taken advantage of. The first one you mention is the U.S. patent system. Which is a little ironic, because it was put into place to preserve incentives for innovation. So, make the case for and against patents. What's the argument? The argument for patents is that imitation is a lot cheaper than innovation. So that, if a firm innovates, creates something new, and another firm can come along, imitate that product, eat away all the profit, and the first firm can't recover its research and development costs. And then they wouldn't have any incentive to do them and you won't get much innovation in the first place. Exactly right. Now, there's lots of arguments against. One of the first arguments against is just to ask: Are patents necessary? Because often it takes a long time to imitate a product. It's not always easy. I have a number of examples. I look at roses, for example. Roses have been around for thousands of years. The Chinese emperor had hundreds of books in his library about how to propagate roses. No one has ever claimed that we don't have enough new roses. And yet, for the first time ever, in 1930, we created in the Plant Patent Act, we could patent roses. So, did patenting of roses lead to more roses, more beautiful roses? Because people could capture the benefits without fear of being copied? Exactly. Did it lead to a flowering? No, it did not. We didn't see any big increase in rose innovation. In fact, we might have seen a little bit of a decrease. Moreover, even today, most new roses are not patented. Most inventions, most innovations are not patented. And I think people are a little bit surprised about this. With a few exceptions--chemicals, pharmaceuticals--being really the two biggest important exceptions. In some fields we don't even all patents, like fashion. Highly innovative, no patents at all. But in most fields, most innovations are not patented at all. You mention an example I've been thinking about recently, which is sports. Somebody innovates a new formation in football. It can't be patented. But coaches spend hours looking for a small edge. It's true that once you see it you can copy it, but usually the person who creates it, for a variety of reasons might be able to implement it better than the copier, either because they understand it better, either because it's theirs; they have more passion for it. And that's also true in many cases for ideas. People come up with ways to make it harder to copy without using patents and the monopoly power that come with them. Certainly there's a lot of innovation in the fashion world without patents. We had a podcast on that. But there are exceptions, as you point out. So, you would not get rid of patents on pharmaceuticals. Why? So, pharmaceuticals are really the classic case of where the innovation-to-imitation costs are extraordinarily high. It costs about a billion dollars to create a new pharmaceutical. The first pill costs a billion dollars; the second pill costs 50 cents. So, that's a classic case where imitation costs really are low. That's the best case for patents, in a field like that. But my question is: Why does every innovation deserve or require the same 20-year patent? Why do we have a system which gives a one billion dollar pharmaceutical--where there's $1 billion in research and development costs--we give that a 20-year patent and one-click shopping gets the same 20-year patent? That makes no sense whatsoever. So, what I suggest is a more flexible system. I'd like to have a 20-year patent, maybe a 15-year patent, maybe a 3-year patent. Something like that. And then we could say: You want to apply for a 3-year patent? We are going to get this through the system quickly; we won't look at it so much. Hurdle to make the case for it smaller. Exactly. You want a 20-year patent, though: You'd better show us that you really are deserving and put some costs in there. Now, a side-note on the pharmaceuticals--I'm surprised you didn't mention this. Maybe you are just trying to be strategic. It's true it costs a billion dollars to develop a new drug; but there's a reason it costs a billion dollars. A lot of that cost is to no avail. It's replicating tests that sometimes already happened in Europe. A lot of it is the regulatory structure around the drug industry. People who are worried about drug pricing--one of the ways to solve the drug pricing problem is to remove the patent or shorten the patent. I'd like to shorten, reduce the research and development costs and the approval costs. Are you with me there? Absolutely. So, we have drug lag and even more importantly, we have drug loss. There are lots of drugs today which probably could be invented, but people know going in the costs are just too high. So, sure, I would like to see those costs come down. As a theoretical point, however, I still think that the pharmaceutical industry is the best case for a patent in that the innovation/imitation costs are very high. But there are other things we can do to bring those costs down.
11:24So, let's talk about the expansion of patentability that's happened in the last 15 years or so, where the courts have allowed ideas to be patented, business concepts. A lot of people you hear have come forth and said this is crazy. And a point you emphasize, which I think is very compelling, which is that when you patent ideas, that makes it hard for people to use those ideas to create new innovations. So, one of the disincentive effects of patenting is that it discourages ideas being used in creative and new ways. Everything is, as you point out, we are always standing on the shoulders of giants--the Isaac Newton quote. Newton didn't have to pay for it, but the rest of us are. You might say: so, that's not a big deal; so, you pay for it. But the problem is that paying for it isn't so simple. Right. So, let me come back to that point in a minute. Before we quite get there, I want to give you another example which I think is important. I want your audience to think about the most innovative U.S. company, the most important innovative U.S. company they can think of. Maybe you are thinking about Apple. Some people would. That's definitely an innovative company. I'm thinking about the Patriots, Bill Belichick, because I like the sports thing. Or maybe a fashion--I don't have any fashion expertise, as listeners know. Go ahead. I'm going to say: Walmart. Now, you think about Wal-mart, the world's largest corporation, half a trillion in sales every year. Estimated to have saved consumers a quarter of a trillion dollars annually. This is an incredibly important U.S. corporation. And if you think about the booming 1990s, where were the big productivity gains in that decade? In retail. Boring, hundred-year-old retail industry. And yet that is where we saw really big productivity improvements. A huge chunk of that coming from Walmart. And how did they do this? Was it coming from some new high-tech invention? No. They did it by better training of the sales staff, better training of cashiers. Through some Radio Frequency Identification (RFID) chips and things like that. Application of technology. Innovation there that clearly was not patented. Exactly. In fact, Wal-Mart, world's largest corporation, has about 60 patents to its name--a trivial amount--including one for a shoe box. So, here we see an incredibly important U.S. company not using patents at all, and I think that's important to really remember. It's a great point. The only caveat I would add is that 60 is a small number compared to, I think you give Microsoft's, which is in the thousands; but it could be that one of those 60 is the key patent that allowed them to use some sort of information technology (IT). But I think that's not true. My guess is, as you point out: They figured out some ways to apply technology and training and other things. Everybody copied them. Target copied them; K-Mart copied them; others copied them who have disappeared--because they couldn't do it as well. For a whole bunch of reasons that you and I have no idea what they are. Assume it had to do with how it was implemented, who implemented it, synergies they had with other stuff they were doing. But clearly they were able to be innovative without it. But in the area of high tech--where are we going to go after this? Cumulative innovation and ideas. So, when we talk about these drawbacks to the current system and how lenient it is and allowing things to be patented that make it harder to innovate--but I look at the pace of innovation. It looks pretty good. I look at the gadgets and the Internet--yes, it's kind of crazy that one-click is patentable, kind of crazy that people can patent ideas, business concepts. It's almost as silly as saying a podcast should be patentable. Whoever gave the first podcast--that was a great invention, a radio thing on the web. But obviously that's foolish and discourages innovation and things that make the world a better place. But what's the evidence that this is causing a big problem? It does appear to be making a lot of employment for lawyers, who have to deal with all these systems and make sure they have taken care of all the intellectual property. Is there something to be worried about? I think the problem is that you may be looking for the evidence where the lamp is. You are looking for evidence of how innovation has been reduced in highly innovative fields. But these highly innovative fields--the Internet and smart phones and so forth--they've been innovative not because of these patents but despite them. And I think the situation is becoming worse in these fields. So, what we are seeing right not is firms like Google and Microsoft buying up these patent arsenals. And they are not doing it because they need access to those technologies. They are doing it because another firm can't sue them and prevent them from innovating. Well, what's bad about that? What's bad about that--I call this the Mutually Assured Destruction--and mutually assured destruction I think was not the greatest way to maintain peace. Probably not the greatest way to maintain innovation either. And I think what the real problem of this idea of innovation through strength--we will be able to innovation because we have this patent arsenal behind us--is that small firms don't have that. So, we are seeing a kind of Intellectual Property (IP) feudalism. We are seeing these very big companies get ahold of these arsenals so nobody can attack them. But that means the small firms can't attack them either. Small firms are being crushed. And what do we know about really disruptive creative disruption? That often comes from the small firms. So, I am worried that we are going to see--yes, you can get innovation if it's from big Google, but what about the little google, the google of 20 years ago, the next google? Which doesn't exist because it can't have the legal department, at its small size, that its competitors have. So, the innovation we are not seeing, that's the invisible innovation. We are not seeing it; we can't look for where it is.
18:04So, some of my best friends are lawyers and it turns out a lot of my best friends are intellectual property lawyers. It turns out I can think of at least three, maybe four friends of mine who are in this world. They are the nicest people. I really mean they are good friends, not just people I happen to know who are IP lawyers. They of course, not surprisingly, think that intellectual property and the expansion of property rights into this area is very natural and crucial, and wonderful. They may be a little too close to the problem. And there are a lot of them. Are they an important special interest? Obviously Google, and large corporations generally, are going to want to discourage small firms from innovating. Are the legal experts who spend all their hours worrying about whether this intellectual property is accessible or not and at what price and negotiating it--they have a strong stake at keeping the world as it is. Are they discouraging the kind of innovations in this area that we might want to be seeing? In a way, though I wouldn't phrase it like that. They are nice people. Absolutely. Of course an IP lawyer very naturally wants to think of themselves as promoting innovation and when you take a partial equilibrium point of view, that's probably what they are doing. But I think you have to see it in the larger picture. And I would frame it like this: I think an incorrect framing and one which we see a lot, is that it's sort of consumers versus the producers of intellectual property. And the consumers want less intellectual property and the producers want more. I think that's a bad way of looking at it. Because when we come to these fields where there's a lot of cumulative innovation, where you are building on previous ideas, standing on the shoulders of giants, then what you have to recognize is that previous intellectual property has veto power on new intellectual property. And intellectual property has two sides. Yes, it's an incentive to innovate. But it's also a cost. When you are building on previous intellectual property, it's a cost of innovation. Patents can be a cost of innovation as well as an incentive for innovation. So, think about a product--if we have a product which requires four other patents to move ahead, build on four other patents--each one of those owners is going to say they want 30% of the profits. Then that's going to be a hard exchange to make. But when we have a hundred previous patents, each of them wants 10% of the profits, it's almost an impossible deal to make. Coasian bargaining is really hard when you've got lots and lots of these people. Just the pure transactions costs of tracking down the hundred and contacting them and opening the negotiating process. Exactly right. And so I think that when we look at the big picture, that's where innovation is going to be slowed down. And it's also where what we need to tell the innovators is not that this is a way of restricting your rights; it's a way of making innovation easier. It's a way of lowering the cost of innovation. It's a way so that you don't need the permission of everyone else to innovation. We want people to stand on the shoulders of giants. As I say in the book, Newton might not have seen so far had he been required to pay for the privilege. So, what we want to tell innovators is: Yes, go ahead and be the Newton, stand on the shoulders of giants, and you don't have to pay for that. We are all going to be able to see farther. It's an inspiring vision. One way to practically implement that is to change, as you suggest earlier, the timing, so not only do we get 20 years. Any other ideas? Would you stop some things from being patented at all? The remarkable thing is that the extension of patents to software and semi-conductors and business methods and the broadening of the interpretation of these patents has been almost all judge-driven. This is actually not legislation so much. It's judges. Judges have decided to interpret these patents in these broad ways. And they don't have to do that. The law hasn't actually changed that much. I talk a little in the book about Thomas Edison and the light bulb, and there actually was a previous patent. Sawyer and Mann had patented to make the incandescent filament. Any fibrous or textile material. And Edison came along, and he tried 5000 different materials before he hit on the one--it happened to be bamboo, and not just any bamboo but bamboo that he had dispatched a man to Japan to find the right bamboo. So he had gone through all of these different types of materials and yet Sawyer and Mann sued him and said: We have a patent on any fibrous material. And the court looked at that and they said, this is crazy. You can't give such a broad patent. Sawyer and Mann didn't actually investigate all 5000 of these. And if we were to give such a broad patent, this would actually discourage innovation. So, they said no to the Sawyer-Mann patent and let Edison go ahead. We could do more of that today. The trouble today is we have not done what the judges did in the Sawyer and Mann case. We've said: You can get a patent on any fibrous material, analogously in many other fields. We've given these broad patents. And that actually discourages people from doing the real work of implementing, of creating a product. Now you can just patent an idea. It's like a science fiction author can patent ideas; long before they are every even possible to be implemented you can patent the idea. Even before it's technologically possible. And that has actually discouraged innovation.
24:28Let's move on to education, which is the next broad theme of your book. You argue that the American education system, both K-12 and at the college levels, has got some serious problems. Let's talk about it. What's wrong with it? And of course, as a result, education is a key part of innovation and productivity. If you don't have a well-educated populace you are not going to have a very good economy. What's wrong with our education system? Let's talk about K-12. Here's two remarkable facts, which have just blown me away. Right now, in the United States, people 55-64 years old, they are more likely to have had a high school education than 25-34 year olds. Just a little bit, but they are more likely. So, you look everywhere in the world and what do you see? You see younger people having more education than older people. Not true in the United States. That is a shocking claim. Incredible. And the reason is that the drop-out rate has increased? Exactly. So, the high school dropout rate has increased. Now, 25% of males in the United States drop out of high school. And that's increased since the 1960s, even as the prospects for a high school dropout have gotten much worse. We've seen an increase, 21st century--25% of males not graduating high school. That's mind-boggling. Why? One of the underlying facts relating to education, which is [?], which is that the more education you get on average--and I'm going to talk about why on average can be very misleading--high school graduates do better than high school dropouts; people with some college do better than high school graduates; people graduating from college do better than people with some college; people with graduate degrees do better than college grads. And the differences are large. Particularly if you compare a college graduate to a high school dropout, there is an enormous difference. So, normally we would say: Well, this problem kind of solves itself. There's a natural incentive to stay in school, and I wouldn't worry about it. Why should we be worrying about it? It doesn't seem to be working. Why isn't it working and what could be done? I think there's a few problems. One is the quality of teachers I think has actually gone down. So I think that's a problem. This is a case of every silver lining has a cloud, or something like that, in that in 1970s about half of college-educated women became teachers. This is at a time when there's maybe 4% are getting an MBA, less than 10% are going to medical school, going to law school. These smart women, they are becoming teachers. Well, as we've opened up, by 1980 you've got 30% or so of the incoming class of MBAs, doctors, lawyers, are women. Which is great. Their comparative advantage, moving into these fields, productivity, and so forth. And yet that is meant that on average, the quality of teachers, the quality pool we are drawing from, has gone down in terms of their SAT levels and so forth. So, I think we need to fix that. Some conservatives are saying it's all the unions and we need to crush the unions. There's something to that. Maybe not crush them. Have them stand aside so that innovation can take place. You are much more politic than I. My point of view is that actually what we need to do is we need to pay teachers more. Now, we need to come up with a bargain, where if we are going to pay more, we need to test, we need to qualify, we need to make sure we are getting quality. We need higher standards. We do pay them more. We pay them a lot more than we did in 1960. But we did it in a way that didn't guarantee that we got better teachers. And you could argue we just didn't pay them enough more to compete with the alternatives. But I think it's worse than that. So, if we doubled all teacher salaries tomorrow, they wouldn't become better teachers. The challenge is: How do you encourage good teachers to be attracted to those higher wages and bad teachers to be rejected because they are not good enough? Right. We paid them more, though we paid them less compared to those other fields that I was talking about that women now have an opportunity to go into. So, it used to be a teacher and a lawyer, starting off on Day 1, having about the same salary. Today, on Day 1, the lawyer's got three times the salary. So, in terms of the opportunities, which are available to smart people, we make teaching a much less desirable place for smart people to be. I'm not sure how important that is. It's an interesting point. We've had a lot of podcasts on education. It just strikes me, if you think about K-12, a lot of K-somewhere--I'm not sure where that second number is--doesn't require the skills of a great MBA, legal, medical mind, a set of subtle, intangible skills that I am not sure are related to what it takes to be a great teacher. Maybe high school math, you need bright people; and we don't do a very good job of attracting math teachers. I think that's a problem. It's not obvious to me that the gray lining to that silver phenomenon of women going into more good-paying fields is a problem with our educational system, with the way we teach our kids. Well, I think it's one problem. I'm going to have to disagree with you a little bit on this point: I have two kids, and it's hard enough for me to manage 2 kids. The idea of managing 20 or 30 in a classroom, keeping them all interested and going forward and dealing with each one of their problems--I that's a really tough job. Oh, I think it's a very tough job! I just don't think IQ or the skills that make someone a successful doctor are necessarily means--I don't think we need to take the [?] medicine and keep them in the classroom. Right but those skills, they do have alternative uses. No doubt. And if those alternative uses are being paid highly, then in order to get those skills, we need to draw from them. Agreed. So one part of it is paying teachers more, but requiring more of these teachers as well. And the other part of it is that we have sort of pushed one yellow-brick road to education in our society. We have said: The only type of education that matters is the sit-down, sit-on-your-hands, sit quietly, pay attention, listen to the teacher, absorb what they are saying, go to college, do this for 12 to 14 to 16 years; and that is the type of success which we count. It's the only type of success which we count. And the goal of high school is to aspire to do that for another 4 years somewhere else. Harder classes, perhaps, but it's the same model. We need to listen to the dropouts, because the dropouts are telling us something important. Because, first, they are dropping out of high school; then a lot of the ones who make it to college even end up dropping out of college. So, this type of learning, hard for a college professor to understand, but some people think college is boring. Strangely enough! Or high school algebra. That's right. What we need to do is to think about other types of education. People think that the only type of education is schooling. And particularly college schooling. But there are other types of education. In Europe, here I think they've done a better job of creating more roads to a high school work force. So, in Germany and Finland and Switzerland, many of these other European countries, 40-70% of the kids in those countries opt for a high school program which involves some sort of apprenticeship, which involves some training. So, it's workplace learning, which combines theory with practice. The students get paid. They are acculturated into the adult world. We don't block off all these teenagers; we introduce them into the adult world. And we provide them with skills. And in the United States we think about these programs, vocational training, as like shop class. Being a mechanic. Right. But there's a lot more to it than that. Being an optician; there's a new field called megatronics--the old term for it is steam fittings, pipe fittings. But when you actually look at it it's massive operations control of how a modern factory actually works. So, these are high skill jobs; require a lot of intelligence, a lot of creativity. But we don't reward them.
34:03And to lead us into the college discussion: Of course, when we have aspects of our college education system that are useful for those activities, we have to gussy them up with intellectual bells and whistles and window dressing to make it feel like it's scholarly. There is obviously a lot of practical things you have to understand to run a factory, a warehouse. We teach some of those things in business schools. But business schools that just do that, would feel: That's just a trade. And so they'd feel they have to have this intellectual pretension if we are going to have them in the university. And the same thing is true with legal education. Every lawyer I've ever met says: I didn't learn anything about being a lawyer in law school. What you learn: the theory of law. It's like interesting. You pay, you have more years of student debt to pay for something that isn't very useful. It's interesting; maybe some people would like to pay more. But that's the only road. We don't have a lot of vocational training in business and legal professions and elsewhere in other activities in the universities. Outside the universities--I see the ads; I assume they are training people. But a lot of what we do in college is not exactly what people would find most useful. It's interesting. Exactly. We've divorced the world of work from college, and we've made college--I mean, it's a great experience. I look at my own university, our university, and we have two Olympic-sized swimming pools; we've got great athletic facilities; we've got restaurants and things on campus, and things like this. But it's totally divorced from the work world. Well let's turn to college now. You have some interesting observations on what's happened in college campuses educationally, particularly with respect to what people study. I find it very funny, because there's an enormous literature in economics where people look at the relationship between education and labor force outcomes--wages, compensation, salary. And the education variable that enters into the equation is inevitably years of schooling. It's like lifting weights. I lift 50 pounds, 100 pounds--so, 12 years of schooling is more than 10, which is more than 8. But of course in the data set are all these people who are studying radically different things, some of which guarantee you a very high-paying job from the beginning, followed by great appreciation; and others who have no employability whatsoever. It's a very strange model. So, talk about what's going on on the college campuses with respect to what people are studying. It's shocking, some of the numbers in your book. Yes, I was amazed when I looked into this data. So, we think about innovation and high tech, and computer science. Computers are exploding, the Internet is exploding. And yet we graduated more students in computer science 25 years ago than we do today. By a small amount. But it doesn't matter. The population is obviously radically larger today as a proportion. And the economy is bigger. And there are more computers. Exactly. And the same thing is true in mathematics and statistics, in chemical engineering; you look at all of the so-called stem fields, science and technology, engineering, mathematics, and we've stagnated. We are absolutely flat. What has grown? One of the things, just to give an example, is the visual and performing arts. We graduated more students in visual and performing arts than in computer science, chemical engineering, and microbiology combined. And we've doubled the number of students graduating in visual and performing arts over the past 25 years, at the same time as the stem fields have been absolutely flat. The vocations are way up. Part of that is because there are a lot more jobs than there used to be in some of those fields. Explosion of the media world in the United States has allowed people to maintain and study things that wouldn't have been very productive in the past. Absolutely. So, I think some of these things are good. I think some of the time we have sold students a bill of goods. So, we have doubled the number of students graduating in psychology, and yet in psychology there aren't as many jobs in the entire country in psychology as we graduate every year. Obviously what's going on there is people are interested in psychology; they want to learn about themselves; they see the college experience as an exploration of self and identity; people are between the ages of 18 and 21, that's a very attractive experience, and psychology seems like a good way to do that. It's not the hardest field. The grading is relatively easy, relative to those other fields we've been talking about. So, a lot of people study it. They don't expect to get a job as a psychologist. You might ask them: What are you expecting to get a job in? That's a good question. But that's what they are doing. College, compared to, say, 1950, where college was where people went to go out and find a job, college today is an extended form, for some people, of adolescence, an opportunity to find one's way in the world. It's a very expensive way to do it. But that's clearly part of what's going on. Yes, I think that's right. So, going back to all those athletic facilities and so forth--this is consumption good. There's no problem with a consumption good so long as you understand what you are buying. But also, it's the taxpayers who are subsidizing most of this education. On the grounds--by the way--there's economists who invoke this externality. How much of an externality if you go study--well, you pick it, basket-weaving? That's absolutely right. There's very little evidence for a positive externality from higher education. Very little evidence overall. If there is an argument to be made, I think the best argument is for the Science, Technology, Engineering, and Mathematics (STEM) fields. So, if we are going to subsidize college education, I would have us subsidize the fields where there are most likely to be these positive externalities. Can you imagine if we told students entering George Mason University and the other 50-plus great universities--we are being a little tough on the schools, but let's face this possibility--but if we tell people when they come in: You want to study psychology, that's $25,000. If you want to study engineering, that's $5000. That's going to be a tough sell to the body politic. Well, you are probably right. I guess maybe we do need some marketing managers to tell us about how best to sell this idea. Maybe we should sell it as a discount: If you are willing to study science, technology, and help your country, then you get a discount on your education. Actually, I think the externalities are small in general. I think the number of people who transform the world and add not just to American well-being but people around the world through their innovations is a very small number. The average graduate in the STEM fields is not doing that. So, I'd say the argument for subsidy, to start with, is small. And we ought to be using prizes and other activities--you mention prizes early in the book--but other ways to incentivize the most gifted people in our society to go into those STEM fields and transform them. Of course, we do know that the creative people instead of taking psychology do what Steve Jobs did and go to India for a few months. And that's not a bad thing to do, either. And of course, we talked about dropouts; there are a lot of great, wonderful contributors to the world who don't go to college and do all kinds of things, some of which are in the headlines, but a lot of which are just being a successful person in life. Being a good parent. There's not a lot--I don't think we should oversell the importance of a high salary or a high standard of living for a country; there's a lot of things going on all over the world that are not measured that are just as important.
42:56So, going back to the college though and talking about these STEM fields, one of the observations you are making, which I think is very important is the fact that college is not a solution in and of itself to people who worry about American competitiveness. And I think for special interest reasons, meaning people like us who are professors, and the middle class, who overwhelmingly benefit, not the poor, from the subsidies to college, there is always this groundswell of interest that the way we need to get out of our stagnation is: More people need to go to college. Well, what you and I are saying, what you are saying and I agree with you, is maybe too many people are going to college already. Or, if they are going, they ought to study something else. I think we need more education, but education is different than schooling. And that's the thing which I think most people are failing to see right now. So, other than hectoring people, and differential pricing schemes, what else might be done to make some of these deals more attractive? Do we need to do anything? They already pay more. One of the problems in the university itself is grade inflation, because grade inflation has hit the arts and the social sciences much more than it has hit mathematics and engineering and so forth. A lot of which are the gateway to medical school where they are going to weed out lots of people and they are going to use grades to do it. Exactly. So, if you want to be a lawyer, for whatever reason it is true that the best thing to do is to get straight As while you are in college, and if you have to do it by taking Intro to History, or Psychology or something like that, rather than Calculus 101, then that's the way to do it. Because in those history classes and so forth, you are much more likely to get that A. One thing we could do: If we could create a more even playing field in terms of grades. And there are ways of doing that. We could look, for example, statistically, and say: If this student got an A while they were in the history class and they got a C while they were in the math class, while this student got an A in the math class and a B in the history class, we can even those out and create an overall grade. But doesn't the market do that already? Do we really need to worry about that? Don't people understand that the grading is easier in psychology or history--I don't know if it is in history, but I've seen actual data on psychology and some of the other social sciences. Everybody knows that. It's not a secret. Why do we have to re-weight in some formal way? What's the big deal? I think it's surprising; I do think there's a puzzle here. I don't actually have the solution to this puzzle. But it is true that employers don't appear to pay as much attention as you and I would to what fields the students graduate with--with some exceptions of course. Either they find it too difficult to do, or they just look at where the person went to college. I do think there is a puzzle there, and I don't know what the answer is. Our colleague, Bryan Caplan, on our sister site EconLog often writes that there's very little value-added at all to education: it's all signaling; I don't care what you majored in so long as you got through, you showed the persistence; the only thing I'm paying for is either you got into the school, which is a filter for quality, and then you got out, because that meant you could do that weird thing called sit at the desk and write papers and take the tests, and that's got some value. Persistence and discipline. I'm not that cynical, but there is part of that there. I think the other part comes back to what you talked about earlier, which is the quality of high school education. If high school math is badly taught, high school science badly taught, you are going to not get those people when they leave high school excited about studying those fields in a more rigorous and intense way when they leave college; and I think that's part of the problem. Yes, that's a good point. If we could start at the bottom and improve people's education all the way along. A point I want to make about education, by the way, is: There's probably no other area where we can have as much as an opportunity to increase innovation and growth than in education. Think about it this way: Almost all U.S. workers will go through the U.S. education system. Not all, but almost all. So, think about if we improved our education system tomorrow. Well, at first we are only going to get a small gain because only the new workers will come in under the new system. But as we get more and more workers coming in under the improved system, that means that we have 100 million people educated a little bit better. We are talking about trillions of dollars of potential gains there. So there's no other place, bottleneck, where we can have as much influence on the U.S. economy or society as the U.S. education system, because it's where all of our workers are going to be channeled at some point, through that system. So a small change there means a big change over the next 40 years. That sounds good; I'm not sure that's true. A lot of what we learn in life, we don't learn in a classroom, and so I'm not sure how--I think there are many ways in which they will become more productive and skilled, and we figure those ways out. And we sometimes do that in spite of our education. And sometimes our education is what allows us to do it. I think it's fascinating--you think about your education and mine--we logged a lot of hours in the economics classroom as undergrads and graduate students. And we learned a lot there. We learned a huge amount. But I'm amazed at how much I've learned since then. You could argue that's what helped me learn how to learn. Certainly there was a basic framework there. But we're in a really narrow technical field. Somebody who goes through the standard K-12 educational system and then goes on to study, it doesn't matter what it is, in college--I just have a feeling a lot of what they learn comes afterwards anyway. Maybe we ought to be shortening the whole process and getting people out into the world at an earlier age. If they were mature enough. Maybe. I think there's some truth to that for college for sure. For K-12, I think it's going to be more important. I would say you are right--people like you and I who have alternative sources of education, our parents, family, friends, peer group. All of these things are working in our advantage. But for a lot of kids in high school, they don't have those other factors working in their advantage. So the one we can really move, the one lever we have, we need to do everything we can to shift that lever. I totally agree.
50:20Let's talk about government, writ large. You have a provocative idea in the book, that we need to get away from what you call the warfare-welfare state and toward a more innovative perspective in government's role. Talk about the warfare-welfare state and what you think we ought to be replacing it with. The warfare-welfare state is really what we have in the United States. If we look at where we are spending our money, a huge fraction is in warfare and in welfare. By welfare you mean transfer payments, not just aid to the family or something like that. You look at the big four: defense, social security, Medicare, Medicaid--these are 60-70% of the budget. And this is all about transfer payments, it's all about dividing the pie. It's not about growing the pie bigger so much. It's all warfare and welfare. We don't even think about innovation; that's often not even part of the agenda. The example I give is thinking about medical care, Obamacare. We had a huge debate over this. It was vociferous, people back and forth. Now, what do we know about medical care? Well, we know two things: one, that a huge amount of medical care is wasted. I think everybody on both the right and the left agree with this point. At a given point in time you can spend a lot or you can spend a little, and it just doesn't make much difference. Look at Steve Jobs, one of the wealthiest people in the world, but he gets cancer; his survival probabilities are not that much higher than if you or I got cancer. All of that wealth does very little in the final analysis. We are all going to die, so it doesn't do anything in the final analysis. But even a few years, doesn't get him so much. I don't think Robin Hanson believes that--we did do that podcast on the singularity. Cryogenics. I'll work with you on that. I'll go with you. The second thing we know is that even though spending more at any given time doesn't buy you that much, medical research actually seems to get you an awful lot. So, the life expectancy in the United States has been going up, a little bit every year; it's fantastic. Even if we look at the gains from cardiovascular survivability--that's actually worth trillions of dollars. The fact that people are living longer is worth trillions. Not all of that is due to research. Some are just eating better. But some of it is. So, we have a potential to have trillion-dollar improvements by thinking about innovation. And yet, did that come up over medical care, in the debate over Obamacare? No. It was all about how to divide the pie, all about is the pie being divided equally. Does everyone have equal access to medical care? When thinking about it in terms of an innovation framework, it's: how can we invest, research, and develop new things which are going to save our lives? Which are going to extend lifespan? And the opportunities there are tremendous. And yet you look at the budget for the National Institutes of Health (NIH), for the National Science Foundation (NSF), and we are talking about $30 billion or something--it's a very small amount compared to what we spend on warfare and welfare. So, some of my best friends work there too; they're great people; I have huge respect for them. Is that money well spent? You say it's only $30 billion; if it were $60 billion, you think we'd get more return? I think it's much better spent than a lot of other things we spend on. And I do like--so, you and I would certainly be in agreement that we wouldn't want to centrally plan a science in any way. But if we think about how the NIH and NSF work, I think that much more coheres with our kind of Hayekian way of doing things in that the money is not centrally planned. It's distributed by peers. So, people make proposals to the NSF, and the NSF gets a group of scientists and engineers and they decide: are we going to fund this or not? It's not perfect, a lot of problems. But the guy at the top is not making those decisions. It's a much more decentralized process. It's got a separate set of problems. There's groupthink, there's fads, there's people honoring their own work implicitly to people who cite them. A lot of problems with that. That's life. But the question is, somebody like Michael Milken, who got cancer and launched a very large effort to solve prostate cancer through--my understanding is through very innovative techniques, outside the box. Didn't go along with what the NIH was thinking. So, I wonder--this is not a presumption, I just don't have the data at my fingertips: the amount of privately spent medical research money dwarfs what the NIH spends. We spend an enormous amount. Now, people debate that's on marketing of new drugs or how much of it is just application rather than fundamental research, and that's a relevant issue. But we spend a lot of money on research and development (R&D) in America. Do you want more of it going through the government? Well, I would like to see the government budget shift from warfare and welfare to more on innovation. So, that's what I think we need to sell. That's a story that Americans intuitively understand. Americans are very forward thinking, very progressive people; they like science; they are interested in a better future, thinking about the future. So, I think we could sell an innovation state. And I'd much rather have an innovation state than to be bombing--Libya? I think Libya's over. Iran is next. You are behind the times. So, just to get people's mindset to change. One argument against that would be that one of the major initiatives of the Obama Administration has been the creation in the green area of environmentally friendly stuff, that led to some disastrous--the story hasn't fully unfolded yet, but Solyndra example where a rather large sum of money was lent to a company that wasn't a viable institution at the time and turned out not to be able to pay it back. Right, so that's exactly the type of centrally planned science which I'm not in favor of. So, that was money going to a specific company with a specific idea; and at the final stages. I think the case for investing in really basic science, at a much earlier stage, where it's open to many different people getting peer-reviewed, not centrally planned, basic science as well as from the universities. Let's get those STEM graduates into the universities, let's fund that a little bit more. That's where I think there is a case to be made. And again, STEM is Science, Technology, Engineering, and Mathematics. Are we in there? Economics? Is that part of the "E"? We are not. But we are STEMish. STEM-like. Among the social sciences, grade inflation is much less in economics. True.
58:26One thing you didn't talk about which surprised me is the venture capital industry. So, one thing that distinguishes America from much of the rest of the world is venture capital, and in all this debate about the 1%, one of the great things about the 1%, wherever they get it from, and we've talked here about some of the 1%--it's not the same people, not a fixed group--but some of the wealthiest people in America by making the world a better place, and some earn it by taking it from the rest of us through the political process. But either way, because they have large amounts of money, we have in America the opportunity for venture capital, where wealthy people steer money into new enterprises. And that's rare. It's not common around the world. It is a huge source of innovation in America, that often benefits people around the world, because a lot of the medical devices and innovations that are going on, technology in Silicon Valley, they are funded by people making a bet; if they make a bad bet they lose an enormous amount of money, if they make a good bet they make an enormous amount. I love that system, I think it works well. My suspicion, and this comes from conversations I've had with venture capitalists, is that we've hamstrung, we've handicapped that industry recently through regulations that weren't designed to affect it but of course ended up doing it perhaps unintentionally. Such as Sarbanes-Oxley. So, we've made it much harder for small firms to go public. Venture capitalists I've talked to say that's not an option. Everybody now tries to get bought out rather than going public on their own. You get bought out by somebody who has already incurred the fixed costs of Sarbanes-Oxley and the legal staff that does that, and that makes it harder. We've closed off a route to come up with new products and ideas. Yes, I think there's a lot of cases like that. I think about innovation as involving ideas, money, and markets. It's bringing all those three things together, which really matter. The venture capitalist part of the industry is an incredibly important aspect of that. On regulation more generally, I think we tend to evaluate regulations one by one: Is this a good idea, is this a good idea, is this a good idea? And yet a thousand pounds of feathers--each one of them is light, but the whole thing is still heavy. And you can have a lot of good regulations together with one bad, one heavy weight. I think this is a problem in our mindset. Michael Mandel has a nice metaphor. He says: These regulations are like throwing a pebble into the stream. One pebble does nothing. But you keep throwing more and more pebbles and pretty soon you block up the stream of innovation. And one of the big influences on my thinking has been Mancur Olson's Rise and Decline of Nations. What Mancur Olson talks about is this accretion of interest groups over time. Everyone is trying to divide that pie up more and more in their favor, and it slows down decision-making. It makes things more bureaucratic, committees in the small and in the large. Just look at what's going on in our politics. Look at something like the Hoover Dam. Let's put aside big government project for the moment. Could we even build the Hoover Dam today? Technologically, yes. But politically could we have the will to do it? There would be so many environmental groups, so many lawyers, so many state and local governments, so many veto players. We have so many players now who can say no, and almost no one who can say yes. The example I think is very telling in the book is how little innovation there is in airport creation in the United States. You can't build an airport in America; it's almost impossible. You can't build an overfly area. The costs are right not--it could be it's not productive enough; it's hard to believe. It should be extremely valuable. But it's clear there are a lot of costs, perhaps worthwhile. But your point is that the costs aren't worthwhile, aren't worth paying. Your point is that the nature of the costs are such that these interlocking aspects of it mean that the real cost is bigger than any one piece of it. Exactly. The real cost is getting all these groups together to an agreement, which is almost impossible. Just think about the infrastructure that we have. A huge amount of our infrastructure was built in the 1930s, 1940s, and 1950s, thinking about the interstate highway system and so forth. The infrastructure of our past to take us to the future. We need to build our own infrastructure and right now I don't even see us capable of doing that. I go to China and you see in China building going on everywhere--highways. And yes, I know, the highways are running through poor farmers' land. They are out of control, Alex. It could be a good thing we are not building our own infrastructure any more. We have too much of it already maybe. It's true they don't have any zoning laws, which I hate; nice conversation with Ryan Avent on how much these bureaucrat interlocking things keep innovation from happening--forget innovation--development is a simpler word here. That's right. But on the other hand, going to a world where a central cabal. It doesn't have to be public. Think about the Keystone Pipeline--you are not able to build that. So, there's a lot of private infrastructure which takes too long to build. We could build these airports privately, but it's just not possible. And here we have an increase in air traffic in the United States and this tiny bottleneck of airports where we cannot build another one. The last one that we built was Denver. Which was when? Like 1978 was the starting of that. It wasn't completed till many years later. I think it was a couple of weeks ago. So, people are still looking for their luggage. Meanwhile China is building 10-100 airports every year. That's not the way to take us to the 21st century. I somewhat agree. I think China, and Japan also--Keynesian zeal, they seem to like concrete a lot. So they are pouring a lot of concrete in those places, some of which is the people who pour the concrete or have a lot of friends.
1:05:17You make some recommendations at the end of the book, some of which we've touched on. Why don't you list them and just talk briefly about the ones we haven't talked about? Sure. So, we talked a lot about patents, and I think we just expanded our patent system too much. We need to prune back on patents to actually leave room for more growth. We need to pay teachers better and in return we need to demand better teachers, more accountability. And this means more charters, more vouchers, more private schools as well. A more competitive, flexible, and open system. We've pushed college as the totem, as the only way to be educated. It's one way of being schooled. It's not the only way of being educated. We need to think more about alternative ways of education, including apprenticeship programs and including focusing education more on the STEM fields. We didn't talk much about immigration. Perhaps because high-skilled immigration I think is such an obvious, such a completely clear thing to do, that it's shocking that we haven't done it already. It's literally easier to win the lottery than it is for a person of advanced and high skills to get a visa into the United States; and what I mean by that is we give out more visas in the lottery program--random allocation--than we do to these people of extraordinary ability. Now that's insane. How can you have a system like that, where you just randomly give out visas and there's more of them than you give to people of extraordinary ability? That's crazy. We need to cut back on regulation and we need to think about it as not simply thinking about regulation as each regulation comes up. We need to think about pebbles in the stream. We need to think about what happens when you accrete, what happens when these things build up. I would like to see us change our mindset from the warfare-welfare state towards innovation. I do believe that Americans are an innovative people. They are a forward-thinking people. They believe in making the pie bigger rather than in fighting over dividing the pie. So, I would like to see a politics which emphasizes innovation more than it does all these other things we've been talking about.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2011/12/tabarrok_on_inn.html. http://www.econtalk.org/archives/2011/12/tabarrok_on_inn.html http://www.econtalk.org/archives/2011/12/tabarrok_on_inn.html Alex Tabarrok Mon, 26 Dec 2011 06:30:00 -0500