Luigi Zingales on the Costs and Benefits of the Financial Sector
Feb 2 2015

Luigi Zingales of the University of Chicago talks with EconTalk host Russ Roberts on whether the financial sector is good for society and about the gap between how banks and bankers are perceived by the public vs. finance professors. Zingales discusses the costs and benefits of financial innovation, compares the finance sector to the health sector, and suggests how business education should talk about finance to create better behavior.

Explore audio highlights, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Aleksandar Maksimović
Feb 2 2015 at 8:50am

Mr. Roberts should invite Edward Krauss or Jeffrey Friedman, authors of the book ‘Engineering the financial crisis’. They pretty much demolish all of the arguments for the financial crisis touted in this episode, from agency problems to the ‘more capital requirements’ will solve everything solutions.

It is closer to the Austrian tradition with it’s emphasis on ignorance and radical uncertainty. Since Mr. Roberts quotes Hayek EVERY episode maybe he should familiarize himself with the book. Arnold Kling argues in the same vein, and frankly I find their arguments more persuasive than the usual public choice and/or moral hazard arguments.

John Roesink
Feb 2 2015 at 11:57am

This was a very enjoyable episode, but I have a nagging question about a central assumption seemingly shared by both Russ and Luigi. The statement that the financial sector is “trying to dupe people better” doesn’t seem consistent with other observations of the financial services industry or society at large. First, if the person selling an index fund is subject to luck in the markets, either positive or negative as was mentioned, why wouldn’t active fund managers be subject to the same effects of luck or timing, just with a higher standard deviation because of the choice of specific stocks or sectors or strategies instead of the averaging effects of an index? Does it necessarily follow that all money managers have the same nefarious goal?

Second, if the only purpose of the finance sector is to dupe investors, why are we still bringing them funds? If the bulk of investors are that naive, doesn’t that call in to question the wisdom of any market-based solution? Mark Perry, blogging on the much more serious subject of sexual assault on campus, has raised the point that if the true crime rate was anywhere near the rate being advertised by the White House (among others), would we still be sending our daughters off to college in ever increasing numbers? With the obvious parallel to putting precious things at risk, would we not be as inclined to protect our investments with as much vigilance as we are inclined to protect our families? The care of one naturally follows from the protection of the other. It seems the financial services sector would have dried up and blown away decades ago if the *sole* purpose was to part fools from their money.

Forgive me if this is painfully naive, as David Mamet said, if you don’t know who the mark is, it’s you. I’m a petroleum geologist and my only economic or finance education has come from listening to every EconTalk since I discovered it in 2008. I have some funds invested in indexes and I have some that are actively managed but I see benefits in both. I do work in a profession that is highly susceptible to the narrative fallacy and survivorship bias so maybe I have an innate tendency to support the money managers. That said, I hope Russ plans to do what he did with Page and Taleb and invite a guest from the industry to offer a counterpoint to the academic perspective.

Feb 3 2015 at 6:13am

This is a really nice episode!

Although I have taken classes in micro/macro/financial economics and understand the importance of the financial system, I see the present state of interaction between real and financial sectors as extremely inefficient.

Consider this simplified example of how a new product emerges: a group of theoretical scientists come up with a new concept, then a group of applied scientists make a new prototype using these ideas, then an entrepreneur with the help of financial sector and a group of engineers turns this prototype into a commercial product. (For a concrete example you can take the invention of the laser diode by Nobel Laureate Zhores Alferov, which later led to Blu-ray technology).

What is the distribution of income in this scheme: I think that theoretical scientists would earn the least amount of money, applied scientists and engineers would make a bit more, but the bulk of the profit from this new product would go to the entrepreneur and the financier.

For me it is not obvious why the value of the work done by a financier is much bigger than the value done by a scientist. That is why I totally agree with Luigi that there is some inefficiency in the market mechanism which leads to the overcompensation of the financial sector.
I think that Luigi and Russ beautifully discusse some of the phenomena which lead to the inefficiency of market forces in this case (complexity of the products, role of government, etc.).

That said, I don’t have a particular solution in mind. Of course, not bailing out those corrupt banks would certainly help.

Matěj Cepl
Feb 3 2015 at 8:16am

@John Reisink

I am afraid the reason is that we don’t have that much choices.

Which leads me to the issue which I am quite surprised nobody discusses at all (what am I missing?). As I understand the dim archaic past of something like thirty years ago, in a civilized country then (in that time I was growing up in the Communist Czechoslovakia, so no civilization for me), people took their excess money to their local bank and they got some reasonable interest on it. What I do remember is that when I was moving for our PhD studies to States in the year 2000 we got in the university FCU something like 4% p.a. on the savings account. Then the Internet Bubble burst, and of course rates went down to around 1% p.a., so I stopped bothering with savings account and I had to start to invest somewhere else. Meanwhile, we didn’t have enough money so investing stopped being interesting to me at all. However, looking around me now, I don’t see much change from those around-1%-pa times. Still the same FCU has today on 18month certificate rate 0.8% p.a. which kind of doesn’t make any sense to use.

Is it just me, but this is all result of politicians (BOTH Republicans and Democrats) swindling their way out of the economical situation by robbing not only future (by creating incredible loans … look at Greece to see where we are heading globally, IMHO) but also by stealing all savings by keeping the interest rate artificially low. It is funny to hear all those bankers to cry out for more loans, when they keep interest rate at 0%! Who in the world would loan a money, when a) they have none in the bank (because nobody saves anything), and b) the interest is so tiny, that it doesn’t make much sense to loan.

Am I completely wrong, or it is a big white elephant in the room which is constantly overlooked by everybody? Is there some show on EconTalk about this issue?

Am I right thinking that Mr. Greenspan, Bernanke, and Ms. Yellen wiped out consumer banking and small people savings? Why should I invest on the market myself? I would rather handed my money down to some specialist who would do it better than me (considering, I would get some reasonable interest back)?

What would actually happen if the central banks of whole world stopped meddling with the interest rate and let it stay at some higher level? Of course, the first reaction would be radical crash of the market, but if you stayed on this normal interest rate for longer time, wouldn’t the market accommodate and result would be a bit more healthy in total?

(blogged on as well)

Feb 4 2015 at 12:19am

I was surprised when Luigi said the simple but difficult solution is to “expose all the waste and abuse”. Would that be sufficient? Does he contradict himself? He starts out by saying that the public’s disapproval of finance is in danger of creating a vicious cycle of bad policies and more abuse. How would mere exposure not just feed the destructive cycle? Perhaps exposure needs to be paired with education on how valuable a properly functioning financial system is?

Also, Russ, if the corporate form of organization is so flawed because of the agency problem, are all those economic historians wrong about its benefits since the Dutch invented limited liability centuries ago? Is it only bad in the financial industry because of externalities or has the world economy been heading down the wrong path since the 17th century?

Feb 4 2015 at 4:33am

Another thing. Maybe I’m biased because I work in the belly of the beast–the financial industry–but doesn’t “regulatory capture” require not just an industry seeking rents, but a government powerful enough to collect and allocate rents? Luigi, aren’t you going to get crony capitalism as long as you have a powerful, indeed growing, regulatory state? Isn’t it easier though to attack industry than the impersonal, Leviathan state? It certainly seems to be more fashionable.

David Conell
Feb 4 2015 at 3:01pm

Russ: Regarding the topic of melding ethics directly into business at universities. I had heard elsewhere that Mormons disproportionately have business vocations. Want to meld ethics? Then enhance the status of an MBA from BYU

Feb 4 2015 at 4:38pm

I’ve only recently found Econtalk and am very grateful for it. Russ does a great job interviewing interesting people. I hope to learn much during hours of future enjoyment listening. That said, I hope others here will not find my negative comments unacceptable.

Dr. Russ Roberts asks Dr. Luigi Zingales “Is the financial sector good for society?” Luigi and a majority of academia say yes. The majority of the public (unsophisticated) says no. Dr. Zingales suggests that education would convince the public to change their opinion. I’m one of the unsophisticated public with no formal training in either economics or finance and I agree with my peers of the stronger opinions that the financial industry is a positive evil. Unfortunately I don’t think education will work, not with most of my friends nor with me – we are too firmly biased already. I recall reading in the WSJ and The Economist, for several years after 2007, articles saying that a big problem was that the CDO’s and CDS’s were not understood by their buyers (big investors) and sellers (banks). I also remember reading, in the WSJ I think, that Ben Bernanke was the inventor of these two financial innovations.

The benefits of finance were stated as a)To smooth risk, to put multiple eggs in your basket, kinds of eggs, b) as an arbitrage argument, that finance helps get the prices right, (Hayek), and c) to match talent with money, i.e. to loan money to innovators.
But for c) the central bank’s policies are constricting the flow of credit to small and new businesses. The big and politically connected get loans; everyone else is on short rations. The Federal Reserve has been open about these trickle-down policies: If financial markets expand enough, rich consumers will spend more in response to the “wealth effect,” which in turn will spur a broader recovery.

Credit has flowed disproportionately to the federal government at suppressed rates of interest. Worse, the Fed gobbled up long-term Treasurys and government-guaranteed mortgages (its purchase of packages of these instruments is also a form of credit allocation). In addition to suppressing the price of money, this vacuuming of ultrasafe bonds distorted credit markets. Financial companies and others need such securities to meet their obligations; whole life insurance policies, for instance, have guarantees. This is why there’s been an insatiable demand for corporate bonds, including junk. I’ve read that this has reduced the supply of credit to non-big business and consumers; plentiful reserves are useless to the economy if they can’t be leveraged into new loans. Compounding the propensity to not lend is regulatory intrusiveness.

Clearly the Fed and Banks have captured the Gov’t and the Gov’t had already captured the Fed and Banks. This situation has created the swinging doors of Gov’t and Banks and full-scale Crony Capitalism. It’s really disgusting and makes the public very, very angry. We break out in fits of Occupying and Tea Party marching.

Keynesians believe that money controls the economy. Not to my knowledge. Classical economists understood that money represents the production of services and products. The idea that manipulating money can magically generate a genuine and durable economic prosperity is as wacky as believing that manipulating the number of parking tickets at an event influences the number of cars that will be manufactured. What this causes is a separation of Wall Street and Main Street and lots of shakiness (risk) in the both. Yet the Federal Reserve believes that what it’s done over the past five years has been a success, not a primary cause of economic stagnation and growing government/bank business cronyism.

These profits from their innovations are being taken from the real economy, all our futures, Main Street, the middle class, the small businesses. So many have now already failed and the middle-sized businesses are certainly feeling the pinch. It’s notable that the ‘hokey stick’ graph of our Federal Debt begins its great increase after 1971, when we went off the last of the gold standard. I used to wish to return to the Volker-rule time. Now I think it’s necessary to return to a full gold standard. And I hope I’m wrong. It will not happen easily or by choice.

Russ Roberts
Feb 5 2015 at 12:11am

John Roesink,

I may have given a false impression about what I think of finance. I don’t think the entire industry is a bunch of crooks and charlatans duping their investors. Not at all.

What interests me are the distortions of the natural feedback loops that would reduce opportunism or imprudence. An investment bank like Bear Stearns that borrowed enormous sums of money and invested it in what turned out to be very risky assets would normally have lost all of that money for its creditors. The government stepped in and most those creditors whole–they lost nothing. That encourages imprudence. People who had lent money to Lehman Brothers which had a similar balance sheet to Bear Stearns would normally have been greatly alarmed by the collapse of Bear Stearns. But they showed very little concern. Lehman continued to be able to borrow money. That may be because their creditors were oblivious. I think not. I think their natural caution was blunted by the rescue of Bear Stearns’s creditors.

Russ Roberts
Feb 5 2015 at 12:17am


Welcome to EconTalk. Nice to have you with us. We’ve done dozens of episodes on these issues from all kinds of different perspectives. Check out the Financial Crisis of 2008 in the archives.

I appreciate your comments. I actually think that Luigi Zingales is on your side. Check out his paper linked above. He is arguing that the public is on to something and that the academics are blind to some of the consequences of financial innovation.

I have many complaints as you do about Ben Bernanke. But you cannot blame for any financial innovations. His mistakes are elsewhere.

Shayne Cook
Feb 5 2015 at 7:56am

First, thank you Russ and Luigi for another very interesting podcast.

And Russ, thank you most of all for your explanation to John Roesink above. I agree with you completely.

The ‘quibble’ I have with your discussion with Dr. Zingales (and other discussions on this topic) is the emphasis you place on “blaming” prominent actors in the financial sector, while leaving the glaring and most detrimental “problem” and associated actors relatively untouched. I’m referring to the exact same governmental (Fed and Treasury) “stepping in” that you refer to in your explanation to John Roesink. And I completely agree that it had the “natural caution” blunting effect you note. But that natural caution blunting effect did NOT just affect Wall Street.

It blunted “natural caution” in nearly every single aspect of U.S. economic flows, including those of State and local governments, industries (most prominently the auto and insurance industries) and many individuals.

The governmental “stepping in” that you referred to was an act of allowing many economic actors – not just those select few on Wall Street – to never be exposed to pre-existing contracts and bankruptcy law – writ large.

I think you’ll agree that the basis of “natural caution” is naturally going to be governed by pre-existing knowledge of THE LAW.

When THE LAW is so blatantly and grossly and purposefully undermined and ignored – and completely replaced by THE JUDGEMENT of MEN (“governors”, as a matter of fact), as it was in 2008, the basis for “natural caution” for all economic actors changes dramatically.

I would argue that no amount of regulation, monitoring, systemic design or legal structure is going to be effective – in any industry – as long as the “governors” are so willing and eager to usurp it all.

The real perpetrators of the mess are not on Wall Street.

Russ Roberts
Feb 5 2015 at 12:12pm

Shayne Cook,

You know that I agree with you that government policies are at the root of many problems related to the financial sector. Unfortunately, the financial sector spends a great deal of effort, time, and money influencing those policies. The system as it is currently constituted encourages misbehavior on both sides of the public private fence. Malfeasance of various kinds by both sides is rational and understandable. But that doesn’t make it right. I find both sides objectionable while understanding that they have incentives to do what they do. If we want the world going forward to be different from how it is now, we need to change those incentives either through culture or the ballot box.

Feb 5 2015 at 2:06pm

I think a more interesting question is: Does debt increase utility on net?
I can think of 2 good uses for debt:
1. Move some consumption to earlier in life when people tend to have less income.
2. Help some new more efficient business grow faster.

Shayne Cook
Feb 5 2015 at 2:51pm


I suspect you and I agree more than we disagree. Again, my ‘quibble’ is that you seem to single out the financial sector. It is true the financial sector spends a great deal of effort, time, and money to influence government policy. The same can be said of every other industry, special interest group, trade association, trade union and individual. The act of voting in a general election is an individual act of attempting to influence government policy. That phenomena is ubiquitous and immutable – why single out only that one constituent of the economy for constant vilification?

Russ, I am not trying to convince you of anything. My original comment was to attempt to convince folks like commenter ‘Warren’, above – the folks who are convinced the U.S. financial sector and financial system are “evil” – that the “evil” isn’t where he (or you) thinks it is.

As a self-governed nation, we are all entitled to influence government policy. And the result, also ubiquitous and immutable, is going to be some combination of good and bad policies. But even the worst of the bad government policies are nowhere near as “evil” as the best of the good government policies that are only arbitrarily and selectively enforced.

And that “evil” lies not in the goodness or badness of laws or policies. It lies in the nation ceasing to be self-governed, when law is usurped by arbitrary whim of the ‘governors’.

Sri Hari
Feb 5 2015 at 10:05pm

Another informative podcast.
Several issues discussed, especially fraud in finance sector, bears similarities to the podcast with William Black, done perhaps 18 months ago.
Zingales remotely debates the issues of fraud, whereas Black had produced a detailed account of how it was managed. With criminal sanctions against false underwriting progressively removed, to call any of the actions of finance sector fraudulent may not be accurate.
Imploring to the sense of moral obligation of executives in finance industry sounded very laughable. Morality is first thing that is lost when millions of dollars can be earned by not being moral.
Bring back the criminal sanctions on dishonest underwriting, control executive pay by linking it to the total capital employed rather than the sliver of equity and raise the equity of all lending institutions to 40%. The vested interests within the finance industry is well entrenched in the political system, for these measures to be ever put into practice.

Michael Byrnes
Feb 6 2015 at 7:01am

Sri Hari wrote:

“Bring back the criminal sanctions on dishonest underwriting, control executive pay by linking it to the total capital employed rather than the sliver of equity and raise the equity of all lending institutions to 40%.”

In my ideal world, executive pay would be linked to executive skin in the game. The Jimmy Caynes and the Dick Fulds of the world walked away from their oversight of a financial disaster with hundreds of millions of dollars of wealth. That is proof enough for me that they were overpaid. Sure, they were left with a tiny fraction of what they would have had without a crisis, but that tiny fraction was enough to protect them from the worst consequences of their own failures. That’s too much. Had they had all of their personal wealth on the line, I believe they (and many others) would have acted differently. To me, that – responsibility – should be the “price” of these massive executive level compensation packages.

Feb 6 2015 at 6:59pm

@ Dr. Russ Roberts

Thank you for you kind welcome and for your advice to read “Does Finance Benefit Society?” You are correct, I agree with Dr. Zingales completely. Next time I’ll read the paper first. And yes, Bernanke is innocent of these two inventions. Pity! Blythe Masters at JP Morgan invented CDS’s; Michael Milken, then at Drexel Burnhan Lambert, invented CDO’s in the late 1980s; and Christopher Ricciardi, at Prudential Securities, issued the first CDO as we know them today in 1999. The internet told me all this. Don’t they get copyrights or patents on these innovative works?

@ Shayne Cook

I share your frustration when not hearing the Gov’t blamed as a source of our problems. I did say “the Gov’t had already captured the Fed and Banks”, and this in spite of their trying to convince us that the Federal Reserve System are private banks and therefore not under their control (unlike the First and Second Bank of the United States, which failed spectacularly). But my comments are in response to a talk about the Financial Sector so I do try to limit the scope of my expressed anger.

Shayne Cook
Feb 7 2015 at 8:36am


That’s a fair explanation, and I appreciate it. And as with Russ, I suspect we probably agree to a greater extent than we disagree. Most significantly, I not only appreciate that you and many others are both angry and resentful in the aftermath of 2008. I can assure you I am just as angry and resentful, and fearful as a result of the events of 2008 – only for different reasons.

But I would argue that you are wrong in at least one respect – this was NOT just a “talk about the Financial Sector”. Referring to the very beginning of this podcast, Dr. Zingales says …

Once the public at large is resentful about the financial system, the rule of law is at risk. And when the rule of law is at risk, finance starts to work not so well.

Please read that first sentence over again – it contains part of the essence of the inseparability of the financial industry and the rule of law. In fact, NO industry or sector can be considered separated from the rule of law.

Dr. Zingales obviously has a grasp of the relationship between the financial sector and rule of law. But in that first sentence, he demonstrates to me (at least) that he has cause and effect exactly backwards. It is precisely the fact that rule of law was selectively abandoned and usurped in 2008 that drives my anger and resentment – and fear. The fact that elements of the financial sector (and the auto industry, and the insurance industry, and a sub-set of borrowers/alleged “victims”, etc.) were apparent “beneficiaries of the bailout” is entirely irrelevant.

What is relevant – and critical – is that the bailout, while exempting those “beneficiaries” from the penalties of the rule of law, simultaneously EXEMPTED ALL OF THE REST OF US FROM THE PROTECTIONS OF THE RULE OF LAW!

Referring to the second sentence in the Zingales quote above, I would argue that not only the financial system, but every single aspect and constituent of the economy is in grave peril when the rule of law is at risk. But it is NOT the scope or responsibility of the financial sector, or any other industry for that matter, to create and enforce rule of law. I, and you, elect and hire public servants to do that. And it was they, and they alone, who failed miserably in 2008 and subsequent.

I would strongly encourage you and others NOT to “limit the scope of your expressed anger”, and resentment – and fear.

Michiel van Wezel
Feb 8 2015 at 2:17pm

In machine learning and statistics there is a concept called type 1 errors and type 2 errors, a.k.a. false positives and false negatives.

The financial system should generate credit, needed for economic growth and innovation. While doing so, both type 1 errors (a credit is given to an entrepreneur that does not pay back) as well as type 2 errors (a credit is NOT given to an entrepreneur that would have paid back) should be avoided. There is a trade-off to be made here and one can question whether this is currently done in an optimal way. (I.e. in europe there is a shortage of credit for innovation.)

Furthermore, the financial system should generate credit at minimal cost. Currently, the share of the financial sector in the economy is approximately 9% *), which seems like a lot for essentially just the credit allocation problem. If, as a thought experiment, we would replace the financial sector by a PC that is programmed to allocate credit with minimal type1 and type2 error, this PC would run at zero cost. Hence, if the damage to the economy caused by using the PC rather than the financial sector is below 9%, the direct overall effect would be positive. As a secondary effect, it would free resources now taken up by the financial sector, so that they can add value directly.

( *) See

Feb 8 2015 at 6:06pm

I didn’t really understand how when the government got involved in the interest rates of payday loans, the supply went up. I suspect there was some other friction that legislation cleared up in the process rather than that specific mandate.

Feb 10 2015 at 3:38pm

It’s funny you bring up payday loans. My issue with payday loans actually regards what they tend to facilitate, namely: buying drugs. This tends to lead many people to financial problems, and is often a determinant factor of the cause of bankruptcy. Just ask bankruptcy attorneys.

Also, my problems with the financial sector tend to almost exclusively revolve around what they do to our social fabric. They ruin dreams of young people by luring them with easy credit and makes them put off their futures, and ruins their credit. The finance sector also sucks a lot of money out of our economy so that an army of 144,000 people? can harass people into paying their bills. And the billionaire class are often the beneficiaries of this ‘slave labor’, for lack of a better term. It’s practically feudalistic in my eyes.

That’s my personal quibble with the sector. There are obviously other problems, but these are my own.

Paul Spring
Feb 10 2015 at 10:47pm

As usual I am baffled. Clearly the financial sector has become a bloated tumor of its original design. It deals in nothing tangible and can effect huge and devastating changes with no human or machine effort involved. Nothing created. How can anyone claim there is value to this monstrous casino?

As far as blunted signaling is concerned, the problem I see with Hayekian thinking is that the temporal element is totally ignored. Yes, things may eventually stabilize to some equilibrium but 1) is that equilibrium beneficial for society as a whole and 2) is the pain and suffering caused by the reckless thrashing of market signals – suffering that can last a significant portion of one’s lifetime – worth the price? Not in my book.

Russ Roberts
Feb 12 2015 at 8:27am

Paul Spring,

My view is that the “monstrous casino” has come about because of a failure to let prices and profit and loss do their thing–encourage prudence and punish recklessness. The government backstop of creditors is what makes the casino monstrous. More here.

Feb 14 2015 at 10:51pm

I enjoy your podcasts and your guests very much.

Russ you normally do a decent job of stating your basis. But something jumped out at me in this episode related to health.

Luigi presented an incredible simple statistic that a controlled look at various countries health expenditures and the resulting increase in lifespans showed that every year the USA continues to get less bang for its buck then other countries. He made the simple statement that this indicated that the USA health care system was less efficient.

Why did you contort yourself so much to walk backwards from that statement? The measure was so broad and simplified that it is very hard to dispute. Why not instead have eyes open with no fear and accept the fact?

Just because you might have to accept the fact that the USA does NOT have the “best health care in the world” does not mean you have have to abandon your belief and trust in markets. I think a more appropriate response could have been that American’s are willing to accept that inefficiency in the name of economic liberty and freedom. Or even that Americans prefer to spend lots of money on things that improve their quality of life while not extending its duration.

Not trying to beat you up to bad, but this type of knee jerk patriotism or ideology peeks out in many podcasts. Maybe I do not understand it because I am not an American and was not bathed in the culture from an early age.

I am sure we all have our moments when an ideological belief sneaks out and trumps our evidence based nature. I hope someone points it out to me when I do it.

Perhaps a morning chat would help quell the urge:
“The USA is my favorite country”
“It is not the greatest country”
“We do much well”
“We do much badly”
“Just like everyone else”

Ron Crossland
Feb 16 2015 at 2:33pm

This comment in no way supports or protests the 2008 bailout, but is presented as a thought experiment for a future podcast.

What if the political process during 2007 and 2008 had allowed the investment firms to fail that had unwisely overextended themselves in risky finances? Further, what if we prosecuted the bad guys we could? And finally what if we had not used any Fed stimulus injection?

I know this may be a tall and complicated counterfactual to contemplate, but many of the complaints I hear about how things have gone is that the government shouldn’t have stepped in, the big banks should have failed, and the bad guys should have been prosecuted. If all these things had happened can we construct a reasonable explanation of what might have happened, since we know what happened in Europe and other financial regions of the world. And if these actions had been taken would it have eased our contempt for the financial sector?

Not sure who to nominate for this idea, but it would make for an interesting podcast.

Ron Crossland
Feb 16 2015 at 2:48pm

For over 20 years I have been a leadership development consultant to mostly large US companies. Part of my repetoire has been teaching ethical/values based decisioning in the business space.

Two trends I’ve observed seem to complement Luigi’s observations. One is that over time there has been less interest in this material because middle to senior managers want to leave such issues defacto to legal. What’s ethical isn’t interesting – only what is illegal.

The second trend is that holder’s of MBAs are continually counted among the least trustworthy of all degreed individuals due to the perception that financial outcomes are the only ones that matter.

I would argue, Russ, that a year or two of liberal arts education – comparative applied philosophy/economics/history of business, science, how to communicate beyond reading sides, and aesthetic appreciation before continued study in any discipline might do the world some good.

But I doubt this would pass the Texas Board of Education’s sensibilities.

Feb 25 2015 at 3:34am

This episode brought me to a small realization about what’s been going wrong. The financial sector has the same “concentration of power” problem as with “Big Government”: it’s more effective to spend money on manipulating the system, than on actually competing.

Partly, it’s like robbing banks because “that’s where the money is”, or going into politics because that’s where the power is. If a smart person wants to accumulate a lot of money with a minimum of effort, the best place to do it will be the financial sector.

But more than that, if you’ve ever played a game (board game, computer game, role-playing game) where there’s an important statistic (a number, measure, score, whatever) that can be used to increase its own value, and which also has effects on the rest of the system, you’ll recognize that there can be a problem if there’s a feedback loop that allows players to arbitrarily increase that statistic. It’s like when someone plays Card X that gives them a bonus and an extra turn, and then the player uses that extra turn to play Card X again, giving them another bonus and another extra turn, which allows them to play Card X again… That seems a lot like what the financial system enables.

Brian Scott
Feb 26 2015 at 11:44am

Thank you as usual for your always stimulating and enjoyable broadcasts. I have two comments on this episode:
1. When a non-native English speaker is combined with an imperfect phone line, I find it difficult at times to make out what is being said. Sometimes I rely on your summary or comment, Russ, to enable me to continue to follow the argument. Don’t forget that the quality of the sound is also degraded by (a) being downloaded on to an MP3, and then, as with me, listened to while driving with the accompanying noise of traffic. I’d be grateful if your sound engineer could ensure the best possible telephone line and sound.
2. In your discussion of comparative health spending versus health outcomes in the US and other rich countries, I was surprised that there was no discussion of the likely impact of the unequal distribution of health spending amongst the respective populations. The US privately dominated health care system, however efficient or inefficient, largely omits millions of Americans lacking health insurance, whilst the UK, for example, has a national health system free to all at the point of delivery. This suggests that low income people in the UK have better access to better, more expensive health care than similar elements of the US population.

Thanks again for very enjoyable programmes.

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

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